Effective January 1, 2023 for calendar-year companies, IFRS 17 is replacing IFRS 43. IFRS 17 contains more detailed and complex prescriptive guidance for recognition, measurement, presentation and disclosure and its scope goes beyond the insurance industry. To understand if IFRS 17 applies to a company, it is key to evaluate if the company’s contracts meet the definition of an insurance contract, as contracts do not need to be labeled insurance contracts to be in the scope of IFRS 17.
Who may be impacted?
Some common areas where insurance contracts may be encountered include performance or financial guarantees, fixed fee service contracts (e.g. road-side assistance, phone screen repair, boiler break down), loans with limits to the compensation to an amount otherwise required to settle the obligation (e.g. loans with death waivers), product and extended warranties, lease contracts and credit cards.
Industries, such as general builders, mining, banking, civil, heavy, and specialist engineering, manufacturing, transportation, that could offer performance guarantees or surety bonds may be in the scope of IFRS 17. The range of contracts and commercial bonds that could be insurance contracts includes performance, maintenance, bid, retention, advance payment and off-site materials bonds.
Subsidiary A and construction Subsidiary B are sister companies with a common parent. Subsidiary A has provided a performance bond to Subsidiary B. The performance bond will cover Subsidiary B for any poor performance by its sub-contractors – e.g. if Subsidiary B’s sub-contractors do not fulfil their contractual obligations such that a building construction is delayed resulting in significant financial damages to Subsidiary B.
- Subsidiary A’s separate financial statements: this contract is an insurance contract and IFRS 17 applies.
- Subsidiary B’s separate financial statements: B is the policy holder and IFRS 17 does not apply.
Non-insurers may have captive insurance companies to manage some of the insurance risk within a consolidated group and may enter into contracts to transfer the risk to an external insurer. If the captive insurance company applies IFRS 4 today, it likely issues insurance contracts that are in scope of IFRS 17.
Key steps to assess whether a contract is an insurance contract
IFRS 17 defines an insurance contract as “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.”
The definition sets out four key steps to work through when assessing whether a contract is an insurance contract in the scope of IFRS 17. If the answer to all steps is ‘yes’, the contract is likely to be in the scope of IFRS 17.
Step 1: Does a contract exist?
Similar to revenue4 and lease contracts5, insurance contracts can be written, oral, or implied by customary business practices. Implied terms also include those imposed by law or regulation.
Step 2: Does the arrangement compensate the counterparty for a specified uncertain event?
The compensation could be a cash payment or a payment in kind. This uncertainty surrounding the insured future event is the essence of an insurance contract and is required to be uncertain at the inception of the contract. Some common types of uncertainties in contracts at inception include the probability of an insured event occurring (e.g. the risk a phone screen will be damaged), the timing of occurrence (e.g. timely compliance of agreed repair), or how much will be paid to the counterparty if the insured event occurs (e.g. warranty and extended warranty).
Step 3: Does the specified uncertain future event adversely affect the counterparty?
For example, a contract that compensates a cell phone owner for screen damage to its phone would meet this criterion, because the phone owner would otherwise be adversely affected by damage to its phone. In contrast, a derivative contract whereby a company will receive payments if there is an earthquake would not meet this criterion because the contract does not require the earthquake to adversely affect the counterparty; the derivative contract will make payments if the earthquake occurs, regardless of whether it caused damage to any of the assets.
Step 4: Does the contract issuer accept significant insurance risk transferred from the counterparty?
Insurance risk is any risk other than financial risk and needs to be significant in any single scenario with commercial substance. Insurance risk is considered significant if the issuer of the contract could suffer a loss as a result of insured events and could have to pay significant additional amounts beyond what would be paid if the insured event had not occurred.
Significance is not based on the likelihood of the event occurring, it is based on what could be paid even if payment is highly unlikely. For example, a contract that requires an insurer to reimburse a company for the value of a property the company owns in the event the property is destroyed by a hurricane is significant because, while the likelihood of a hurricane destroying a building is low, if it did occur, the payment by the insurer would be substantial and well beyond the premiums paid by the counterparty.
In assessing significance, companies should make the assessment from the perspective of the issuer, at an individual contract level, and consider the time value of money. Contracts that expose the issuer to both financial risk and significant insurance risk are insurance contracts.
What exemptions are available?
After determining that a contract has the characteristics of an insurance contract, companies need to assess whether the contract falls within the mandatory scope exemptions of IFRS 17. These exemptions are as follows:
Warranties that are provided by a manufacturer, dealer or retailer in connection with the sale of its goods or services to a customer – e.g. a standard product warranty issued by a retailer when selling a laptop to a customer – are in the scope of IFRS 15 or IAS 376 ,even if they meet the definition of an insurance contract.
However, if the product warranty is issued by a sister company of the retailer when the laptop is sold, the warranty is in the scope of IFRS 17 in the sister company’s separate financial statements, subject to possible application of the fixed-fee service contract election discussed below, because the warranty is not issued in connection with the sale of goods by the sister company itself.
For the consolidated financial statements of the parent company, the warranty would be out of the scope of IFRS 17 because it was issued in connection with the sale of goods of the consolidated entity.
Financial guarantees grant the counterparty the right to be reimbursed by the issuer for a loss that it incurs when a specified debtor fails to make payment when it is due under the debt instrument. Such arrangements usually meet the definition of an insurance contract and can have various legal forms (e.g. guarantee, letter of credit). A non-insurer might provide financial guarantees that are incidental to its main business – e.g. to support borrowings of its subsidiaries or of its customers.
