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Unbundling insurance components under IFRS 17: when is a contract not a contract?

Insurance Consulting and Technology
IFRS 17 Solutions

April 9, 2018

With the countdown to the implementation of the new global insurance accounting standard – IFRS 17 – well and truly on, insurers are (or should be) trying to understand what changes they’ll need to make to comply.

close up of a person signing a set of documents

In getting into the detail of the requirements, one question has been the focus of much discussion – can an entity unbundle multiple insurance components contained within a single contract? If so, when? And how? And do insurers have a choice? These points, already a source of heated debate in our client discussions, were also one of the main topics in the recent meeting of the IASB Transition Resource Group (TRG).

These are not academic points. They matter to insurers – since they will impact the fundamental classification, recognition, measurement and presentation of large parts of insurers’ portfolios, how reserves are calculated, and how the profits (and losses) are recognized. Here’s why.

Spoiler alert: the answers are not ones many insurers would hope for, neither are they consistent with what they currently do for accounting/reserving/reporting purposes…

So remind me, what’s the issue again?

IFRS 17 requires an entity to separate distinct investment and other non-insurance components from the insurance contract. But it makes no mention of whether an insurer is required to, permitted to, or prohibited from, separating individual insurance components within one insurance contract. Many contracts commonly written by insurers may include two or more insurance components – think of disability riders with a life policy, multi-line commercial policies, combined motor policies or many reinsurance contracts.

Why should we care either way?

Unlike many other frameworks, the starting point for IFRS 17 is not the risk, but the contract. This may be a major change for actuaries, in particular; seemingly requiring a rather more legal analysis than usual. If components included in a single contract are taken together this will significantly impact measurement (think of contract boundaries, onerous contracts, grouping). Many in the industry believe that insurers should be allowed to split such contracts into individual risks, as they currently do (and are required to do under Solvency II).

What did the TRG conclude?

The TRG reasserted that the lowest unit of account in IFRS 17 is the contract that includes all insurance components, and that entities would normally design contracts to reflect their substance. Nevertheless, there may be circumstances where the legal form of the contract does not reflect the substance of the contractual rights and obligations. In such cases, the entity would be required to separate the contract into components in order to reflect that substance. An assessment of the substance is necessarily judgmental and might consider interdependency of the risks, whether they lapse together and whether they can be priced and sold separately, as well as other relevant factors such as the basis for commissions.

When might that be the case – the omelette scenario?

The example given by the IASB is “when more than one type of insurance cover is included in one legal contract solely for the administrative convenience of the policyholder and the price is simply the aggregate of the standalone prices for the different insurance covers provided”.

So what does that all mean in practice?

Let’s consider somebody buying bacon and eggs. There are three options (and please bear with me here!):

  1. Go into a supermarket and buy bacon and buy eggs
  2. Go into a café and order a plate of bacon and eggs
  3. Go into a café and order a ham omelette

In 1), the items have been included in one bill for the administrative convenience of the shopper and so are two items. In 3) it is clear that the product is one – it cannot be unbundled (you can’t “unmake an omelette” after all). In 2) the conclusion would be that these have been served together as a single dish and so, even if we could price them separately and move them apart on the plate, they are effectively one purchase (one contract).

The right decision may be fundamental in determining both model design and the financial results

This is a different way of approaching the topic than companies have been used to. Essentially the TRG is saying that contracts comprising multiple insurance components should be treated as one contract unless there is clear evidence that this is simply an addition of multiple unrelated products, i.e. in substance they are clearly two or more separate contracts included in one document – the policy. An entity would never have an option to decide whether to separate these components – it would either be prohibited from doing so or be compelled to do so, depending on the substance of the contract.

The implications are enormous – a motor insurer may end up having three separate portfolios – third party liability, own damage and comprehensive (policies covering both) – each requiring separate measurement. Similarly, riders within a life insurance contract may influence whether the contract is onerous as well as where the contract boundary falls. Exercising judgment based on the substance of each contract will be laborious.

So is your contract essentially a supermarket shopping list, an omelette or a good cooked breakfast? A wrong decision could lead to fundamental errors which will require a lot of unscrambling.

Disagree? By all means join the debate. But remember that the IASB has left no doubt that it has no intention of changing the standard itself, only of adding clarity, where necessary, to aid companies in implementing IFRS 17.

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