IFRS 17 requires the segmentation of contracts issued by an insurer based on annual cohorts, or in shorter time buckets, in order to closely steer the evolution of their commitments towards insured parties as they are serviced over time.
As various changes, especially in economic environment, could occur between two consecutive years, insurers will be obliged to identify each of these changes, and to assess and manage their impacts on their own contractual service margin (CSM).
On another note, cohorts will reflect the real profits related to the service to be provided, without any possibility for older onerous contracts to be compensated for by new ones which would cover the inherent technical and financial risks.
Few aspects of IFRS 17 have been as controversial as the use of annual cohorts. Some insurers have long questioned this feature, arguing that it violates the fundamental principle of insurance, especially for contracts under the variable fee approach where profit mutualization is mandatory between contracts of different generations and the related risks are fully shared. Furthermore, they have called into doubt the usefulness of the information obtained, while pointing out that the costs necessary for its application will remain considerable.
Indeed, in its March 2020 letter to the International Accounting Standards Board (IASB) on IFRS 17 amendments, the European Financial Reporting Advisory Group (EFRAG) drew the Board’s attention to these concerns and recommended that the IASB reconsider its position on the matter.
After much debate and consultation, the IASB made it clear that annual cohorts must be taken into account for IFRS 17 and issued an article on the topic in April 2020 (“In brief: IFRS 17 Insurance Contracts—Why annual cohorts?”).
Its decision is mainly explained by the importance of users of financial statements having clear information on profitability. It implies that mixing information based on different generations of contracts is not acceptable, as users would not be able to fully model future profitability. In addition, not applying annual cohorts could result in accounting losses being delayed, which the Board would view as unacceptable and imprudent accounting.
Most of the arguments provided by insurers against annual cohorts were refuted by the Board. As a conclusion, while acknowledging the costs of implementation for insurers, the IASB considers that these are outweighed by the gains.
For those insurers that took the option of not applying annual cohorts during their IFRS 17 projects, the decision of the Board will definitely add an unwelcome complexity. The additional data load needed to retain information by generation is not negligible and has potential impacts on IT too. Additional actuarial work will be required to define an acceptable calculation of the CSM by generation and further discussions between insurers on this subject seem likely.
The reduction in interest rates has already been putting a lot of pressure on the business model of many life insurers in recent years. The IASB’s decision will be another blow to the models of those insurers that offer a General Fund to their clients. As balance sheets will likely be impacted by the decision, with more onerous contracts being displayed in the financial statements, it could also encourage insurance companies’ management teams to think differently about the profitability of their portfolios.
This article has been written together with François Guillot and Yakoub Abadlia.
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