Backwards and in high heels: what makes reinsurance under IFRS 17 so complicated

Results of the Insight Life Solutions 2022 industry-wide IFRS 17 survey and subsequent discussions with its participants revealed that reinsurance is still a topic steeped in uncertainty for many insurers. The reason for this, in short, is that reinsurance is the Ginger Rogers to insurance’s Fred Astaire under IFRS 17: reinsurance does everything insurance does, just backwards…and in high heels.

Backwards because reinsurance movements usually mirror those of their insurance counterparts: reinsurance contracts held are generally assets rather than liabilities; premiums are outflows rather than inflows; the reinsurance risk adjustment represents a transfer of risk away from the insurer rather than towards it; and the loss recovery component is a mechanism for an instant boost to the P&L, offsetting the immediate drop associated with the loss component. All this thinking in reverse requires any insurer (and their models, systems and processes) to keep their wits about them during implementation and reporting.

High heels because of the additional complexities of the reinsurance balance sheet (not seen on the insurance side) that require some fancy footwork to navigate, from reinsurance contract boundaries to subsequent measurement of the reinsurance CSM.

The metaphor held before the June 2020 amendments to the IFRS 17 Standard, and, since then, it has only been reinforced. The amendments introduced the concept of the loss-recovery component as an offset to the loss component, forging new links between insurance and reinsurance contracts and groups. It is these links that make the measurement of the loss-recovery component, and hence reinsurance reporting, so complex.

This article touches on some of the elements of the loss-recovery component and other aspects of reporting for reinsurance contracts held that make it one of the more complicated aspects of IFRS 17 and the subtleties that insurers should bear in mind when implementing them.

1. Reinsurance contract boundaries, grouping, and measurement

One of the first reinsurance-related questions insurers need to consider is what constitutes a reinsurance contract boundary and hence which cash flows should be included in its measurement.

The measurement of reinsurance contracts held is similar to that of insurance contracts issued in that cash flows within the boundary of a reinsurance contract held arise from the substantive rights and obligations of the insurer (IFRS17:63).

As a practical application of the above definition, think of a reinsurance treaty’s notice period, which allows either party to cancel the contract with, say, three months’ notice. Due to the notice period, the contract boundary for this reinsurance contract held will include the reinsurance cash flows relating to the following three months of new business the insurer expects to write over that period. Within an annual period, there would therefore be four separate reinsurance ‘contracts’ held by the insurer. [1]

If contracts issued by the insurer are covered on a risk-attaching basis, all covered insurance contracts written during a particular three-month period would be ‘attached’ to the associated reinsurance contract for the entire insurance policy term. These insurance contracts indirectly determine the cash flows, the profitability and the IFRS 17 grouping of the reinsurance contract in question. Actuarial and accounting systems, therefore, need to keep track of the reinsurance group of each insurance contract written until it is no longer in force.

Another implication is that, at a given valuation date, insurers need to estimate all expected future cash flows within the boundary of a reinsurance contract, including those from underlying insurance contracts expected to be issued in the future. So, if a reinsurance contract with a three-month contract boundary incepted on 1 December, the 31 December valuation of the reinsurance contract would not only need to include estimated future cash flows stemming from insurance contracts written in December but also those from insurance contracts expected to be written in January and February. The insurer would, therefore, need to establish a suitable methodology to quantify expected new business (e.g. based on sales forecasts or business plans). This introduces operational complexity, misalignments between reinsurance and insurance reporting, and concerns around intellectual property, as sensitive business assumptions around future sales might indirectly now need to be made public.

2. Risk of non-performance of reinsurers

The measurement of the expected present value of future cash flows of a reinsurance contract includes an adjustment for the risk that the reinsurer may fail to satisfy its obligations under the reinsurance contract held (IFRS17:63).

This is an additional calculation – one without an equivalent in the measurement of insurance contracts issued – for which the insurer needs to set an appropriate methodology. According to the Insight IFRS 17 survey, South African insurers generally plan to repurpose the recoverable reinsurance haircut SAM requires – or some variation based on the reinsurer’s credit rating – to determine the required adjustment. The insurer may need to consider whether any modifications to the SAM calculation are required and ensure that changes in credit assumptions are accounted for appropriately.

3. Changes in fulfilment cash flows related to future service

The June 2020 amendments made provision for establishing a loss-recovery component at initial recognition to offset the loss component. The loss-recovery component reduces the reinsurance CSM calculation, increases profit and is relatively straightforward to calculate as the product of:

• the loss recognised on the underlying insurance contracts; and
• the percentage of claims on the underlying insurance contracts the entity expects to recover from the group of reinsurance contracts held.

(IFRS17:B119D)

But what happens at subsequent measurement? How do changes in reinsurance fulfilment cash flows adjust the reinsurance CSM and loss-recovery component?

At subsequent measurement, insurers will need to measure the CSM of each reinsurance group based on the guidelines in paragraph 66 of the standard. Paragraph 66(c) says that the CSM must be adjusted for: 

Changes in the fulfilment cash flows…to the extent that the change relates to future service, unless:

• the change results from a change in fulfilment cash flows allocated to a group of underlying insurance contracts that does not adjust the contractual service margin for the group of underlying insurance contracts…

This means that the reinsurance CSM adjustment is based on what happens in the underlying insurance group(s). If the underlying insurance contracts are in a profitable insurance group with a CSM, the change in reinsurance fulfilment cash flows adjusts the reinsurance CSM. If the underlying insurance contracts are in an onerous insurance group and hence have a loss component, the change in reinsurance fulfilment cash flows adjusts the loss-recovery component as per paragraph B119F:

After an entity has established a loss-recovery component…, the entity shall adjust the loss-recovery component to reflect changes in the loss component of an onerous group of underlying insurance contracts…

If the underlying insurance group moves from a profitable position to a loss-making position, or vice versa, the insurer must find a sensible way to split the change in reinsurance fulfilment cash flows between the reinsurance CSM and loss-recovery component.

4. The grand finale: paragraph B119F

B119F is the last paragraph in the IFRS 17 standard pertaining to the measurement of reinsurance contracts. It alludes to the reversal of the loss-recovery component – an item which adjusts the reinsurance CSM and the P&L – specifying that it should reflect changes in the loss component of an onerous group of underlying insurance contractsbut is not prescriptive about how the reversal should be calculated. This means that insurers must formulate an appropriate methodology to do so.

It also says that [t]he carrying amount of the loss-recovery component shall not exceed the portion of the carrying amount of the loss component of the onerous group of underlying insurance contracts that the entity expects to recover from the group of reinsurance contracts held. It is not obvious how the aforementioned “portion of the loss component” should be calculated, seeing as the loss component of an insurance group is not measured separately per related reinsurance group or for reinsured versus non-reinsurance cash flows. Insurers must devise a pragmatic way to determine the portion of the loss component expected to be recovered to enable them to perform the required test.

The issues outlined in this article are just some considerations that would apply even to those insurers with very straightforward reinsurance arrangements. It can be easy to slip up when dealing with a reinsurance structure that has many to many relationships between insurance and reinsurance groups. We have found, however, that by working through the IFRS 17 paragraphs one at a time, the challenges are not insurmountable. It is, therefore, worthwhile for every insurer to look in the mirror, don their highest heels, and choreograph the methodology, modelling and systems impacts introduced by the IFRS 17 reinsurance requirements, step by step.

[1] This annual period may not necessarily align with the insurer’s financial reporting year, which introduces complexities of its own.