TAKEAWAYS
The first article of the series by the IFRS 17 Working Group, published in the July issue of this journal, provided an overview of the differences between FRS 117 Insurance Contracts (FRS 117) and the reporting and solvency requirements under the Risk-Based Capital 2 (RBC 2) framework prescribed by the Monetary Authority of Singapore (MAS).
The following areas were covered in the first article:
Contract boundary is fundamental to the measurement of the fulfilment cash flows of a group of insurance contracts as it represents the period in which the future cash flows are captured as part of the insurance contract liabilities under FRS 117.
In this second article, the IFRS 17 Working Group explores specific considerations around the determination of contract boundaries for the life insurance business under FRS 117 and RBC 2.
Under FRS 117, the cash flows are within the contract boundary if they arise from substantive rights and obligations during the period in which the entity can compel the policyholder to pay the premiums or the entity has substantive obligation to provide the policyholder with insurance contract services. Any fulfilment cash flows arising after the contract boundary form part of a future contract.
There are general definitions of the term of liabilities in Appendix 3A of MAS Notice 133 Notice on Valuation and Capital Framework for Insurers, which state that the starting point to derive the term of a policy’s liabilities under RBC 2 is the contractual term of the policy. An insurer should also consider any options in the contract when deciding whether the term of a policy’s liabilities should be extended beyond the contract term. Special considerations shall be given to the contract boundary of a long-term medical policy with reference to paragraph 3.1.4 of MAS Notice 133 (refer to the table).
FRS 117 provides specific requirements for determining when an insurer’s substantive obligation to provide insurance contract services ends, as summarised in the table. The summary table covers the relevant requirements under FRS 117 and RBC 2, respectively:
Requirements under FRS117 and RBC
Example:
A term life insurance contract has a three-year coverage period. However, it is cancellable at the end of every one year (“policy anniversary”) at the sole discretion of the insurer. Under FRS 117, the boundary of this insurance contract will be one year. Nonetheless, the measurement of the insurance contract liabilities arising from such contract is generally assuming cash flows projection for a period of three years until the end of the three-year coverage period when it is measured under RBC 2, except for a few specific products which also satisfy the criteria to be valued with a short-term boundary. In determining the term of insurance contract liabilities under RBC 2, any relevant professional standard should be considered, as stated in Appendix 3A of MAS Notice 133.
Under FRS 117, restrictions on the insurers’ ability to adjust the pricing of a premium or level of benefits that have no commercial substance will not prevent a new contract boundary from being created as a future contract as it has no discernible effect on the economics of the transaction. As such, the future cash flows beyond the repricing date may fall within the boundary of the existing insurance contract instead of a new insurance contract.
In accordance with FRS 117.B64, contract boundary is reassessed at each reporting date to include the effect of changes in circumstances on the entity’s substantive rights and obligations (that is, changes in fulfilment cash flows). Such reassessment considers whether there are changes to the constraints affecting the entity’s practical ability to set a price or adjust the level of benefits to fully reflect the risks in the contract or portfolio at the reporting date. An example discussed in the IFRS 17 Transition Resource Group (TRG) meeting in September 2018 is as follows:
Example:
An insurer issues a health insurance policy for a coverage period of five years. The insurer has the right to reassess the individual policyholder’s risks and reprice the premium on an annual basis. However, the repricing of premium is limited to a premium increase of 100% of the premium charged in the previous year.
Under RBC 2, for long-term medical policies, insurers are also required to regularly assess if there is any change in circumstances that may affect its practical ability to reprice. Where an insurer assesses that there has been a change in circumstances, the insurer must revalue the portfolio based on the new boundary arising from the change in circumstances, from the next valuation date after such a change.
Currently many insurers leverage on the regulatory reporting requirements and apply similar treatment in their statutory financial statements or vice versa for RBC 2 reporting and FRS 104 reporting. These alignments reduce the need to keep different sets of books for regulatory reporting and the statutory financial statements applying FRS 104.
