In May this year the International Accounting Standards Board released IFRS 17, the new international accounting standard for insurance contracts. The Australian Accounting Standards Board has adopted the standard without material change, as AASB 17. This d’finitive is about the actuarial determination of general insurance liabilities under AASB 17. We identify the key features and differences from current practice. This represents our initial views on AASB 17 – but it’s early days, and we expect it to be a couple of years before a generally accepted interpretation of the standard emerges. finity.com.au In this edition: AASB 17 vs AASB 1023 How will general insurance liabilities be different? What about APRA Reporting? September 2017 IFRS 17 becomes AASB 17
Transcript
In May this year the International Accounting Standards Board released
IFRS 17, the new international accounting standard for insurance contracts.
The Australian Accounting Standards Board has adopted the standard
without material change, as AASB 17.
This d’finitive is about the actuarial determination of general insurance
liabilities under AASB 17. We identify the key features and differences from
current practice. This represents our initial views on AASB 17 – but it’s early
days, and we expect it to be a couple of years before a generally accepted
interpretation of the standard emerges.
finity.com.au
In this edition:
AASB 17 vs AASB 1023
How will general insurance liabilities be different?
What about APRA Reporting?
September 2017
IFRS 17 becomes
AASB 17
| IFRS AASB17 | September 2017 02
Liabilities at a glanceThe table below sets out the high level differences between AASB 1023 and AASB 17 for general insurance liabilities.
High level observationsAASB 17 is the same as IFRS 17
AASB 17 adopts the international version of the accounting standard, as is, with two qualifications:
1. At this stage AASB 17 will not apply to not-for-profit public sector entities – including numerous workers compensation, CTP and lifetime care schemes. The AASB is currently considering the applicability of AASB 17 to those entities.
2. The AASB has confirmed that Australia-specific disclosures are being replaced entirely with those of IFRS 17. However, the AASB will review the usefulness and necessity of these disclosures, so this is an area that may change.
It is a much longer and more technical standard
Writing a global accounting standard does not lend itself to brevity. AASB 17 weighs in at 33,500 words, compared to AASB 1023 on 18,300. The new standard crosses life, health, and general insurance, and has two measurement approaches. It ‘feels’ more technical and prescriptive compared to AASB 1023’s more principles-based approach.
AASB 137 and discount rates
There have been no changes to AASB 137 (Contingencies), which is used in Australia for self-insurance liabilities and by accident compensation schemes where there is no insurance contract.
While preparing the new standard, however, the IASB drew attention to the different discounting approaches in various standards, including the international versions of AASB 17 and AASB 137.
Those differences remain, but the IASB has started a project to review why discount rates are different in different standards. They are expecting to publish their findings in late 2017.
ASPECT AASB 1023 AASB 17
Outstanding Claims Discounted central estimate, with risk margin Similar – “Liability for Incurred Claims.”
Unearned Premium – 12 month contracts
Written premium is set aside as an Unearned
Premium liability, earned over term of contract.
“Liability for Remaining Coverage”
Similar, but appears to be based on premium
received, not written.
Unearned Premium – multi-year contracts
Same approach as 12 month contracts.
“Liability for Remaining Coverage”
Different – will be similar to APRA Premium
Liability.
Identifying unprofitable contracts
Liability Adequacy Test (LAT) at segment level.
“Onerous contract” test, at more granular level.
For 12 month contracts, need to test only if “facts
and circumstances” suggest they are onerous.
| IFRS AASB17 | September 2017 03
The central estimateAs with AASB 1023, the central estimate of the liability under AASB 17 is intended to be the mean of all possible outcomes. AASB 17’s appendix sets out, in some detail, how the central estimate should be calculated. The detail is often prescriptive compared to AASB 1023, and may lead to changes in accepted Australian practice.
For example, AASB 17 explicitly prohibits allowing for post-balance date experience in estimating the outstanding claims. The central estimate must reflect the conditions applying at the balance date, including the uncertainties that existed on that day.
The risk adjustmentThe risk adjustment under AASB 17 is comparable to the AASB 1023 risk margin. An insurer will set a risk adjustment that reflects its own risk appetite, and must disclose the adopted probability of sufficiency. This is current practice under AASB 1023.
On our reading of AASB 17, gross risk margins and reinsurance risk margins will need to be disclosed in the balance sheet – with the risk adjustment for reinsurance recoveries representing the amount of risk transferred to the reinsurer. Currently most insurers disclose only a net risk margin in their accounts, although APRA requires gross risk margins to be reported in APRA forms.
Reinsurance recoveriesUnder AASB 17 the central estimate of reinsurance recoveries needs to include an allowance for the risk of “non-performance” by the reinsurer, including possible disputes. Under AASB 1023 it is common practice to assume that all reinsurance recoveries will be recoverable, unless there is a material risk of default; this aligns with APRA prudential reporting.
