IFRS 17 defines ‘insurance risk’ and ‘financial risk’ as follows.
Insurance risk - Risk, other than financial risk, transferred from the holder of a contract to the issuer.
Financial risk - The risk of a possible future change in one or more of a specified interest rate, financial instrument price, commodity price, currency exchange rate, index of prices or rates, credit rating or credit index or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract.
The main reason for distinguishing insurance risk from financial risk is that arrangements that give rise to financial risk are typically accounted for as financial instruments under IFRS 9 Financial Instruments. It is relevant to note, however, that some arrangements (such as some life insurance products) give rise to both financial and insurance risks. In circumstances where the insurance risk component is significant (which is discussed further below), the arrangement would be considered an insurance contract.
For non-insurers, a key issue to consider when assessing whether a particular arrangement gives rise to insurance risk is whether the entity will be required to compensate the counterparty for a change in one or more non-financial variables that are specific to the counterparty. This is best demonstrated by way of examples:
If a non-insurer agrees to compensate a counterparty for any loss in the residual fair value of a vehicle belonging to the counterparty as a consequence of the vehicle being damaged by fire, the non-insurer is exposed to insurance risk.
In contrast to Example 1, if a non-insurer agrees to compensate the same counterparty for any loss in the residual fair value of the same vehicle, but excluding changes in fair value attributable to changes in the physical condition of the particular vehicle (due to, for instance, fire), the non-insurer is exposed to financial risk
Notwithstanding that in both of the foregoing examples the non-insurer is on risk to compensate the counterparty for changes in the residual fair value of the vehicle, the event that triggers the payment of compensation (and potentially the amount of compensation paid) will differ. In the first example, the event is a fire that damages or destroys the specific vehicle, whereas in the second example the event is a change in the mean or median residual fair value of all vehicles in the same class, ignoring the impact of changes in the physical condition of any specific vehicles.
These examples also demonstrate another necessary feature of an insurance risk – it must be a risk to which the counterparty was already exposed prior to entering into the arrangement with the non-insurer. If an arrangement permits a counterparty to, for instance, avoid paying a fee to the non-insurer in respect to an arrangement in the event that the counterparty enters into bankruptcy, this feature (the obligation to pay the fee) is not regarded as an insurance contract because it is not a risk to which the counterparty was already exposed prior to entering the arrangement.
Is the insurance risk significant?
Having established a contractual arrangement exposes a non-insurer to insurance risk, the next step for the non-insurer is to assess the significance of the insurance risk.
IFRS 17 clarifies, among other things, that insurance risk is significant if, and only if, the insured event could cause the non-insurer to pay additional amounts (including any assessment and claims handling costs) that are significant in any single scenario (assessed by reference to the contract itself), excluding (as alluded to above) scenarios that have no commercial substance.
Accordingly, if an insured event could require the non-insurer to pay additional amounts in any scenario that has commercial substance, the insurance risk might be considered significant, despite the:
- Insured event being extremely unlikely
- Expected (probability-weighted) present value of the contingent cash flows representing a small proportion of the expected present value of the remaining cash flows from the contract
- Non-insurer transferring substantially all of the significant risks to a reinsurer, and/or
- Non-insurer expecting to make no overall loss on the portfolio of contracts to which the insurance contract belongs.