As a comparison, FRS 117 has more clearly defined requirements than FRS 104, which reduces the discretion of insurers in their consideration mainly in terms of the level of aggregation as well as for reinsurance contract.
Under FRS 117, the lowest unit of account is the contract that includes all the insurance components (May 2018 TRG.17a). For contracts that have a legal form of a single contract but in substance are comprised of multiple contracts, the contract boundary would need to be identified for each individual in-substance contract. Alternatively, for contracts that have multiple insurance components which are nevertheless accounted for as one contract, the boundary would be determined for the contract in its entirety.
Example:
An insurer issues a whole life base plan with a yearly renewable critical illness rider attached so that the policyholder can enjoy a more comprehensive insurance coverage. The rider can be repriced on its renewal date whereas the premium and benefits of the base plan are guaranteed throughout the coverage period. The rider and base plan in this example are assessed to be a single contract due to high interdependency and the rider will lapse together with the base plan. On a standalone component basis, the contract boundary of the rider will be one year if it meets the requirements of paragraph 34 under FRS 117. However, as the rider is combined with the base plan, the overall contract boundary will extend beyond one year as the determination of contract boundary should be assessed on the single contract inclusive of the base plan and the rider in its entirety and the insurer cannot fully adjust the pricing of premium or level of benefits of the combined insurance components.
Under RBC 2, there may be insurance contracts for which the basic plans and their riders could be written in different insurance funds or sub-funds and have very different risk characteristics while there are no specific criteria to assess for combination. The unit of account is defined in the First Schedule to the Insurance Act 1966 as any contract of insurance whether or not embodied in or evidenced by an instrument in the form of a policy, and references to issuing a policy are to be construed accordingly. In other words, a basic plan or a rider can be construed as a policy and be classified as per section 16 of the Insurance Act 1966.
FRS 117 requires the reinsurance contracts held to be measured as a separate contract (that is, independent of the measurements of the underlying contracts). The requirements on whether the various components of an insurance contract can or cannot be separated apply to reinsurance contracts held as well. It is expected that different coverages under one reinsurance treaty could be measured as a combined reinsurance contract and the period of the various coverages shall be considered in determining the contract boundary.
The estimate of reinsurance cash flows could be short term under FRS 117 if there is any presence of provision that allows the reinsurer to close the treaty to new business with short-term notice, for example, a three-month notice period. In this case, separate reinsurance contracts are effectively established for each reporting period. As of quarter end, the cash flows from future new business would belong to future reinsurance contracts and would not be included in the valuation of the ceded reinsurance liability or asset as at the date of quarterly valuation.
Under RBC 2, while the reinsurance contract liabilities are reported separately at the fund level, it does not require the aggregation of reinsurance cash flows at the reinsurance contract level that may straddle across insurance funds. The terms of liabilities apply to both gross and net cash flows. In practice, the boundary typically extends to the very last cash flow of the direct contracts.
A separate paper will be issued to provide more comprehensive discussions on the topics specific to reinsurance contracts held.
Insurers are expected to have less discretion in the determination of contract boundary in view of the specific requirements under FRS 117. While most insurers are trying to align the contract boundary under FRS 117 with the current RBC 2 to reduce the need for keeping different sets of cash flows, full alignment could be challenging.
In the upcoming article, the IFRS 17 Working Group, in collaboration with the committee members of the Singapore Actuarial Society Life IFRS 17 Workgroup, will discuss specific considerations around the measurement of insurance liabilities for life insurance business under FRS 117 and RBC 2.
This is the second of a series of articles from the IFRS 17 Working Group (set up under the ambit of the ISCA Insurance Committee) to help insurers in Singapore navigate through the differences between FRS 117 and RBC 2.
Alvin Chua is Chairman, IFRS 17 Working Group (WG) and Director, KPMG Services Pte Ltd; Celina Goh is a WG member and Head of Finance, Manulife (Singapore) Pte Ltd; Goh Wei Shee is a WG member and Senior Manager, Ernst & Young LLP.
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