Identifying and measuring the components of insurance contracts
Last month, we looked at the when insurance contracts are recognised (Booking insurance contracts – It’s all in the timing). This month, we look at how an entity would account for any non-insurance components contained within an insurance contract.
Accounting for non-insurance components of an insurance contract
It is not uncommon to find that an insurance contract contains one (or more) components that are not in the nature of insurance coverage. For instance, some life insurance products (sometimes referred to as ‘whole life insurance’) include an arrangement whereby the insurer invests a part of the premiums in a savings account on behalf of the policyholder, the balance of which is provided to the policyholder in the event that the insured event occurs or the policyholder surrenders (cancels) the insurance policy. As the resulting balance of the savings account is not necessarily dependent on the insured event, from the insurer’s perspective, it is in the nature of a financial liability rather than an insurance contract.
When confronted with an arrangement that comprises two or more identifiable and distinct components, International Financial Reporting Standards (IFRS) and New Zealand equivalents to International Financial Reporting Standards (NZ IFRS) typically require the issuer of the product to account for each of the components separately, as if each component was a stand-alone arrangement. In some cases, however, IFRS and NZ IFRS might permit or require two or more components to be accounted for as a single component for practical reasons, such as:
- It may be difficult to reliably attribute cash flows to the individual components because the components are rarely or never sold separately, and/or
- Comparable reporting results can be achieved, particularly where the cash flows of the individual components are interrelated, by the issuer of the product accounting for multiple components together using a single measurement model.
Unsurprisingly, IFRS 17 Insurance Contracts requires insurers to apply a similar approach to insurance contracts with non-insurance components.
Separating insurance and investment components
When an insurer issues an insurance contract that requires the insurer to provide the policyholder with both:
- Insurance contract services – insurance coverage plus, if applicable, services related to managing a clearly identified pool of assets that the policyholder will share in along with other policyholders, and
- An investment component – the right to a lump sum (which may reflect a fixed or variable return), irrespective of whether the insured event occurs,
IFRS 17 requires that the insurer separately account for the investment component if, and only if, that investment component is ‘distinct’.An investment component is distinct if, and only if, both of the following conditions are met:
- The investment component and the insurance component are not highly interrelated, and
- A contract with equivalent terms is sold, or could be sold, separately at least in the same jurisdiction.
- The insurer is unable to measure one component without considering the other component. For instance, when the value of one component changes in direct response to a change in the other component, or
- The policyholder is unable to benefit from one component unless the other component is also present. For instance, if the lapse or maturity of one component would cause the lapse or maturity of the other component, this would suggest the two components are highly interrelated.
Separating other components from insurance and investment components
Insurance contracts might also comprise components in addition to, or instead of, an investment component. In such circumstances, the insurer is required to:
- Apply the relevant requirements in IFRS 9 Financial Instruments to determine whether there is an embedded derivative in the contract (which may be distinct from any investment component), and if so account for the embedded derivative in accordance with that Standard, and
- Separately account for any distinct goods or services (other than insurance contract services) to be provided to the policyholder in accordance with IFRS 15 Revenue from Contracts with Customers. Accordingly, under IFRS 17 an insurer would:
- Apply IFRS 15 to attribute the cash inflows between the insurance component and any promises to provide distinct goods or services other than insurance contract services, and
- Attribute the cash outflows between the insurance component and any promised goods or services other than insurance contract services, accounted for by applying IFRS 15 so that:
- Cash outflows that relate directly to each component are attributed to that component, and
- Any remaining cash outflows are attributed on a systematic and rational basis, reflecting the cash outflows the entity would expect to arise if that component were a separate contract.
Note: Under IFRS 9, the accounting for embedded derivatives can differ subject to whether:
- The non-derivative host and the derivative each have economic characteristics and risks that are not ‘closely’ related and a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative in IFRS 9, and
- The issuer of the instrument meets any of the necessary criteria that permit or require the entity to account for the entire arrangement at fair value through profit or loss.
For more on the above, please contact your local BDO representative.