Understanding Contractual Service Margin: The Insurer's Perspective

The contractual service margin (CSM) is a fundamental concept introduced by IFRS 17, which establishes key principles that entities must apply to all aspects of the accounting of insurance contracts. CSM defers profit recognition, which may affect the timing of tax payments. CSM is the unearned profit that an entity expects to earn as it provides services. This means that the profit from the contract is realized by the insurer over multiple future accounting periods as it provides services under the contract.

IFRS 17 and CSM

IFRS 17 establishes key principles that entities must apply to all aspects of the accounting of insurance contracts, including recognition, measurement, presentation, and disclosure. The standard aims to increase the usefulness, comparability, transparency, and quality of insurers' financial statements.

A fundamental concept introduced by IFRS 17 is the contractual service margin (CSM). CSM, in most cases, represents the unearned profit that an entity expects to earn as it provides services. This unearned profit relates to a group of profitable insurance contracts and their future services. At initial recognition, the CSM represents the profit yet to be earned under the issued insurance contracts.

The CSM is calculated as the difference between the premium received and the fulfilment cash flows. Fulfilment cash flows are the sum of the present value of probability-weighted expected cash flows, reflecting financial risk, and an explicit risk adjustment for non-financial risks such as mortality or morbidity risk.

The introduction of CSM by IFRS 17 is expected to lead to significant changes in performance reporting for many insurers that apply the new standard. The CSM concept is only applicable to profitable contracts, and it cannot be negative. This restriction means that when an insurer writes loss-making business, they cannot establish a "negative CSM" and defer loss recognition.

CSM and tax

The contractual service margin (CSM) is a fundamental concept introduced by IFRS 17, which establishes key principles that entities must apply to all aspects of the accounting of insurance contracts. The CSM, in most instances, represents the unearned profit that an entity expects to earn as it provides services.

The CSM is gradually released over the term of the contract as services are provided. The insurer realizes profits (associated with a contract) over multiple future reporting periods as it provides the contractual services. In other words, the insurer is required to defer the unearned profits on the issuance of policies, only recognizing a corresponding part of the profits that relate to each and every respective period over the contract term.

The CSM defers profit recognition, which may affect the timing of tax payments and give rise to deferred tax considerations. Insurers will generally need to calculate the CSM at the transition date when adopting the new standard, applying the new rules retrospectively with adjustments to their retained earnings. Under this retrospective approach, an insurer restates its financial statements to recognize and measure insurance contracts as if IFRS 17 had always applied and recognize the net difference from the old rules in equity on the transition date. The portion of profits previously recognized in retained earnings for contracts issued prior to transition that are still unearned at the time of transition will be included in the CSM and realized over future accounting periods.

The tax consequences of the creation and reversal of the CSM depend on the local tax rules. In countries where the taxation of insurance contracts is aligned with IFRS standards, profits previously recognized for income tax purposes based on financial statements prepared under IFRS 4 may be subject to tax again under IFRS 17 through the recognition of the CSM in future years' accounting net income. Even if tax legislation is designed to avoid double taxation, a specific amendment may be needed to prevent a large tax loss arising at the point of transition. For example, a spreading rule should help maintain the stability of the government’s tax revenues while protecting taxpayers from the effects of any loss restriction or loss expiry rules.

CSM calculation for profitable contracts

The contractual service margin (CSM) is a fundamental concept introduced by IFRS 17, which establishes key principles that entities must apply to all aspects of the accounting of insurance contracts. The CSM represents the unearned profit on a group of insurance contracts, and its release to profit or loss over time is significant in depicting the performance of insurance companies.

The CSM calculation for profitable contracts is an important aspect of IFRS 17. The CSM at inception is the difference between the premium received and the fulfilment cash flows. Fulfilment cash flows refer to the sum of the present value of probability-weighted expected cash flows, reflecting financial risk, and an explicit risk adjustment for non-financial risks such as mortality or morbidity risk.

For profitable contracts, the CSM balance is positive. At initial recognition, the CSM represents the profit still to be earned under the insurance contracts issued. This unearned profit is then released to profit or loss, which is expected to be a significant component of the 'insurance service result' under IFRS 17.

The ''full retrospective approach' (FRA) and the ''modified retrospective approach' (MRA) are two methods available for CSM calculation for existing portfolios at the transition date. The choice of grouping the contracts, along with the transition method, will impact the level of CSM. Modelling the CSM at the lowest level (coverage, claim, policy, or contract level) can aid in determining the optimal allocation of groups.

Additionally, the 'fair value' (FV) method can be used to determine the CSM prospectively. While the FRA should be applied first, if it is not possible, then the MRA or FV method can be chosen. The interpretation of IFRS 17's "coverage period" is relatively clear, referring to the period during which the entity provides insurance contract services. This may, however, present challenges when compared to the requirements of SII.

CSM and loss-making contracts

CSM, or Contractual Service Margin, is a fundamental concept introduced by IFRS 17, which establishes key principles that entities must apply to all aspects of the accounting of insurance contracts. CSM represents the unearned profit on a group of insurance contracts that relates to the future services to be provided.

When the CSM of a group of contracts represents a loss at inception, such a loss is immediately recognised in profit or loss. Such contracts are onerous in nature, meaning that the cash outflows exceed the value of cash inflows.

In the context of loss-making contracts, it is important to note that when an insurer writes loss-making business, it cannot establish a "negative CSM" and defer loss recognition into the future. This is because the CSM is floored to zero in such circumstances. This principle can be illustrated using simplified examples, such as those provided in academic research.

The interpretation of the "coverage period" under IFRS 17 is relatively clear, particularly given the clarification that, where there is no contractual due date, the first payment is deemed to be due when it is received. However, in some instances, the date may be difficult to ascertain. For example, policy administration systems may not always have an embedded link to pricing models, and consequently, existing processes may not be able to immediately identify when a loss-making policy has been written.

CSM and VFA eligibility

The CSM, or Contractual Service Margin, is a fundamental concept introduced by IFRS 17. It represents the unearned profit that an entity expects to earn as it provides services. In other words, it is the profit that an insurance company makes from the services it provides.

IFRS 17 establishes key principles that entities must apply in all aspects of the accounting of insurance contracts, including recognition, measurement, presentation, and disclosure. The standard aims to increase the usefulness, comparability, transparency, and quality of insurers' financial statements.

The VFA, or Variable Fee Approach, is a measurement model mandated for contracts with direct participation features that meet specific VFA eligibility requirements. These are insurance contracts that are substantially investment-related service contracts, where an entity promises an investment return based on underlying items.

To be classified as VFA-eligible, a contract must meet the following criteria:

• The contractual terms specify that the policyholder participates in a share of a clearly identified pool of underlying items.
• The entity expects to pay the policyholder an amount equal to a substantial share of the fair value returns on the underlying items.
• The entity expects a substantial proportion of any change in the amounts to be paid to the policyholder to vary with the change in the fair value of the underlying items.

It is important to note that the classification of a contract as VFA-eligible is set at the inception of the contract and is not changed thereafter.

The GMM, or General Measurement Model, is the "default" measurement model for insurance contracts. It is used to measure contracts without direct participation features or products that fail to meet the VFA or PAA eligibility requirements. The PAA, or Premium Allocation Approach, is intended as a simpler alternative for contracts with a coverage period of one year or less.

The existence of these two measurement models, GMM and VFA, can lead to a drastic divergence in the CSM over time, which can materially impact the amounts and timing of profit recognition. Therefore, it is not simply a matter of choice for companies, and IFRS 17 outlines the eligibility criteria that must be met to qualify for the VFA.

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