RECOMMEND: The final countdown to IFRS 17 …

The International Accounting Standards Board (IASB) issued IFRS 17 in May 2017, 20 years after the project on insurance contracts started. In June 2020, the IASB issued amendments to IFRS 17 to respond to the concerns and implementation challenges raised by insurers and other stakeholders.

IFRS 17 requires all companies that issue insurance contracts to account for insurance contracts in a way that provides:

• Current estimates at each reporting date of the obligation created by the insurance contracts, reflecting up-to-date information about cash flows arising from insurance contracts and the timing and risk associated with those cash flows, and
• Information about
  o The sources of profit or losses through underwriting activity and investing premiums from customers, and
  o The extent and nature of risks arising from insurance contracts

IFRS 17 is expected to provide users of financial statements with more relevant information about the company’s financial position and performance, as well as better transparency. In addition, as a result of consistent accounting requirements, the IASB expects significantly improved comparability.

SAICA identified the need to assist with the consistent implementation across the industry and established the IFRS 17 SAICA interest group in 2018. South African insurers, the Prudential Authority, representative industry bodies and auditors participate in this group that meets three times a year. The interest group discusses and shares IFRS 17 implementation issues and challenges, but does not have the mandate to issue guidance or to make decisions.

Looking back at the interest group’s journey over the past four years, many technical IFRS 17 issues have been discussed. A summary of the issues will be available on SAICA’s IFRS 17 portal (IFRS 17 – Insurance Contracts | SAICA). A few of the topical issues are discussed in this issue:

• Cash-back products
• Policyholder taxes
• Directly attributable expenses
• Incurred insurance service expenses in the scope of another standard included in the liability for incurred claims

The articles summarise the discussions in the interest group and will assist insurers to understand the various views in the industry and identifying which view is most appropriate to their circumstances.

Five months to go for December year-ends and 11 months to go for June year-ends …

Insurers argue that IFRS 17 was by far the biggest change they have had to deal with in the past few years. Apart from the technical issues, IFRS 17 had a major impact on people, processes and systems. Now is the time not to take the foot off the pedal (the accelerator, not the brake)!
As IFRS 17 has to be applied retrospectively, insurers should focus on the ultimate goal of the IFRS 17 implementation project – to have transition numbers available in terms of IFRS 17 for the transition date − 1 January 2022 for December year-ends and 1 July 2022 for June year-ends.

Cash-back products
Cash-back products are unique to South Africa. The big question for the short-term industry is whether these products could qualify as short-duration contracts in IFRS 17. This is an important consideration, as it will impact the decision on the measurement model. If the contracts are short-duration contracts, insurers may apply the simplified premium allocation approach that is more closely aligned to their current accounting model.

A typical example is as follows:

Contract boundary

Example
An insurer issued a motor policy in terms of which cash will be paid to the policyholder if he/she does not claim for three consecutive years. The policyholder will receive 10% of all premiums paid within this period (three years).
The insurer reprices the insurance policy annually, on the policy’s anniversary. At that point, the insurer will set the price for the renewed contract as it would for a new contract issued on that date with the same characteristics as the existing contract. A policyholder may cancel the policy at any time and with immediate effect. The insurer may cancel the policy by giving the policyholder 30 days’ notice.
The policyholder will not receive the cash-back if the policy is cancelled before the cash-back has been paid, and therefore the cash-back does not meet the definition of an investment component in IFRS 17.

The first important question was to determine whether the cash-back had an impact on the contract boundary of the insurance contracts. IFRS 17 states the following on contract boundary:

Cash flows are within the boundary of an insurance contract if they arise from substantive rights and obligations that exist during the reporting period in which the entity can compel the policyholder to pay the premiums or in which the entity has a substantive obligation to provide the policyholder with insurance contract services. A substantive obligation to provide insurance contract services ends when:
(a) the entity has the practical ability to reassess the risks of the particular policyholder and, as a result, can set a price or level of benefits that fully reflects those risks (IFRS 17.34).

