Defining contract boundaries Defining contract boundaries

Exposure draft of amendments to IFRS 17

International Accounting Standards Board, June 2019

 

Cash flows that are outside the contract boundary on initial recognition

September 2018 TRG meeting

 

Accounting for group insurance policies 

September 2018 TRG meeting

 

Considering constraints when assessing the contract boundary

May 2018 TRG meeting

 

Contract boundaries for contracts with the option to add coverage

May 2018 TRG meeting

 

Boundaries of contracts with annual renewable terms

February 2018 TRG meeting

 

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With the Board having published its exposure draft of the amendments to IFRS 17, you can find our latest insight and analysis at home.Kpmg/ifrs17amendments.

 

What's the issue?

An insurer’s practical ability to reprice an insurance contract at a future date can affect the amount of estimated future cash flows it recognises within that contract’s boundary. At the September meeting, TRG members focused on cash flows that are outside the contract boundary on initial recognition and how to account for changes in circumstances related to these future cash flows.

The question that arises is how to account for these future cash flows in subsequent periods. 

For example, how should an insurer account for the exercise of a renewal option if cash flows related to renewal periods were outside the contract boundary to begin with? Should the exercise of the option be accounted for as the extension of the existing contract or as a new contract? 

 

What did the TRG discuss?

TRG members observed that cash flows may fall outside of the contract boundary because the insurer has a right to reprice premiums related to future insurance coverage periods – e.g. renewal periods. If these cash flows eventually occur, they would be considered cash flows arising from the substantive rights and obligations of a new contract. 

This means that cash flows relating to the same legal contract could possibly fall into more than one group of insurance contracts when accounting for them under IFRS 17.

TRG members also observed that some cash flows may be outside the contract boundary on initial recognition because constraints limiting an insurer’s ability to reprice the contract had no commercial substance. If circumstances change and these constraints gain commercial substance, then these cash flows that were once outside the contract boundary may then fall inside the boundary. When contract boundaries are reassessed in this manner, the CSM of the existing group of contracts needs to be adjusted. 

 

What's the impact?

IFRS 17 may require an insurer to separate what is currently thought of as one contract into several shorter duration contracts, for example if there is a unilateral repricing option relating to future coverage periods. 

The observations made in this and previous discussions about contract boundaries emphasise the need to fully understand the substantive rights and obligations of insurance contracts when applying the contract boundary requirements.    

Determining contract boundaries requires careful analysis and may require significant changes to systems and processes.

 

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What's the issue?

An insurer may write a group contract under which it provides insurance coverage to the members of an association or to the customers of a bank, referred to as certificate holders.

In the situation under consideration, the insurer has the right to terminate this policy at any time with a 90-day notice period which, in turn, terminates the insurance coverage for all of the certificate holders.

This raises three questions.

• Is the policyholder the association/bank or the individual certificate holders?
• Is this a single insurance contract or multiple insurance contracts?
• What is the contract boundary?

 

What did the TRG discuss?

Identifying the policyholder 

TRG members considered which of the parties to the contract would be compensated for an insured event. They observed that when an insurer repays the debt of a certificate holder to a bank as a result of an insured event that adversely affects the certificate holder, the individual certificate holder is the one being compensated even though the bank receives the payment. Therefore, the certificate holder is the policyholder in this arrangement.

 

Considering whether it is a single contract or multiple contracts

TRG members observed that relevant factors might include whether:

• the insurance contract is priced and sold separately to each certificate holder
• the certificate holders are connected to one another; and
• the insurance coverage is an optional purchase for each individual. 

TRG members observed that there is significant judgement involved in concluding whether the substance of the policy reflects multiple contracts with individual certificate holders or a single contract with an association or bank.

 

Defining the contract boundary

TRG members observed that in this particular case the contract boundary is 90 days because the insurer’s substantive obligation to provide services under a contract ends at the point that it can terminate the contract. 

 

What's the impact?

Group policy terms and conditions can vary widely in their structure, and this is a timely reminder that in preparing for IFRS 17 insurers have to analyse all the relevant facts and circumstances of each arrangement to determine: 

• who the policyholder is; 
• whether in substance it is indeed a single contract or multiple contracts under IFRS 17 (see also Separating insurance components of a single contract); and
• which cash flows are included in its measurement (see also Boundaries of contracts with annual renewable terms). 

 

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What's the issue?

When an insurer has a substantive obligation to provide services to its policyholders, the cash flows that arise from the substantive rights and obligations are within the contract boundary and are included within the measurement of the group of contracts to which they relate.

A substantive obligation to provide services ends when the insurer has the practical ability to reassess the risks of the particular policyholder (or of the portfolio of insurance contracts) and, as a result, can set a price or a level of benefits that fully reflects the reassessed risks.

A question that arises is what constraints may limit an insurer’s practical ability to reprice a contract. 

 

What did the TRG discuss?

Under IFRS 17, an insurer’s practical ability is not constrained if it can:

• set the same price it would for a new contract with the same characteristics as the existing contracts issued on that date; or
• amend the benefits to be consistent with the price it will charge.

TRG members agreed that a constraint that applies equally to new contracts and existing contracts would not limit an insurer’s practical ability to reprice existing contracts to reflect their reassessed risks. 

