CSM – Accounting treatment
Under the currently effective IFRS 4 Insurance Contracts, a wide range of practices are permitted and many insurance companies recognize profit from an insurance contract at the point of sale. The new accounting standard IFRS 17, which becomes effective for annual periods beginning on or after 1 January 2023, requires that such day 1 profits are offset with a liability – the CSM. The CSM is gradually released over the term of the contract, so that the profit from the contract is realized by the insurer over multiple future accounting periods as it provides services under the contract. As such, the CSM represents the unearned profits that an insurer is required to defer on the issuance of insurance contracts and to recognize these profits as the services are provided in the future. [IFRS 17.BC21]
The new requirements may significantly affect the amount of an insurer's annual profit. Insurers will generally need to calculate the CSM at the transition date when they adopt the new standard, applying the new rules retrospectively with adjustments to their retained earnings. Under this retrospective approach, an insurer restates its financial statements to (1) recognize and measure insurance contracts as if IFRS 17 had always applied and (2) recognize the net difference from the old rules in equity on the transition date. The portion of profits previously recognized in retained earnings for contracts issued prior to transition that are still unearned at the time of transition will be included in the CSM and realized over future accounting periods. [IFRS 17.C3–C4]
CSM – Variation in tax treatments
The tax consequences of the creation and reversal of the CSM depend on the local tax rules. In some countries, the taxation of income from premiums received or earned and tax deductibility of expenses related to settlement of claims is based on specific tax rules, or is aligned with local GAAP or the regulatory financial statements.
In other countries, the taxation of insurance contacts is aligned with IFRS® Standards.
Tax follows IFRS Standards
As a result of the transitional adjustment to retained earnings, absent local tax legislation specifically dealing with changes in accounting policies, profits previously recognized for income tax purposes based on financial statements prepared under IFRS 4 may be subject to tax again under IFRS 17 through the recognition of the CSM in future years' accounting net income.
Even if tax legislation is designed to avoid double taxation, a specific amendment may be needed to prevent a large tax loss arising at the point of transition. For example, a spreading rule should help maintain the stability of the government’s tax revenues while protecting taxpayers from the effects of any loss restriction or loss expiry rules.
In determining the financial impact of adopting IFRS 17, insurers will need to focus on not just the quantum of taxable profits but also the timing of their recognition. Tax rates could trend upwards in the future, which may mean that changes which defer the recognition of profits could increase the insurer’s overall tax liability over the life of the product.
Countries that base the local tax calculation on the accounting under IFRS Standards may choose to depart from that position in future. Under IFRS 17, the taxable profit would be deferred with the booking of the CSM and only be realized over time as services are provided. We expect that some tax authorities may not favor such a deferral and may preserve an approximation of the existing tax treatment of insurance profits.
Not recognizing the deferral of profits via the CSM for tax purposes would compensate for the effect of transitioning to IFRS 17. This should mean that the size of the transitional adjustment for tax purposes should be smaller and mitigate the need for special tax rules (such as spreading) to smooth out the effects of transition.
Tax does not follow IFRS Standards
In those countries where profits on insurance contracts are taxed earlier than under IFRS 17, recording the CSM results in a deductible temporary difference.
Under IAS 12 Income Taxes, an entity recognizes a deferred tax asset in relation to a deductible temporary difference to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be realized. In performing the recognition assessment, the entity considers all its deductible temporary differences and unused tax losses against available taxable temporary differences and other sources of future taxable profits. Because the profit used for the asset recognition test is adjusted to exclude the reversal of the temporary differences – i.e. it is not the bottom line of a tax return – the release of the CSM resulting in the reversal of the deductible temporary difference may support recognition of the related deferred tax asset. [IAS 12.29(a)(i)]
Insurers and tax authorities will need to address how these significant accounting adjustments are treated for income tax purposes. Insurers will need to understand the sensitivity of their results to potential changes in tax laws and tax rates. Modelling may be important to analyzing the sensitivity, particularly for insurance companies that are modelling the potential effects of BEPS Pillar 2.
We would like to thank Philip Jacobs and Gordon Gray for their valuable contribution to this article. For further information and guidance on the topic, please contact a member of the team.