Applying the General Measurement Model in IFRS 17 Insurance Contracts to a portfolio of insurance contracts – onerous contracts

In the October and November 2021 editions of Accounting News (since renamed Corporate Reporting Insights), we looked at a number of fictitious worked examples demonstrating how a relatively simple portfolio of insurance contracts would be accounted for under the general measurement model in IFRS 17. In all of these examples, we assumed the portfolios comprised insurance contracts that were expected to be profitable from the perspective of the insurer.

In this month’s edition, we will look at how contracts that are expected to be unprofitable when written (i.e. onerous on initial recognition) would be accounted for under IFRS 17.

When is an insurance contract classified as an onerous contract?

An insurance contract is classified as onerous at the date of its initial recognition if the sum of the following on that date are a net outflow:

The fulfilment cash flows allocated to the contract
Any previously recognised insurance acquisition cash flows arising from the contract
Any cash flows arising from the contract at the date of initial recognition.

There are a range of reasons why an entity might sell an insurance policy that is onerous. For instance, an insurer might, in an attempt to capture a greater share of a particular insurance market, price its policies lower than its competitors, which in turn results in some of the contracts being onerous.

IFRS 17 requires that when a portfolio of insurance contracts includes onerous contracts, the onerous contracts must be identified as such by being grouped and accounted for separately from profitable contracts in the same portfolio. The main purpose of this treatment is to ensure profitable contracts do not mask unprofitable contracts within the same portfolio.

It is important to note, however, that not all onerous contracts are required to be separately accounted for. IFRS 17 does not require an insurer to treat insurance contracts as onerous if the only reason those contracts are onerous is because a law or regulation specifically constrains the insurer’s practical ability to set different pricing or benefit levels for policyholders with different characteristics.

How are onerous insurance contracts accounted for?

When a group of insurance contracts are initially identified as onerous, IFRS 17 requires an entity to recognise a loss immediately in respect to groups of onerous contracts. As explained by the IASB in the Basis for Conclusions to IFRS 17, this reflects the view that the carrying amount of a group of insurance contracts should reflect the obligation of the entity to provide future service, and that amount should be at least equal to the fulfilment cash flows. Furthermore, if an insurance contract is identified as onerous, the loss associated with the contract is required to be immediately recognised, even if this is before the coverage period commences or the first premium is due from the policyholder. This approach is consistent with the treatment of onerous contracts under both IFRS 15 Revenue from Contracts with Customers and IAS 37 Provisions, Contingent Liabilities and Contingent Assets.

Example

To demonstrate the implications of onerous contracts under IFRS 17, we assume the following fact pattern.

BDO Pet Insurance Ltd has written 100 three-year insurance policies to commence on 1 July 2022.

The policies insure the holder for up to 50% of any eligible veterinarian bills they incur in respect to their pets during the coverage period.

Each holder of a policy is required to pay an annual $65 premium, payable on the first day of each year of the coverage period.

For the purposes of measuring the insurance contracts under IFRS 17, and based on past experience with similar types of insurance policies, BDO Pet Insurance Ltd adopts the following assumptions:

Expected annual cash outflows are $7,000 per annum
All insurance claims that are incurred during a year will be paid at the end of the year
No policies will lapse during the coverage period and no extension periods are offered under the policy
Discount rate of 5% per annum
BDO Pet Insurance Ltd is not exposed to any material financial risk in respect to the insurance policies
The risk adjustment for non-financial risk is measured at 5% of the present value of the expected cash outflows
BDO Pet Insurance Ltd incurs no initial acquisition costs in respect to the insurance policies.

In addition, for the purpose of demonstrating the accounting for these policies under IFRS 17, we will assume all of the policies are equally onerous.

Based on the foregoing assumptions and information, BDO Pet Insurance Ltd measures the portfolio of onerous contracts on initial recognition as outlined below.

	$
Estimate of the present value of future cash inflows	18,586
Estimate of the present value of future cash outflows	19,063
Estimate of the present value of future (net) cash flows	(477)
Risk adjustment for non-financial risk	(953)
Fulfillment cash flows	(1,430)
Contractual service margin	0
Insurance contract asset/(liability) on initial recognition	(1,430)
Loss recognised on initial recognition of insurance contract liability	1,430

As demonstrated above, on initial recognition the fulfilment cash flows attributable to the insurance policies issued by BDO Pet Insurance Ltd are expected to produce a net outflow to the entity. Accordingly, BDO Pet Insurance Ltd will:

Set the contractual service margin for the portfolio of onerous insurance contracts to zero, and
Recognise a loss equal to the fulfilment cash flows, which comprises the estimate of the present value of future (net) cash flows and the estimated risk adjustment for non-financial risk.

If BDO Pet Insurance Ltd’s assumptions at the commencement of the insurance contracts hold for the term of the contracts, the entity would measure the insurance contracts for each of the three years as follows.

Year ended 30 June 2023	Estimates of present value of future cash flows ($)	Risk adjustment for non-financial risk ($)	Contractual service margin ($)	Insurance contract liability ($)
Opening balance (asset)/liability	0	0	0	0
Changes related to future service: new insurance contracts	477	953	0	1,430
Cash inflows	6,500	_	_	6,500
Insurance finance expenses	953	48	_	1,001
Insurance finance income	(604)	_	_	(604)
Changes related to current service	0	(398)	_	(398)
Cash outflows	(7,000)	_	_	(7,000)
Closing balance – (asset)/liability	326	603	0	929

Year ended 30 June 2024	Estimates of present value of future cash flows ($)	Risk adjustment for non-financial risk ($)	Contractual service margin ($)	Insurance contract liability ($)
Opening balance (asset)/liability	326	603	0	929
Cash inflows	6,500	_	_	6,500
Insurance finance expenses	651	30	_	681
Insurance finance income	(310)	_	_	(310)
Changes related to current service	0	(380)	_	(380)
Cash outflows	(7,000)	_	_	(7,000)
Closing balance – (asset)/liability	167	253	0	420

Year ended 30 June 2025	Estimates of present value of future cash flows ($)	Risk adjustment for non-financial risk ($)	Contractual service margin ($)	Insurance contract liability ($)
Opening balance (asset)/liability	167	253	0	420
Cash inflows	6,500	_	_	6,500
Insurance finance expenses	333	13	_	346
Insurance finance income	0	_	_	0
Changes related to current service	0	(266)	_	(266)
Cash outflows	(7,000)	_	_	(7,000)
Closing balance – (asset)/liability	0	0	0	0

Next month

In next month’s edition of Corporate Reporting Insights, we will continue to look at the measurement of onerous contracts and the implications under the general measurement model in IFRS 17 of onerous contracts becoming more or less onerous over time.

Need assistance?

Please contact Dean Ardern if you need help with accounting for your insurance contracts.