Given that IFRS 17 does not specify the sources of potential constraints on these reassessments, it does not limit these constraints to those of a contractual, legal or regulatory nature. 

 

What's the impact?

It may be more readily apparent when regulatory or legal requirements impose constraints on an insurer’s practical ability to reprice its contracts than market and other constraints. 

When making this assessment, it will be important to consider whether market or other constraints apply equally to all insurers operating in the same jurisdiction for new and renewed contracts. If all insurers can reprice ‘as good as new’ – i.e. how they would set prices on new contracts – then there is effectively no constraint on their practical ability to reprice for the purpose of assessing the contract boundary. 

 

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What's the issue?

Insurers may issue contracts that give the policyholders the option to add insurance coverage at a future date. If a policyholder exercises that option, then the insurer is obliged to provide additional coverage.

The question that arises is whether the expected cash flows resulting from the future exercise of the option are included within the contract boundary, and therefore within the measurement of the group of contracts that it relates to.

 

What did the TRG discuss?

TRG members observed that before determining the contract boundary at the inception of an insurance contract, an insurer should consider whether:

• the contract needs to be separated into multiple insurance components to reflect the insurer’s rights and obligations under the contract (see Separating insurance components of a single contract); 
• and the obligation to provide additional coverage at a future date is substantive. 

TRG members appeared to agree that as long as the option:

• is not considered to be a separate contract; and
• reflects a substantive obligation at inception, 

the insurer should assess the contract boundary for the entire contract, including the option. 

TRG members also observed that the cash flows related to such an option would be: 

• outside the contract boundary if the insurer has the practical ability to reprice the whole contract when the policyholder exercises the option; and
• inside the contract boundary if the insurer has the practical ability to reprice only the additional future coverage when the policyholder exercises the option.

TRG members expressed different views about whether an option would create substantive rights and obligations if the insurer sets the premiums for the additional coverage only when the policyholder exercises the option.

In addition, it was noted that the insurer’s intention to reassess risk or reprice is irrelevant to the contract boundary assessment – i.e. the contract boundary ends when the insurer has the practical ability to reprice the whole contract, even if it is unlikely to actually exercise its right to reprice.

 

What's the impact?

To determine whether cash flows are inside the contract boundary of an existing insurance contract, insurers need to evaluate whether these contracts need to be separated into multiple insurance components. If not, insurers need to consider whether providing the policyholder with an option to acquire future additional coverage gives rise to substantive rights and obligations. 

Currently, when measuring insurance contracts that give the policyholders the option to add insurance coverage at a future date, it is common to consider the premium for each component (i.e. the base contract and the option) separately. Under IFRS 17, if the rights and obligations related to the option are substantive and the contract is not separated into multiple components, then the contract boundary is established for the contract as a whole. Insurers may need to develop new estimates for some of the cash flows in order to measure these contracts under IFRS 17.

 

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What's the issue?

Step-rated yearly renewable term (YRT) contracts and unit-linked contracts with additional insurance benefits contain several features that could impact the accounting under IFRS 17. Contracts, like these, contain all or some of the following.

 

Contract feature	Further details
Annual renewal guarantee	The contract is guaranteed renewable every year
Annual premium increases	Increases in premiums/insurance fees are set at inception and based on the policyholder’s age
Annual repricing mechanism	The insurer can reprice the premium/insurance fee annually, based on the emergence of risks within the portfolio to which the contract belongs – i.e. there is no further underwriting of the individual policyholder

These features raise the question of whether the different cash flows on initial recognition should include expected cash flows that relate to expected renewals after the next annual repricing date – i.e. whether the contract boundary should be greater than one year.

 

What did the TRG discuss?

TRG members appeared to agree that insurers should only consider the ability to reassess and reprice policyholder risks when determining contract boundaries. They observed that policyholder risks are risks transferred from the policyholder to the insurer. The IASB staff noted that these can include insurance and financial risks but exclude risks that are not transferred from the policyholder to the insurer under such contracts – e.g. lapse and expense risk.

TRG members also noted a distinction between repricing based on a reassessment of:

• portfolio risks based on the emergence of risk within the existing portfolio; and 
• more general community risks based on the emergence of risk within a broader group of policyholders.

The former was the subject of the types of contracts discussed above and would therefore result in a contract boundary that excludes expected future contract renewals. 

 

What's the impact?

Management needs to consider all of the terms and conditions when assessing the contract boundary under IFRS 17, including which risks are reassessed and repriced and at what level.

Under IFRS 17, the boundaries of these contracts may be limited to the year for which premiums have been received. 

One possible outcome of having shorter contract boundaries might be that contracts initially written and priced to reflect an insurer’s expectation of future renewals are measured in a manner that does not reflect that expectation. This may cause contracts to be considered onerous when they are initially written (e.g. due to significant insurance acquisition cash flows incurred when the contract is initially written) and only profitable if and when they are renewed. This is considered further in Measuring insurance cash flows.

 

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This topic page is part of our Insurance – Transition to IFRS 17 series, which covers the discussions of the International Accounting Standards Board and its Transition Resource Group (TRG) regarding the new insurance contracts standard.

You can also find more insight and analysis on the new insurance contracts standard at IFRS – Insurance.

 

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