Jane Dotson
Insurance contracts are agreements between an insurance provider and a policyholder that combine features of both a financial instrument and a service contract. Insurance contracts are a unique type of contract that generates cash flows with substantial variability over a long period. The accounting for insurance contracts is a complex process that involves assessing the expected cash flows, recognising revenue, and managing risks and uncertainties. The International Financial Reporting Standards (IFRS) have developed standards such as IFRS 17 to guide the recognition, measurement, presentation, and disclosure of insurance contracts. These standards have brought about significant changes to how insurance contracts are accounted for, requiring companies to make system upgrades and collaborate across different functions.
| Characteristics | Values |
|---|---|
| Definition | An insurance contract is a "contract under which one party (the insurer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder." |
| Types | Short-duration contracts and long-duration contracts |
| Examples of short-duration contracts | Property insurance, homeowners insurance, auto policies, liability insurance, and most forms of health insurance |
| Examples of long-duration contracts | Whole life insurance, endowment policies, and various types of annuity contracts |
| Accounting standards | IFRS 4, IFRS 17, GAAP, SAP, ASU 2018-12, ASC 944 |
| Accounting implications | Insurance contract liabilities and assets can be affected by the specific types of coverage provided and the accounting policies and significant judgments applied under IFRS 17. Insurers need to assess the impact of uncertain external events, emerging economic risks, and changes in market and non-market variables on insurance contract liabilities. |
| Premium calculation | Based on historical data aggregated from similar policies and paid in advance of protection. |
| Cost to the insurer | Not known until the end of the policy period or long after, when the cost of claims can be calculated with finality. |
| Reporting requirements | An insurance company's annual financial statement includes a balance sheet, an income statement, and a Capital and Surplus Account. |
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What You'll Learn
IFRS 17 Insurance Contracts
Insurance contracts combine features of both a financial instrument and a service contract. Many insurance contracts generate cash flows with substantial variability over a long period. IFRS 17 Insurance Contracts sets out principles for the recognition, measurement, presentation, and disclosure of insurance contracts within its scope. It replaces IFRS 4, which was an interim standard that allowed entities to use a wide variety of accounting practices for insurance contracts, reflecting national accounting requirements and their variations.
IFRS 17 is effective for annual reporting periods beginning on or after 1 January 2023, with earlier application permitted as long as IFRS 9 is also applied. It combines the current measurement of future cash flows with the recognition of profit over the period that services are provided under the contract. It also presents insurance service results (including insurance revenue) separately from insurance finance income or expenses.
IFRS 17 requires an entity to make an accounting policy choice: it must decide whether to recognise all insurance finance income or expenses in profit or loss, or to recognise some of that income or these expenses in other comprehensive income. It also includes an optional simplified measurement approach, or premium allocation approach, for simpler insurance contracts.
IFRS 17 has a specific accounting approach for participating contracts, defined as 'insurance contracts with direct participation features'. This approach is referred to as the variable fee approach (VFA).
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Premium allocation approach
Insurance contracts combine features of both a financial instrument and a service contract. The International Accounting Standards Board (IASB) issued IFRS 17 Insurance Contracts, which sets out principles for the recognition, measurement, presentation, and disclosure of insurance contracts. IFRS 17 includes an optional simplified measurement approach, called the premium allocation approach, for simpler insurance contracts.
The premium allocation approach is a simplified method of measuring insurance contract liability. It is similar to the IFRS 4 insurance accounting method. This approach is optional and can be applied when the coverage period of each contract in the group is one year or less. It is applicable to most short-duration non-life and general insurance contracts, including property, vehicle, and health insurance contracts.
Under the premium allocation approach, insurance entities charge premiums as compensation for providing insurance protection over the contract period. The written premium is the total amount that a policyholder is required to pay under the insurance contract, unless it is cancelled. The earned premium is the amount the insurance entity recognises as revenue for the coverage provided under the contract. Premium revenue is typically earned over the contract period, with the unearned premium liability representing the unexpired portion of premiums in force as of a particular financial statement date.
Endorsements, which are amendments to existing insurance contracts, can change the scope or terms of the policy and typically affect policy premiums. Endorsements may include changes to coverage limits, deductibles, insured risks, or administrative information. Audit premiums are adjustments to the policy premium to accurately reflect the insurance exposure under the contract. Periodic premium audits are performed to update the existing premium estimate to reflect the actual exposures under the contract.
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Accounting for long-duration contracts
Insurance contracts are a combination of a financial instrument and a service contract. They often generate cash flows that vary substantially over a long period. Accounting for long-duration insurance contracts has seen some significant changes in recent years. The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2018-12, requiring "targeted improvements to the accounting for long-duration contracts", also known as LDTI. This update is the biggest change in US GAAP for life insurers in 40 years.