Generally, members believed that the cash-back feature did not impact the contract boundary when the principles in IFRS 17.34 are applied to the example above. Some viewed the contract boundary as 30 days as the right to cancel seemed to have commercial substance and reflected a substantive right (IFRS 17.2). Others argued that the contract boundary is 12 months (i.e. up to the repricing point). If the insurer cancels, it may be seen as not treating customers fairly. On that basis, the members argued that the right to cancel was not substantive. However, there was a general consensus that the boundary was short (30 days or 12 months).

Effectively, for IFRS 17, if the boundary is 30 days, there will be 36 insurance contracts issued and if the boundary is 12 months, there will be three contracts issued (in a three-year period).

Accounting for the cash-back feature
The interest group considered whether the cash-back feature should be included as part of the liability for remaining coverage or the liability for incurred claims on the basis that the insurer is applying the premium allocation approach.

The general consensus was that the expected value of the cash-back should be accrued for in the liability for incurred claims in each contract period (30 days or 12 months).

It is argued that the cash-back should be accrued for as one necessary pre-condition for payment has been met (in the contract period of 30 days or 12 months), specifically the passage of a discreet element of time. The policyholder met the eligibility criteria and is building up to the total anticipated cash-back payment at the end of the reward cycle (three years in the example).

Policyholder taxes
In South Africa, the trustee principle is applied when taxing policyholder income that is accounted for in the applicable policyholder fund of a long-term insurance company. This is on the basis that insurers are deemed to hold and administer certain of their assets on behalf of various categories of policyholders while the balance of their assets represents shareholders’ equity.

This income tax system has been designed such that the income tax which is collected from the insurer in respect of the policyholder funds approximates the income tax which would have been collected, had the income tax been levied on the income due to each of the policyholders in their individual capacities.

The question is how such policyholder taxes should be accounted for in terms of IFRS 17.

IFRS 17 states the following:

Cash flows within the boundary of an insurance contract are those that relate directly to the fulfilment of the contract, including cash flows for which the entity has discretion over the amount or timing. The cash flows within the boundary include:
(j) payments by the insurer in a fiduciary capacity to meet tax obligations incurred by the policyholder, and related receipts (IFRS 17.B65)

FRS 17.B66 and B121 were amended as part of the 2020 amendments as follows:

The following cash flows shall not be included when estimating the cash flows that will arise as the entity fulfils an existing insurance contract:
(f) income tax payments and receipts the insurer does not pay or receive in a fiduciary capacity or that are not specifically chargeable to the policyholder under the terms of the contract (IFRS 17.B66)

Paragraph 83 requires the amount of insurance revenue recognised in a period to depict the transfer of promised services at an amount that reflects the consideration to which the entity expects to be entitled in exchange for those services. The total consideration for a group of contracts covers the following amounts:

• (ia) amounts related to income tax that are specifically chargeable to the policyholder’ (IFRS 17.B121)

Based on the above paragraphs, the income tax payments and receipts are included in the fulfilment cash flows (if they are specifically chargeable to the policyholder under the terms of the contract) as well as the reimbursements of amounts specifically chargeable to the policyholder.

Example
The expected policyholders’ share of the investment return earned on underlying items is R1 000. The policyholder tax rate is 28%. Charges of R280 will be specifically charged to the policyholders in respect of this investment return.
The company also has R300 of expenses and obtains tax deduction of R84. This tax relief is not credited to the policyholders. The payment to the South African Revenue Service is for the net amount of R196 (R280 – R84).
Should R280 or R196 be included in the fulfilment cash flows?

Staff Paper AP2F discussed at the February 2020 IASB meeting noted no profit would arise for the insurance entity because cash outflows (income tax payments to the tax authority) would always result in equal cash inflows (reimbursement of income tax charged to a policyholder).

