Insurance Contract Liabilities Under IFRS 17

Approach to Policy Reserves

While the new IFRS 17 standard as released changed a few details and added a few wrinkles compared to the previous drafts, the fundamental approach to the basic calculations of the policy reserve at a reporting date is much as expected. The final standard describes a general model of calculating a policy reserve from three main components but no longer refers to this model as "The Building Block Approach" as earlier materials did. These components are described below along with a brief commentary on expected challenges and complexities in supporting them:

  1. Fulfilment Cash Flows
    The term Fulfilment Cash Flows (FCF) has been introduced to refer to the sum of three separate components:
    a) Unbiased probability-weighted estimates of future cash flows;
    b) The application of discount rates to these future cash flows to obtain a net present value
    c) A Risk Adjustment (RA) for non-financial (i.e. insurance) risks, that compensates the insurer for bearing these risks

  2. The Contractual Service Margin
    One of the stated objectives of IFRS 17 is to ensure that profits are recognized as services are provided and not at the sale or issue of the contract. The Contractual Service Margin is the mechanism that achieves the capitalization and deferral of unearned profits for the insurance products in force. In the normal case of a profitable portfolio, the initial value of the CSM is calculated as the negative of the FCF at initial recognition, which thus assures there is no profit reported from the sale of the business. However, if the business is onerous at issue (premiums less than the expected benefit and expense costs), the resulting FCF is established as a positive liability with the resulting loss charged to the P&L.

Fulfilment Cash Flows in AXIS

The projection and present value estimates of future cash flows portion of the FCF is readily handled in AXIS by the Policy Premium reserve methodology with an appropriate discount rate as described in the standard. The discount rate for the FCF calculation is not determined based on the assets actually held by the company to back the liabilities but is independently established based on current estimates of market rates at the reporting date which reflect the time value of money, the characteristics of the cash flows and the liquidity characteristics of the insurance contracts.

The methodology for the Risk Adjustment calculation however is not prescribed by the IFRS 17 standard and discussions with clients and industry will be needed to clearly define the various possible approaches and determine if any additional AXIS features are needed. Earlier discussion papers identified three likely approaches:

  1. The Cost of Capital Approach (COC)
    This method of adding margin to a reserve involves projecting an estimated solvency capital requirement over the duration of the business and discounting the projected costs at an appropriate set of discount rates. AXIS already supports a COC approach to reserve margins for many products.

  2. Tail Value at Risk (TVaR) and Value at Risk (VaR) Approaches
    Both the TVaR and VaR approaches involve projecting the expected distribution of losses and determining a metric from that distribution with a specified confidence level. For example, the TVaR or Conditional Tail Expectation (CTE) metric is defined as the average of the selected percentage of the tail scenarios from a stochastically generated loss distribution.

    While AXIS can perform stochastic calculations and calculate both VaR and TVaR metrics directly, these typically require complex and resource intensive Monte Carlo simulations. It is unlikely that such complexity is justifiable or practical every reporting cycle and accordingly a proxy method will be needed to estimate an equivalent measure deterministically for the purposes of RA calculations on a given portfolio of business. It is not yet known what proxies will be acceptable.

  3. Explicit Assumption Margins
    Current Canadian GAAP practice requires an explicit margin be added for each assumption entering the calculation of policy liabilities and is readily supported in AXIS. Earlier papers and recent discussions of possible RA methodologies indicate that setting explicit margins on each non-financial assumption would be an acceptable method provided the margins are calibrated to an equivalent "confidence level" as specified in the standard. How this would be done is not clear.

Contractual Service Margin (CSM)

The CSM as described above is fairly simple to determine as of the issue date, and the components of the roll forward of the CSM are outlined clearly in the published standard. However, there are some unresolved questions about how the CSM roll forward components will be calculated in practice, and these issues will hopefully be clarified by industry discussion or new professional guidance.

There are also some fundamental challenges in supporting certain aspects of the CSM calculations:

  1. Managing CSM Calculations at a Group Level
    IFRS 17 requires the reporting entity to identify portfolios of insurance contracts, which are subject to similar risks and managed together. Portfolios must be further divided into groups of contracts, according to issue periods and expected profitability at outset. The CSM is recognized initially for each defined group of contracts and must be tracked forward in time for that group as a whole, separately from all other groups.

    CSM Groups cannot include policies issued more than 12 months apart and once allocated contracts must remain with their original groups until they are derecognized.

    AXIS will be enhanced to enable CSM calculations to be performed at the CSM Group level even when member policies or benefits under policies need to be modeled in different modules of AXIS. However, the process of allocating policies to appropriate CSM groups will probably need to be performed prior to its initial recognition at a reporting date, and provided to AXIS as an input item.

  2. Reflecting required inputs to the CSM Roll Forward
    The calculation of the CSM balance for a group of contracts at a reporting date will require the input of several new data elements:
    a) The previously reported CSM balance or cumulative reported loss for that group
    b) The locked in discount rates established when the group was recognized
    c) The impact of non-financial experience gains in the current period
    d) The impact of non-financial assumption changes on the FCF over the period
    e) The rate of amortization of the CSM balance into revenue based on the current actual and projected future delivery of insurance services

    Some of these elements will depend on projections of the cash flows and other elements of the underlying policies under multiple sets of assumptions. The support of the CSM calculations therefore will require the ability to track a variety of assumptions, at both at contract and group levels, and consolidate calculations of projected items from the model point level up to the appropriate CSM group level. As CSM balances are updated for a reporting date for all defined groups, they must also be retained to help drive the subsequent period's CSM roll forward.

    AXIS will be enhanced to handle the CSM calculations as they become more clearly defined, passing up components based on the seriatim projections, and reflecting the required assumptions. The Assumption Set changes to liability Cells introduced in AXIS in 2016 will greatly facilitate the management and usage of the multiple sets of assumptions involved in IFRS 17.

Further technical discussions relating to the detailed implications of IFRS 17 and how Moody's Analytics is addressing its challenges will continue to be developed and communicated to all of our clients.