Financial guarantee contracts are not in the scope of IFRS 17 unless the issuer has previously asserted explicitly that such contracts are insurance contracts and has used accounting applicable to insurance contracts. An issuer may elect to account for these contracts either:
- under IFRS 17, if it has previously asserted explicitly that it regards such contracts as insurance contracts and accounted for them on that basis. Judgment is required in determining whether previous assertions in financial statements or elsewhere are sufficiently explicit to continue to apply insurance accounting. Applying IFRS 17 will, however, bring significant changes to the measurement of these contracts; or
- under the financial instruments standards7 .
The policy election is made irrevocably on a contract-by-contract basis when the issuer first applies IFRS 17.
Credit card contracts, or similar contracts that provide credit or payment arrangements, meet the definition of an insurance contract if, and only if, the company does not reflect an assessment of the insurance risk associated with an individual customer in setting the price of the contract with that customer. Financial instruments arising from such contracts are in the scope of IFRS 98. In line with the requirements of IFRS 9, if the entity provides the insurance coverage to the customer as part of the contractual terms of a credit card or similar contract, then it separates the insurance coverage component and applies IFRS 17 to it. The entity applies other applicable standards to the other components of the contract, which might include IFRS 15 and/ or IAS 37.
Contractual rights and obligations
Contractual rights and obligations contingent on the future use, or right to use, a nonfinancial item (e.g. some license fees, royalties, variable and other contingent lease payments and similar items) are in the scope of IFRS 15, IAS 389, and IFRS 16.
Residual value guarantees
Residual value guarantees provided by a manufacturer, dealer or retailer and a lessee’s residual value guarantee when they are embedded in a lease are in the scope of IFRS 15 and IFRS 16.
Employers’ assets and liabilities
Employers’ assets and liabilities from employee benefit plans are in the scope of IAS 1910 and IFRS 211 and retirement benefit obligations reported by defined benefit retirement plans are in the scope of IAS 2612.
Contingent consideration payable or receivable in a business combination is not in the scope of IFRS 17.
Insurance contracts in which the entity is the policyholder, unless those contracts are reinsurance contracts held, are not in the scope of IFRS 17.
What elections are available?
After determining that a contract is an insurance contract in the scope of IFRS 17, companies need to consider whether the following accounting policy elections are available at the time of IFRS 17 adoption:
Fixed fee service contracts
Fixed fee service contracts that meet the definition of an insurance contract may be accounted for under IFRS 15 if all of the following conditions are met:
- The issuer does not reflect an assessment of the risk associated with an individual customer in setting the price of the contract with that customer;
- The contract compensates the customer by providing services, rather than by making cash payments to the customer; and
- The insurance risk transferred by the contract arises primarily from the customer’s use of services rather than from uncertainty over those services.
A company sells annual breakdown contracts for boilers. In Year 1, the fees for these services are fixed and in subsequent years the services are repriced based on the frequency of call-outs by the customer in Year 1 and the age of the individual boiler and central heating system. The contract compensates the customer by providing services and the risk arises primarily from the use of the services.
The contracts meet condition 1 in Year 1. However, in Year 2 the company assesses the risk based on the individual customer’s circumstances and as a result condition 1 is not met and the company is required to apply IFRS 17.
Alternatively, if the company assesses the risk based on a collective assessment of its customers, rather than on an individual basis, it can elect to apply IFRS 17 or IFRS 15.
The policy election is made irrevocably on a contract-by-contract basis when the issuer first applies IFRS 17.
Loan contracts that meet the definition of an insurance contract but limit the compensation for insured events to the amount otherwise required to settle the policy holder’s obligation created by the contract may be accounted for under IFRS 9 or IFRS 17.
The policy election is made irrevocably for each portfolio of insurance contracts when the issuer first applies IFRS 17.
A bank issues a retail mortgage loan with life insurance coverage. The consideration for the life insurance coverage is part of the overall interest rate charged on the mortgage and the outstanding balance of the mortgage is waived if the borrower dies.
This loan qualifies as an insurance contract and the bank can make a portfolio level irrevocable election to apply IFRS 17 or IFRS 9.
What disclosures are required during pre-transition?
IAS 813 requires disclosure about standards that have been issued but are not yet effective regardless of whether the entity adopts them early. These disclosures include known or reasonably estimable information relevant to assessing the possible impact that application of the new standard will have on the entity's financial statements in the period of initial application.
Where applicable, companies have to also consider the disclosure requirements under SAB 7414. While the SAB 74 disclosure requirements within the financial statements are similar to those required by IAS 8, SAB 74 requires disclosure over control and governance considerations that are outside of the financial statements.
Unlike the insurance industry guidance under US GAAP, IFRS 17 applies to all companies, not just insurance companies. Companies should identify contracts that might meet the definition of an insurance contract and understand whether these are addressed under any of the IFRS 17 mandatory exemptions and elections. For insurance contracts to which IFRS 17 applies, the accounting implications could be significant and create differences with US GAAP.
Companies that prepare stand-alone financial statements need to carefully evaluate contracts with their parent and affiliates; some contracts may be out of the scope of IFRS 17 or eliminated in consolidation at the group level, but in-scope in the stand-alone financial statements. Companies should also consider whether they have the appropriate processes and controls in place to implement the requirements of IFRS 17 and prepare the related pre-transition disclosures.
For more in this topic, read KPMG publication, IFRS 17 for non-insurers.