Based on the above, it seems that R280 should be included in the fulfilment cash flows, in other words equal to the amount specifically chargeable to the policyholder. It will be included as an inflow as the amount chargeable to the policyholder, but also as a tax cash flow. The tax relief of R84 is not passed on to the policyholders and will be reflected in the income tax line item in the income statement of the insurer.

The example may not apply to all insurers. Insurers should consider their specific facts and circumstances to determine what amounts are specifically charged to the policyholder.

The interest group considered whether income tax payments and receipts are specifically chargeable to the policyholders and whether this ability to charge is reflected in the terms of the contract. The interest group specifically referred to IFRS 17.2 which states that −

An entity shall consider its substantive rights and obligations, whether they arise from a contract, law or regulation, when applying IFRS 17. A contract is an agreement between two or more parties that creates enforceable rights and obligations. Enforceability of the rights and obligations in a contract is a matter of law. Contracts can be written, oral or implied by an entity’s customary business practices.

The terms of contract may be seen as the wording in the actual contract with the policyholder. Alternatively, members argued that it can be interpreted wider based on IFRS 17.2 which refers to ‘contracts can be written, oral or implied by an entity’s customary business practices’.

Directly attributable expenses
Cash flows within the boundary of an insurance contract are those that relate directly to the fulfilment of the contract and include those over which the entity has discretion.

IFRS 17 states the following regarding these cash flows:

The cash flows within the boundary of a contract include:

• (l) an allocation of fixed and variable overheads (such as the costs of accounting, human resources, information technology and support, building depreciation, rent, and maintenance and utilities) directly attributable to fulfilling insurance contracts. Such overheads are allocated to groups of contracts using methods that are systematic and rational, and are consistently applied to all costs that have similar characteristics (IFRS 17.B65).

IFRS 17.B66 states that the following cash flows shall not be included in the fulfilment cash flows:

• (d) cash flows relating to costs that cannot be directly attributed to the portfolio of insurance contracts that contain the contract, such as some product development and training costs. Such costs are recognised in profit or loss when incurred

A number of points were debated when the interest group considered what are directly attributable costs that should be included in the fulfilment cash flows.

It is important that insurers document the rationale as to why they believe that certain costs are directly attributable. IFRS 17 does not define what ‘directly attributable’ means. Insurers are urged to finalise their discussion on directly attributable costs with their auditors as it may have a big impact on transition numbers.

We have included examples of costs and views and concerns raised by the industry group as to whether these costs are directly attributable:

View TABLE

As can be seen from the above analysis, there are various views in the industry as to which costs are directly attributable and which costs are not directly attributable. As indicated above, a good, supportable rationale should be provided as to why certain costs are directly attributable. When only a percentage of the costs are directly attributable, also explain how the percentage is calculated.

Lastly, insurers should document how the overheads are allocated to groups of contracts using methods that are systematic and rational, for example using hours spent by employees.

NOTES
1 IFRS 17 Insurance Contracts is effective for year-ends commencing on or after 1 January 2023.
2 https://www.ifrs.org/content/dam/ifrs/project/insurance-contracts/current-stage/educational-materials/why-change-insurance-contracts-accounting.pdf.
3 IFRS 17 defines the liability for incurred claims as an entity’s obligation to ‘investigate and pay valid claims for insured events that have already occurred, including events that have occurred but for which claims have not been reported, and other incurred insurance expenses and pay amounts that relate to insurance contract services that have already been provided or any investment components or other amounts that are not related to the provision of insurance contract services and that are not in the liability for remaining coverage” (IFRS 17 Appendix A).
4 The liability for remaining coverage is ‘an entity’s obligation to investigate and pay valid claims under existing insurance contracts for insured events that have not yet occurred (ie the obligation that relates to the unexpired portion of the insurance coverage)’ (IFRS 17, appendix A).
5 https://www.ifrs.org/content/dam/ifrs/meetings/2020/february/iasb/ap2f-amendments-to-ifrs.pdf

Author
Esther Pieterse, Technical Partner, KPMG and Chairperson of the SAICA IFRS 17 interest group