Where reinsurers are highly rated, we would not expect the allowance for non-performance to be significant.
Setting discount ratesAASB 1023 deals with discounting in 250 words, and makes it clear that risk-free discount rates must be used. AASB 17 devotes nearly 2,000 words to the topic. There are two approaches:
• The “bottom up” approach involves adjusting a liquid risk-free yield curve for any illiquidity in the insurance contracts. In Australia, the general consensus (and APRA’s view) is that general insurance portfolios are not illiquid, so the result should be similar to the current risk- free yield curve.
• The “top down” approach, which starts with market returns implied by a reference portfolio of assets, adjusted to eliminate factors not relevant to insurance contracts.
In theory the two approaches should give a similar result for general insurance, but in practice there may be divergence. Either way the adopted discount rate must be disclosed in the accounts.
Insurance liabilitiesThe two largest liabilities on a general insurer’s balance sheet are the outstanding claims liability and the unearned premium. The rest of this d’finitive focuses on determining these two liabilities under AASB 17.
“Liability for Incurred Claims” – currently outstanding claimsThe outstanding claims liability will look similar under AASB 17, with some differences. The liability must be a central estimate, discounted, with a risk adjustment. At a high level this will be very familiar to Australian general insurers.
| IFRS AASB17 | September 2017 04
“Liability for remainingcoverage” – currently unearned premium Two methods now
For general insurance there are two approaches that will be relevant:
• Premium Allocation Approach (PAA) – the simpler approach, which may be applied to contracts up to one year in duration. This is similar to the current approach of creating an unearned premium liability and earning it over time, although with some important differences (set out below).
• Building Blocks Approach (BBA) – more complicated, and generally used for contracts with a duration of more than one year. It resembles the current APRA Premium Liability calculation
The PAA ApproachThe simpler PAA can be used where:
1. The coverage period (“contract boundary”) is up to one year.
The coverage period ends when an insurer has the practical ability to reassess risk and reprice (or adjust benefits) for either individual contracts or an entire portfolio. For most products the contract boundary is the renewal date.
2. The coverage period exceeds one year, but the following criteria are met:
• The PAA liability is expected to be “not materially different” from the BBA liability
• The level of variability in cashflows prior to claims occurring is not significant. As an example, general insurance products with high cancellation rates may be assessed as having significant variability in cashflows prior to claims occurring.
Most (but not all) general insurance products will be able to adopt the PAA approach; see the table below.
OR
Liability for Remaining Coverage
Premium Allocation Approach (PAA)
Calculation similar to unearned premium
Building Blocks Approach (BBA)
More complexSimpler method
Will possibly use only premium recieved (vs written)
Can be used where contractduration ≤ 1 year
(and some other circumstances)
Equivalent to current unearned premium
No profit on Day 1
Calculation similarto APRA premium liability
Default approach
Definitely able to use PAA — 12 month contractsNot necessarily eligible for PAA —
contract/coverage exceeds 12 months
Domestic motor and home Construction and Engineering (life of project)
Medical indemnity – claims madeOne year proportional reinsurance – risks attaching cover
(treaty has coverage period of 2 years)
One-year XOL reinsurance – losses occurring cover
The PAA calculation
| IFRS AASB17 | September 2017
PAA — Written vs received premium
The key difference from AASB 1023 is the use of premiums received, rather than premiums written:
• AASB 17 appears to differentiate between premium receipt (used for the PAA), and initial recognition of the contract (BBA)
• AASB 1023 uses initial recognition – creating an unearned premium reserve that reflects the full expected written premium.
However, when calculating the Insurance Revenue for Coverage Provided (essentially earned premium), the standard directs insurers to use expected premium receipts – a concept that looks more like written premium.
For insurers with significant volumes of business that is paid quarterly or monthly, the Liability for Remaining Coverage under the PAA (if calculated using premiums received) may end up significantly lower than today’s unearned premium.
PAA — Grouping of contracts
For the PAA, contracts must be grouped by:
• Portfolio (e.g. Motor, Home) – this is already common practice
• Underwriting year
• Whether contracts are definitely profitable (“not onerous”), or where it is not clear whether contracts will ultimately be profitable. In some cases, contracts that are definitely unprofitable (“onerous”) need to be separated. See “Onerous contracts,” page 5.
For business with 12 month contracts, a maximum of two underwriting years would be involved in the Liability for Remaining Coverage calculation.
It’s not clear whether the current underwriting year will need to be distinguished in the Liability for Incurred Claims. Either way, AASB 17 allows for calculations of future cashflows to be done at an aggregate level and then allocated back to individual groups.
It is clear that underwriting years that pre-date the implementation of AASB 17 will not need to be split.
Overall, grouping has the potential to add a degree of complexity to liability estimates.
