Since its initial publication in May 2017, IFRS 17 Insurance Contracts (‘IFRS 17’) has been the subject of much discussion, deliberation, and has also led to significant change. The standard applies to insurance contracts issued and reinsurance contracts held.
The definition of an insurance contract is “a contract under which one party (the issuer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder.”
This definition potentially brings a broad range of contracts into the scope of the standard. Given the standard is applied at the contract level, and not just by insurance entities, there could be an impact on entities that do not consider themselves traditional insurers.
For non-insurers, the application of the standard could give rise to significant complexity from a financial reporting perspective, and a process perspective. One common type of insurance contract that could drive such complexity is the treatment of issued financial guarantee contracts.
For non-insurers, the application of the standard could give rise to significant complexity from a financial reporting perspective, and a process perspective.
What is a financial guarantee contract?
Under a financial guarantee contract (‘FGC’), the issuer (guarantor) is required to make specified payments to reimburse the holder for a loss that it incurs because a specified debtor fails to make a payment when due. A common example of a financial guarantee contract is a parent company providing a guarantee over its subsidiary's borrowings to the subsidiary’s lender.
What is the impact of IFRS 17?
FGCs meet the definition of an insurance contract.
Prior to IFRS 17, entities had an accounting policy choice to either apply IFRS 4 Insurance Contracts ('IFRS 4') or IFRS 9 Financial Instruments ('IFRS 9'). IFRS 4 essentially permitted entities to adopt an approach in line with IAS 37 Provisions, Contingent Liabilities and Contingent Assets (‘IAS 37’), where FGCs were disclosed as a contingent liability and not recognised on the face of the statement of financial position until an outflow under the contract became probable. Most non-insurers adopted this approach to accounting for FGCs as it was simple to apply in practice. Although a limited number of entities, primarily in the financial sector, did adopt an IFRS 9 approach.
Entities that had previously adopted an IFRS 9 approach must, in an IFRS 17 era, continue to adopt an IFRS 9 approach. The accounting implications of which are described in more detail below.
For those entities that had chosen to apply IFRS 4, they now have a further opportunity to choose between two possible accounting treatments, provided that:
- The entity issuing the FGC has previously explicitly asserted that it regards such contracts as insurance contracts, and
- The entity has accounted for them on that basis.
If the conditions above are met, then the entity may irrevocably elect on a contract-by-contract basis, to apply either IFRS 17 or IFRS 9.
Applying IFRS 17
Unlike IFRS 4, under IFRS 17 grandfathering of accounting policies is not available, therefore entities will need to reassess how to account for FGCs they have issued.
When an entity issues a FGC at market rate, it will typically receive a premium in exchange for its commitment to compensate the contract holder in the event that the third party defaults. The entity has assumed a liability to provide coverage to the contract holder. Generally, it would be compensated for taking on this risk. If the compensation is at market rate, then the premium received (or, if the premiums are being paid over-time, the net present value of all future premiums) would equal the initial liability for the remaining coverage. This would be recorded as the day 1 insurance contract liability.
Subsequent to the initial recognition, IFRS 17 would require the initial insurance contract liability to be remeasured at each reporting period. The liability would comprise two elements:
- A liability for the remaining coverage which is predominantly a probability weighted estimate of the fulfilment cash flows under the FGC.
- A liability for incurred claims, which is the obligation to pay compensation for claims that have already occurred.
Applying IFRS 9
Entities will apply IFRS 9 to FGCs in the circumstances outlined above, by election or requirement.
For entities that apply IFRS 9, FGCs must be measured initially at its fair value and subsequently at each reporting date at the higher of:
- The amount initially recognised less the cumulative amount of income recognised in accordance with the principals of IFRS 15 Revenue from Contracts with Customers (‘IFRS 15’), and
- The loss allowance that would be recorded on the exposure – i.e., the expected credit losses under IFRS 9.
For FGCs that were previously accounted for under IFRS 4 and if they are still recorded only as contingent liabilities, these will now have to come on to the statement of financial position. Entities will have to estimate the day 1 fair value of the FGC and then reduce this by the amount that would have been recorded as income to date. They will also have to estimate the ECL that would apply to the exposure under IFRS 9. The FGC liability will be recorded at the date of transition at the higher of those two amounts.
For FGCs previously accounted for under IFRS 4, where a provision has been recognised, the recognised provision will have to be adjusted to the amount that would represent the ECL under IFRS 9 principles, which may well be a different amount.
What about intra-group FGCs?
For FGCs issued by a parent over the external borrowings of a subsidiary, often no premium is paid by the subsidiary in consideration for the FGC. Under IFRS 9, if this is the approach adopted, the parent will be required to recognise a liability for the amount calculated in accordance with the measurement requirements of IFRS 9.
This will entail estimating the fair value of the guarantee on the date it was entered into, reducing this by any element that would have been recorded as income and then comparing the residual to the ECL on the exposure calculated in accordance with IFRS 9. In such circumstances (i.e., where no actual premium is charged) it would appear that the parent is providing the guarantee in its capacity as shareholder and as such should account for the day 1 fair value of the deemed premium as an additional investment in the subsidiary.
Examples of how to quantify the fair value of the deemed premium could include:
- The price a third-party market participant would seek to issue the same FGC.
- The difference in the net present value (‘NPV’) of the underlying loan under the existing terms, and the NPV of the loan had the FGC not been in place.
What else needs to be considered?
In addition to the above there are additional factors that should be considered when deciding with which standard will be applied.
Disclosure requirements
The disclosure requirements under IFRS 17 are onerous. There is a requirement for granular disclosures about recognised amounts, significant judgements, and risks.
Transition and comparative information
As discussed above, in the appropriate circumstances an entity may irrevocably elect to apply IFRS 17 or IFRS 9 on a contract-by-contract basis.
If an entity chooses to apply IFRS 17, comparative information for FGCs would need to be restated in accordance with IFRS 17, and all relevant transitional disclosures would be required.
Comparative information might not be restated in accordance with IFRS 9 if the issuer of the FGC is initially applying IFRS 9 at the same date as IFRS 17, as IFRS 9 does not generally require a company to restate comparative information when IFRS 9 is initially applied and does not allow restatement for financial instruments derecognised before the date of initial application.
How KPMG can help
The transition and continuing application of IFRS 17 is not straightforward and is likely to be time consuming. For companies who issue FGCs externally to third parties, or internally to other group companies, there could be a material impact and additional complexity is certainly introduced. For this reason, it is important that companies engage with the change proactively and seek advice from accounting and actuarial specialists as necessary.
Get in touch
For further information on IFRS 17 and how it could impact your business, please contact our team below. We'd be delighted to hear from you.
