Everything You Need To Know About the Measurement of Future Cash Flows under IFRS 17

Under IFRS 17, the new standard which provides a set of risk management and overall principles accounting of insurance contracts, the base model is the General Measurement Model, also known as GMM in short. GMM is often called BBA or ‘Building Block Approach’ because that is how it was addressed during the project phase in exposure drafts. In this blog, we’ll be talking about the building blocks of this model – which comprise ‘Fulfilment Cash Flows’ and the ‘Contract Service Margin’ (CSM – the unearned profit) in the contract.

The Calculation of Insurance Contract Liability

Insurance Contract Liability or Obligation implies, on any date, the sum total of all Reimbursement Amounts; all accrued and unpaid premiums and charges for “Unutilized Credit Limit Capacity” under the insurance policy; and all other accrued and unpaid amounts then due and payable to the insurer under the insurance policy, and any other transaction document.

According to the General Management Model of IFRS 17, the formula for calculating Insurance Obligation is as under:

Fulfilment Cash Flows + Contract Service Margin = Insurance Obligation

Here, Fulfilment Cash Flows include the following elements:

• Net future cash flows (Inflows less Outflows)
• Discounting rate
• Explicit Risk Adjustment

Therefore, Fulfilment Cash Flows are measured by taking into consideration the current value of net future cash flows, and in addition to that, an explicit risk adjustment regarding the uncertainty pertaining to the amount and timing of cash flows for the insurance risk.

Every component of the Fulfilment Cash Flows reflects a potential change from the present accounting practices for insurance contracts. Thus, all these components will require careful examination to ensure proper adherence to the new standard, i.e. IFRS 17.

1. Present Value of Future Cash Flows

a)   Expected Future Cash Flow

Estimates of Net Future Cash Flows

Net future cash flows provide an estimate of future cash outflows and inflows that arise when the party fulfils the insurance contract. These estimates – which are explicit, current, unbiased, probability-weighted – calculate the net cash flows over the duration of the contract.

• Explicit: According to this, the estimation for the adjustment for non-financial risk will be done separately from other estimates. The adjustment for the time value of money and financial risk is also usually estimated in separation from the cash flow estimates.
• Current: The future cash flows estimates should be indicative of conditions that are present during the measurement date. This includes the assumptions about the future at that date, and must consider all supportable and reasonable information which is available, minus the undue effort or cost about timing, amount, and unpredictability of those future cash flows.
• Unbiased: These estimates comprise the expected value of the complete range of potential outcomes and are neither meant to be optimistic nor conservative. In other words, it should be unbiased.
• Probability-weighted: The expected value reflects a probably-weighted average of various scenarios that depict the complete range of potential outcomes. For every scenario, the entity must recognise the outcome’s timing, amount, and probability. The approach of identifying the highly possible outcome and the least likely outcome does not meet the requirements listed by IFRS 17.

The future cash flow estimates must be reflective of the entity’s perspective, given that the estimates of relevant market variables show consistency with market prices observable for those variables. Also, only those cash flows that fall within the boundary of the insurance contract are supposed to be included in the calculation of this estimate.

Inclusions in Net Future Cash Flows

The cash flows are included in one single account line item, namely the Insurance Contract Liability. It consists of items such as:

• Premiums (which include instalment premiums)
• Adjustments of premiums (for example – Experience adjustments that are expected to be implemented in the future)
• Claims to be paid on the losses incurred
• Claims expected to be paid on losses in the future
• Costs of Acquisition (or costs of underwriting)
• Expenses related to an insurance claim (i.e. legal and adjuster fees, expenditures for internal processing of claims, etc.
• MiscellaneousEarlier, most of these items were recognised and accounted for individually, separate from other items. However, they are now included in the same balance sheet line item. Estimates of net future cash flows are updated regularly with every reporting period, as changes in conditions and estimates take place.

Exclusions in Net Future Cash Flows

The following items are excluded from net future cash flows:

• Investment returns (general account)
• Components separated from the insurance contract
• Reinsurance contracts held
• Income tax payments or receipts that the entity does not receive or pay in a fiduciary capacity
• Costs which cannot be directly attributed to the portfolio of insurance contracts
• Cash flows resulting from wasted labour or other resources utilised for contract fulfilment
• Cash flows resulting from future insurance contracts

b)   Discount Rates

Discount rates in this case refer to the current discount rates in the market. These rates are used to normalise the current value of expected future cash flows.

2. Risk Adjustment

Risk Adjustment is the compensation required by a company for bearing the insurance risk. Insurance risk refers to a type of non-financial risk that may comprise the uncertainty of the cash flows, their timing, or both of them.

3. Contractual Service Margin

Contractual Service Margin or CSM refers to the amount that is equal and opposite to the net cash inflow of the two earlier components. CSM makes sure that no day one profit is recognised in P&L (Profit & Loss) for all the contracts.

Therefore, this is all you need to know about the measurement of future cash flows under IFRS 17. For more information about IFRS 17, stay tuned for our upcoming blog in this series – ‘Understanding New Actuarial Models Under IFRS 17 and Data Required.’

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