Direct participating contracts Direct participating contracts

IFRS 17 – Risk mitigation option

International Accounting Standards Board meeting, February 2020

 

Exposure draft of amendments to IFRS 17

International Accounting Standards Board, June 2019

 

Accounting for direct participating contracts when reinsurance contracts held are used to mitigate financial risk

International Accounting Standards Board, January 2019

What’s the issue?

IFRS 17 Insurance Contracts allows entities to apply the risk mitigation option where they use derivatives to mitigate financial risk arising from insurance contracts with direct participation features. The Board confirmed in December 2019 that the risk mitigation option would be extended to apply to entities that purchase reinsurance contracts held to mitigate this financial risk. The risk mitigation option permits an entity to recognise the effect of some or all of the changes in financial risk on insurance contracts with direct participation features in profit or loss, when they would otherwise adjust the contractual service margin. This option is provided to eliminate accounting mismatches that would otherwise occur when such derivatives or reinsurance contracts are not underlying items of the direct participation contracts concerned. 

Insurers provided feedback to the Board that accounting mismatches would also arise when non-derivative financial assets are used to mitigate financial risk that arises from insurance contracts with direct participation features. 

 

What did the Board decide?

The Board has decided to extend the risk mitigation option in paragraph B115 of IFRS 17. The option will be extended to permit an entity that uses non-derivative financial assets, measured at fair value through profit and loss, to mitigate financial risk that arises from insurance contracts with direct participation features. 

 

What’s the impact and what’s next?

This extension will provide additional relief for many insurers with insurance contracts with direct participation. The application of the risk mitigation option, where permitted, might reduce the accounting mismatch that arises from application of B113(b) of IFRS 17 to insurance contracts with direct participation features. If applied, this option means that the effect of applicable changes in financial risk not arising from the underlying items can be recognised immediately in profit or loss, as will gains and losses on qualifying assets held by the entity to mitigate those effects. The application of this option may highlight any ineffectiveness in an entity’s risk mitigation strategy.

The risk mitigation option may also provide partial relief for entities in relation to accounting mismatches for contracts that change in nature over time – which was an issue raised by some respondents. For example, a contract with a savings phase that provides an option to convert to an annuity at a guaranteed rate may be required to apply the variable fee approach, while an annuity contract without the savings phase would typically apply the general measurement model. Applying the risk mitigation option in its revised form would allow the entity to recognise the effects of applicable changes in financial risk not arising from underlying items directly in profit or loss for both the insurance contracts, together with the effects of non-derivative financial assets used to mitigate financial risk.

These issues are not entirely resolved as the risk mitigation option cannot be applied to periods before the date of transition to IFRS 17 and retrospective application is not permitted. The risk mitigation option can be applied prospectively from the transition date onwards, but will not resolve an accounting mismatch that is already present at transition. Further relief may be provided by applying the fair value approach to contracts that meet the criteria for use of the risk mitigation option.

Application of the risk mitigation option is subject to the eligibility criteria of B116 of IFRS 17. Insurers wishing to explore the use of the extended risk mitigation option for insurance contracts with direct participation features should check that they have a documented risk management objective and strategy for mitigating financial risk using relevant non-derivative financial assets, derivatives or reinsurance contracts held.

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 may use derivatives to mitigate the financial risks arising from the direct participating contracts it issues. This could give rise to an accounting mismatch because the change in the derivatives’ fair value is recognised immediately in profit or loss under IFRS 9 Financial Instruments. However, using the variable fee approach, the related change in the insurance contracts’ value is generally accounted for by adjusting the CSM, rather than being recognised immediately in profit or loss. 

To avoid this accounting mismatch, IFRS 17 permits an insurer to take account of the effect of risk mitigation, allowing it not to adjust the CSM for the change in financial risk but to recognise that change in profit or loss instead, subject to certain conditions being met (the ‘risk mitigation option’).

Some reinsurance contracts are structured in a way that enables the cedant to transfer financial risks arising from its underlying contracts. An accounting mismatch, similar to that described above, may arise when the underlying contracts are accounted for under the variable fee approach.

This is because reinsurance contracts are ineligible for the variable fee approach. As a result, changes in the financial risk of the reinsurance held are recognised in profit or loss (or other comprehensive income), while the change in the financial risks of the underlying contracts adjusts the CSM.

Under current IFRS 17, the risk mitigation option that is available to reduce mismatches like these is only available when an insurer uses a derivative to mitigate financial risk. 

 

What did the Board decide?

The Board’s tentative decision proposes to expand the risk mitigation option for direct participating insurance contracts so that it may be applied when an insurer uses a reinsurance contract held to mitigate financial risk. This means that insurers would be permitted not to adjust the CSM when either a derivative or a reinsurance contract held is used for risk mitigation purposes, subject to specific conditions being met. 

 

What’s the impact?

The Board discussion has confirmed that reinsurance contracts held are not eligible for the variable fee approach, even if the underlying contracts are direct participating contracts. This is consistent with the view that a reinsurance contract held should be accounted for separately from the underlying contracts issued.

In practice, some reinsurance contracts held are underlying items of the direct participating contracts. In these circumstances, risk mitigation is automatically captured when applying the variable fee approach. This is because both the changes in the fulfilment cash flows of reinsurance contracts arising from the effects of financial risk and the corresponding changes in those of the direct participating contracts adjust the CSM.

The proposed expanded option could address accounting mismatches that arise when reinsurance contracts that are not underlying items are held to mitigate the financial risks of direct participating contracts. 

This amendment would allow insurers to better reflect their risk mitigation activities in their financial reporting regardless of whether they have used derivatives or reinsurance contracts to mitigate financial risk.

 

Back to top  |  Other topics in this series

 

This topic page is part of our Insurance – Transition to IFRS 17 series, which covers the discussions of the IASB's Transition Resource Group (TRG) for Insurance Contracts.

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

 

Other topics in this series