Premiums recieved in period
Acquisition costs being deferred less any amortisation of costs previously deferred
Opening liability + +
0ClipboardPageNumber
_ Acquisition costsInsurance revenue
for coverage provided in period
• Equivalent to earned premium under AASB 1023
• Based on expected premium receipts
05
Onerous contracts The Liability Adequacy Test (LAT) from AASB 1023 is replaced by the concept of “onerous
contracts” – contracts where a net cash outflow (loss) is expected.
Under the PAA
The starting point is to assume that no contracts are onerous, unless facts and circumstances suggest otherwise. Where they do (such as where management reporting suggests a product is loss making), a liability for the group of onerous contracts would need to be created.
One potential approach for the PAA would be to keep doing the LAT at portfolio level, and where it looks as if a whole portfolio would fail the LAT, investigate and identify the group of onerous contracts.
Under the BBA
Each portfolio of contracts needs to be segmented into:
1 ) Those that are onerous
2 ) Those that are definitely not onerous
3 ) Those that may or may not be onerous
This is similar in concept to the LAT, but whereas the LAT is done at a ‘segment’ level (and segments can be quite broad), under the BBA the test is done for groups of contracts within each portfolio.
The BBA ApproachThe BBA is the default approach under AASB 17, and will apply where an insurer cannot, or chooses not to, apply the PAA.
The BBA calculation
The BBA is a cashflow projection for the Liability for Remaining Coverage. As noted, it’s similar in concept to the APRA Premium Liability – but it includes cash inflows (e.g. future premiums to be received) as well as outflows (claim payments). It is discounted, and includes a risk adjustment.
For multi-year policies like LMI, the Appointed Actuary will likely already have a reasonably sophisticated approach to estimating the Premium Liability, which could form the basis of a BBA approach under AASB 17.
The Contractual Services Margin – no profit on inception
The BBA calculation includes a “Contractual Services Margin” (CSM) – a balancing item that ensures that no profit is recognised on Day 1, and that profit is ‘earned’ over the period of coverage.
On Day 1, the CSM liability is set so that the assets from the insurance contract (cash received, or to be received) equal the liabilities; see diagram below.
Calculation of CSM to Ensure No Profit on Day 1
The CSM is earned in proportion to “coverage units” which reflect the “benefits provided under a contract”. We would expect this to be broadly similar to earning of premium (and embedded profit) under AASB 1023, in line with the pattern of incidence of risk. There are, however, complex rules around the recalculation of the CSM at each balance date. In practice this may lead to material differences from AASB 1023.
Recognition of contracts
Contracts are only recognised from the date coverage is provided. However if premiums are due to be paid before coverage begins, the contracts are recognised when the first premium payment is due.
If facts and circumstances suggest that a group of contracts is onerous (unprofitable), a liability must be recognised immediately – prior to coverage starting, or the first premium due date. It’s not clear how this will work in practice.
Additional thoughts — AASB17 implementationWhat will APRA do?Ten years ago, there was a significant difference between AASB 1023 financial statements and APRA prudential reporting forms. APRA later aligned its forms fairly closely with AASB 1023, although some differences remain.
With the move to AASB 17, it is not clear whether APRA will once again align its prudential reporting with financial statements. Given the similarities between the BBA and the APRA Premium Liability, it appears possible that APRA will mandate BBA-style reporting for prudential reporting. APRA may also take its own view in specific areas, such as the discount rate, and this could lead to different liability estimates being adopted for financial reporting and prudential reporting.
Unclosed premiumWhere the PAA is used (most general insurance contracts), the implications for the treatment of unclosed premium are not clear. If the Liability for Remaining Coverage under the PAA is only created when the premium is received, but the insurance revenue is calculated from inception based on expected premium receipts, it is possible that the Liability for Remaining Coverage may end up negative for a short period
of time!
Accounting for proportional reinsurance will become awkwardAs discussed, most direct general insurance contracts will be accounted for using the PAA method. Quota share or surplus reinsurance written on a risks attaching basis would need to be accounted for under the BBA, leading to a different approach on the gross and reinsurance side.
06| IFRS AASB17 | September 2017| IFRS AASB17 | September 2017
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Cross subsidies may spring into focusDepending on how the practical treatment of onerous contracts play out, and the level of disclosure required, products with a high degree of cross-subsidy between contracts may get greater focus from management and boards. This may lead insurers to rethink some cross-subsidies.
DisclosuresDisclosures will be important – as they drive a lot of activity for actuaries and accountants. The AASB will be reviewing the AASB 17 disclosures, and we will keep a watching brief as the requirements evolve. The required level of disclosure around onerous contracts will be of particular interest.
About FinityFinity is Australia’s largest independent actuarial and analytical consulting firm. We provide a comprehensive suite of consulting services to insurers across Australia and New Zealand. Our unrivalled depth of knowledge about the insurance industry has been developed over three decades.
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This article does not constitute either actuarial or investment advice.
While Finity has taken reasonable care in compiling the information presented, Finity does not warrant that the information is correct.
