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Life Insurance, IFRS 17, and the Contractual Service Margin

On a high level, insurance companies are in the business of buying, selling, and pooling risk. By piecing together a portfolio of uncorrelated risks, insurance companies are able to provide value by spreading the risks among the participants, and profit from the aggregate premiums that participants pay. Insurance companies sell policies to its customers, in return for a contract that pays out the policyholder when an insured event occurs.

For example, for life insurance, in the event that the policyholder dies early at 40, the beneficiaries of the policyholder will get a large payout that is typically higher than the premiums that they pay. On an individual basis, the insurance company will lose money on the contract. However, many of the other policyholders will not die until 80, in which case the insurance company will profit. The expected likelihood of death and other events are determined by actuarial models, which are crucial in the profitability of an insurance company.

Life Insurance Income Statement and IFRS 17

As discussed, the revenues of an insurance company comprise mainly of the premiums it receives from policyholders. The costs would be any claims paid out to its policyholders, as well as selling costs such as commissions to its brokers and agents. However, there is an issue with these numbers from an accounting perspective, particularly from longer term contracts (longer than a year), the revenues do not match the costs. Namely, the claims that an insurance company pay are not on the same contracts that the insurance company gets its revenues from. Shorter term contracts, such as P&C, are less exposed to this issue, as the claims paid out largely correspond to the contracts that they receive premiums from.

IFRS 17 partially mitigates this issue. The new accounting standard introduces a new concept known as the Contractual Service Margin, or CSM, in its GMM, or General Measurement Model. The CSM is a liability (unearned revenue) in an insurance company’s balance sheet which acts as an accrual, to spread the revenues from a particular contract over the life of its contract, and better match revenues to costs in longer term contracts.

Another big change in IFRS 17 is the granularity of reporting. Insurance companies will need to provide more detailed disclosures into its policies, particularly which policies are profitable, not profitable, and could possibly become not profitable. Additionally, insurance related revenues must be reported separately from investment related revenues (from the float).

There are many other smaller changes in IFRS 17, such as measurement for direct participation contracts and the Variable Fee Approach, but we will not cover them here. IFRS 17 takes effect January 1, 2023, and will cover most non-US insurance companies.

Contractual Service Margin

The CSM is essentially the net present value (NPV) of insurance contracts, and can be positive or negative. Calculating the CSM is similar to any other NPV calculations, you take the discounted cash inflows minus cash outflows. In the case of insurance, the inflows are insurance premiums, outflows are fulfillment cash flows (FCF), which claims that must be paid out in the future. The net cash flow (inflows minus outflows) is the adjusted for financial risk (discounting by an appropriate discount rate) and insurance risk (actuarial models). Typically, the financial risk adjustment is upwards, as outflows is further in the future compared to inflows, and insurance risk is downwards.

In any given period, CSM is accumulated as new insurance business is sold. The CSM is also adjusted by any claims that are paid out to the policyholders, as well as any changes in actuarial assumptions (people living longer would be a positive adjustment, as an insurance company will no longer have to pay out as much in the future). A portion of the ending balance of the CSM is then allocated into the income statement, and becomes the revenues for the period. This concept is similar to capitalizing and subsequently allocating costs into the income statement.

As mentioned previously, the CSM is essentially the NPV of the insurance contract, or a portfolio of contracts, but the CSM cannot be negative. In the case where the NPV is negative, the state is known as Loss Component (LC). A new contract, or portfolio of contracts sold with Loss Component is called an Onerous contracts, meaning they are immediately expected to lose money over its lifetime for the insurance company. The accounting treatment for Onerous contracts is conservative, they are recognized immediately in the income statement as costs, rather than spread out through the lifetime of the contract. Loss Components are also registered in the balance sheet, and are systematically allocated to the income statement (not in the same way that CSM is allocated to the income statement, to avoid double counting the losses).

A contract, or a portfolio of contracts, could start profitable and in CSM, but become unprofitable at any given moment, due to changes in assumptions (such as actuarial expectations of death or injuries).

Implications of CSM

The change from premiums based revenues to CSM based revenues will have a big effect on the income statement. The revenues in a period for a life insurer is no longer based on how much premiums they receive, but the weighted average of the profitability of its previous contracts. This means that new contracts will have a muted effect on its income statement, and revenues will become smoother year over year. Of course, cash flows will remain unchanged and you can get details on how many new contracts are sold through the statement of cashflows, or non-IFRS or non-GAAP measures in its disclosures. Ratios such as Expense Ratio and Loss Ratio will rely on disclosures rather than the income statement.

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