The scope of the ASU 2018-12 requirements includes the liability for unpaid claims on traditional life and limited-pay contracts. The update will change the way insurers report their financials, potentially exposing weaknesses in businesses' operating models. Earnings could become more volatile, and balance sheets and income statements could change significantly. However, performance comparisons among insurers will become more standardized and transparent, giving stakeholders a clearer perspective on risk.
ASU 2018-12 focuses on long-duration contracts written, ceded, or assumed by insurers and reinsurers. Long-duration contracts are expected to remain in force for an extended period and are not subject to unilateral changes in provisions. Examples include universal life-type products, limited-pay contracts, certain participating life insurance contracts, and term and whole life insurance.
The ASU introduces changes to the net premium ratio (NPR) method, requiring insurers to recalculate the NPR annually over the lifetime of a contract. It also standardizes the discount rate used to determine liability for future policyholder benefits. Additionally, it requires market risk benefits (MRBs) to be accounted for at fair value, with changes in fair value recognized in net income.
The implementation of LDTI will require significant resources in finance, actuarial, project management, and information technology. Insurers will need to plan ahead to understand the strategic implications and prepare for implementation factors affecting business operations.
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Insurance contract liabilities and assets
Insurance contracts are a combination of a financial instrument and a service contract. They generate cash flows with substantial variability over a long period. The insurance industry is divided into two segments: property/casualty (non-life insurance) and life/health insurance. The former includes home, auto, and business insurance, while the latter includes life, long-term care, and disability insurance, as well as annuities and health insurance.
Insurers estimate expected cash flows, including unbiased estimates of catastrophic losses, under existing contracts. They consider the coverage provided under the terms and conditions of issued insurance contracts and evaluate the precise extent of coverage, including any exclusions and limitations. When determining their obligations under insurance contracts, insurers must also assess the impact on insurance contract liabilities. For example, in response to heightened climate-related risks, an insurer might choose not to renew contracts in high-risk areas, impacting the recoverability of related IACF assets.
IFRS 17, effective for annual reporting periods beginning on or after January 1, 2023, provides guidance on recognizing and measuring insurance contracts. It combines the current measurement of future cash flows with the recognition of profit over the contract period. It also requires entities to make an accounting policy choice regarding the recognition of insurance finance income or expenses in profit or loss statements. The previous standard, IFRS 4, allowed for a wide variety of accounting practices for insurance contracts, reflecting national requirements.
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Insurance contract intangible assets
Insurance contracts combine features of both a financial instrument and a service contract. Many insurance contracts generate cash flows with substantial variability over a long period. Insurance contract intangible assets are those that are identified and measured when a contractual relationship exists or the asset is capable of being separately transferable.
In a business combination, other intangible assets must be identified, recognized, and measured at fair value when a contractual relationship exists or the asset is capable of being separately transferable. Business combinations involving insurance entities typically include the acquisition of various types of intangible assets, including customer relationships, such as renewal rights on short-duration insurance contracts, cross-selling opportunities, and customer/member lists, as well as distribution channels.
The life of an intangible asset for contracts with insurance agents depends on how long the insurance agents will stay under contract with the acquirer. The intangible asset for insurance agents cannot be amortized over the life of the insurance contracts the agents are expected to sell.
ASC 944 includes highly specialized accounting guidance that is applicable only to insurance entities, as defined. The insurance contract accounting guidance within ASC 944 applies to those written (issued) contracts qualifying as insurance, as well as assumed reinsurance contracts and purchased reinsurance contracts.
The FASB issued new guidance, Accounting Standards Update 2018-12, Financial Services—Insurance (Topic 944): Targeted Improvements to the Accounting for Long-Duration Contracts (ASU 2018-12), which revises key elements of the measurement models and disclosure requirements for long-duration insurance contracts issued by insurers and reinsurers. It is the biggest change in US GAAP for life insurers in the last 40 years.
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Frequently asked questions
IFRS 17 is an accounting standard for insurance products issued by the IASB. It sets out principles for the recognition, measurement, presentation and disclosure of insurance contracts. It replaces the previous standard, IFRS 4, which was only an interim standard.
IFRS 17 requires fundamental accounting changes to how insurance contracts are measured and accounted for. It combines current measurement of future cash flows with the recognition of profit over the period that services are provided. It also requires the separation of insurance service results and insurance finance income/expenses.
Insurers need to assess the impact of uncertain external events on insurance contract liabilities. They must also consider the longer-term effects that are not financial risks, such as increased lapse volatility and changes in expense assumptions. Insurers must also estimate expected cash flows under existing contracts, excluding possible claims under future contracts.
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