Identifying and measuring the components of an insurance contract
Last month, we looked at when insurance contracts are recognised (Booking insurance contracts – It’s all in the timing). This month, we look at how an entity would account for any non-insurance components contained within an insurance contract.
Accounting for non-insurance components of an insurance contract
It is not uncommon to find an insurance contract contains one (or more) components that are not in the nature of insurance coverage. For instance, some life insurance products (sometimes referred to as ‘whole life insurance’) include an arrangement whereby the insurer invests a part of the premiums in a savings account on behalf of the policyholder, the balance of which is provided to the policyholder in the event that the insured event occurs or the policyholder surrenders (cancels) the insurance policy. As the resulting balance of the savings account is not necessarily dependent on the insured event, from the insurer’s perspective, it is in the nature of a financial liability rather than an insurance contract.
When confronted with an arrangement that comprises two or more identifiable and distinct components, International Financial Reporting Standards (IFRS) and Australian Accounting Standards (AAS) typically require the issuer of the product to account for each of the components separately, as if each component was a stand-alone arrangement. In some cases, however, IFRS and AAS might permit or require two or more components to be accounted for as a single component for practical reasons, such as:
- It may be difficult to reliably attribute cash flows to the individual components because the components are rarely or never sold separately, and/or
- Comparable reporting results can be achieved, particularly where the cash flows of the individual components are interrelated, by the issuer of the product accounting for multiple components together using a single measurement model.
Unsurprisingly, IFRS 17 Insurance Contracts requires insurers apply a similar approach to insurance contracts with non-insurance components.
Separating insurance and investment components
When an insurer issues an insurance contract that requires the insurer to provide the policyholder with both:
- Insurance contract services – insurance coverage plus, if applicable, services related to managing a clearly identified pool of assets that the policyholder will share in along with other policyholders, and
- An investment component – the right to a lump sum (which may reflect a fixed or variable return), irrespective of whether the insured event occurs,
IFRS 17 requires that the insurer separately account for the investment component if, and only if, that investment component is ‘distinct’.
An investment component is distinct
if, and only if, both of the following conditions are met:
- The investment component and the insurance component are not highly interrelated, and
- A contract with equivalent terms is sold, or could be sold, separately at least in the same jurisdiction.
An investment component and an insurance component are highly interrelated if, and only if:
- The insurer is unable to measure one component without considering the other component. For instance, when the value of one component changes in direct response to a change in the other component, or
- The policyholder is unable to benefit from one component unless the other component is also present. For instance, if the lapse or maturity of one component would cause the lapse or maturity of the other component, this would suggest the two components are highly interrelated.
Otherwise, the investment component and the insurance component would not be considered highly interrelated.
The following example is based on Example 4 of the Illustrative Examples to IFRS 17, and demonstrates how an entity would apply the foregoing criteria for separating insurance and investment components.
Example 1 - Separating components from a life insurance contract with an account balance
Entity Z issues a life insurance contract with an account balance and receives a once-off premium of $1,000 when the contract is issued. The contract promises to pay the following:
- A death benefit of $5,000 plus the amount of the account balance - if the insured passes away during the coverage period, or
- The account balance - if the contract is cancelled.
The account balance is increased annually by voluntary amounts paid by the policyholder, increased or decreased by amounts calculated using the returns from specified assets, and decreased by fees charged by the entity (there are no surrender charges).
Entity Z has an insurance claims processing department to process insurance claims received, and a separate asset management department that manages and reports on investments. In addition, an investment product with equivalent terms to the account balance offered by Entity Z, but without any insurance coverage, is sold by another financial institution operating in the same jurisdiction as Entity Z.
Separating the account balance
The existence of an investment product with equivalent terms being sold in the same jurisdiction indicates that the components may be distinct.
However, if the right to death benefits provided by the insurance coverage either lapses or matures at the same time as the account balance, the insurance and investment components are highly interrelated and are therefore not distinct. Consequently, the account balance would not be separated from the insurance contract and would be accounted for under IFRS 17.
Separating other components from insurance and investment components
Insurance contracts might also comprise components in addition to, or instead of, an investment component. In such circumstances, the insurer is required to:
- Apply the relevant requirements in IFRS 9 Financial Instruments to determine whether there is an embedded derivative in the contract (which may be distinct from any investment component), and if so account for the embedded derivative in accordance with that Standard, and
- Separately account for any distinct goods or services (other than insurance contract services) to be provided to the policyholder in accordance with IFRS 15 Revenue from Contracts with Customers. Accordingly, under IFRS 17 an insurer would:
- Apply IFRS 15 to attribute the cash inflows between the insurance component and any promises to provide distinct goods or services other than insurance contract services, and
- Attribute the cash outflows between the insurance component and any promised goods or services other than insurance contract services, accounted for by applying IFRS 15 so that:
- Cash outflows that relate directly to each component are attributed to that component, and
- Any remaining cash outflows are attributed on a systematic and rational basis, reflecting the cash outflows the entity would expect to arise if that component were a separate contract.
Note: Under IFRS 9, the accounting for embedded derivatives can differ subject to whether:
- The non-derivative host and the derivative each have economic characteristics and risks that are not ‘closely’ related and a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative in IFRS 9, and
- The issuer of the instrument meets any of the necessary criteria that permit or require the entity to account for the entire arrangement at fair value through profit or loss.
The following example is based on Example 4 of the Illustrative Examples to IFRS 17, and demonstrates how an entity would apply the foregoing criteria for separating insurance components from any other goods or services offered under the contract to the policyholder.
Example 2 - Separating goods or services from a life insurance contract
Using the fact pattern provided in Example 1, Entity Z is required to consider whether the insurance services and/or investment management services provided to the policyholder should be accounted for separately from the insurance contract under IFRS 15.
Identifying any embedded derivatives
A derivative, as defined in IFRS 9, has the following characteristics:
- Its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable (‘underlying’), provided in the case of a non-financial variable that the variable is not specific to a party to the contract
- It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market forces, and
- It is settled at a future date.
While the investment component would be expected to be settled at a future date, the policyholder is not promised a return based on a specific rate, index or price. Further, the account balance is not smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market forces. Accordingly, the contract provided by Entity Z does not contain an embedded derivative.
Separating the insurance component
Claims processing activities are part of the activities the entity must undertake to fulfil the contract, and the entity does not transfer a good or service to the policyholder because the entity performs those activities. Thus, the entity would not separate the claims processing component from the insurance contract.
Separating the investment management component
The asset management activities, similarly to claims processing activities, are part of the activities the entity must undertake to fulfil the contract, and the entity does not transfer a good or service to the policyholder because the entity performs those activities. Thus, the entity would not separate the asset management component from the insurance contract.
In next month’s edition of Accounting News we will start examining the different measurement models available under IFRS 17, commencing with the building blocks and the General Model.