One of the major areas of discussion around IFRS 17 is the choice of transitional measurement to use when a full retrospective approach is not possible. The fair value approach appears simple, but, upon closer inspection, presents a number of practical questions.
One question our clients have been grappling with is the concept of a loss component under the fair value approach. How can the concept of a loss component exist when the buyer in a fair value transaction would require a profit margin to be built in by definition? In other words, to use car sale terminology, is it possible to put a fair value on the insurance version of a “lemon”?
What is fair value?
According to IFRS 17 Standards, a fair value transitional approach may be applied if it is impossible or impracticable to apply a full retrospective approach. Under this approach, the contractual service margin (CSM) is determined as the difference between the fair value of a group of insurance contracts (measured in accordance with IFRS 13) and its fulfilment cash flows at the transition date (which are determined in accordance with IFRS 17).
In other words, the fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
CSM and loss component under fair value
At surface level, it would seem that if a block of business is profitable, i.e. the fair value at transition date is more than the value of the fulfilment cash flows measured at that date, the difference between the two values would be the CSM, and this would be the profit the entity would make upon transferring the business to a third party at the fair value.
On the other hand, if the fair value was lower than the fulfilment cash flows measured at transition date, the insurer would make a loss upon transferring the business to a third party at the fair value, and the extent of this loss would be equal to the difference between the fulfilment cash flows and fair value, i.e. the loss component.
So a loss component may exist in theory, but how would this work in practice? To be willing buyers, market participants require a profit margin to be built into the price – IFRS 13 even allows for this – so how can a loss-making fair value exist?
Fair value vs transaction price
To answer this question, let’s first differentiate between fair value and transaction price. The fair value is a theoretical measure, informed by the general market conditions under which the company operates. This is not necessarily equal to what the actual transaction price would be.
In a transaction between two specific companies, while a fair value-type approach could form a basis for the transaction price, there would be other factors at play which could mean that the two measures would not be equal e.g. specific reinsurance arrangements, strategy and diversification benefits of the buyer, etc.
So, the fair value should not be thought of as the price a specific market participant would agree to in a realistic transfer.
Bearing in mind the correct definition of fair value, let’s consider the fair value measurement itself. Which situations would result in a fair value transition approach leading to onerous contracts, and thus the existence of a loss component?
A loss component may arise from adjustments to fulfilment cash flows
One of the key differences between the fair value and IFRS 17 fulfilment cash flows (FCF) is the
fair value measurement is market-based, i.e. it is calculated based on assumptions that market participants would use when pricing the asset or the liability under current market conditions, including assumptions about risk. FCF measurement, however, is entity-specific.
A common method of measuring FCF is the Present Value technique, which is also consistent with the income approach to measure fair value. So fair value could be calculated as FCF plus certain adjustments, such as:
Discount rates in fair value measurement need to reflect the entity’s own credit risk (firms are not allowed to make an allowance for their own credit risk when estimating FCF). This would result in an increase in the discount rate, resulting in a lower fair value compared to FCF.
Expenses need to reflect the market view of expenses associated with fulfilling the obligations of the group of contracts, e.g. the entity might have been locked into high per policy expenses in the past, but could find, perhaps due to technological advances, less onerous outsourcing agreements in current market conditions.
In measuring the fair value, the risk adjustment should reflect a degree of risk aversion consistent with market view and would potentially need to be updated to reflect differences from risks covered in the FCF.
Tax, reinsurance and other synergies that may be available in the market would need to be reflected in the fair value. Likewise, those included in FCF, but not available in the market would need to be excluded.
Depending on the prevailing market conditions at the time of transition, the above adjustments could mean the fair value approach will result in the contracts being onerous at transition.
IRR sensitivities reducing the fair value: a case study
Fair value may also be calculated using a pricing approach. Some of our clients use this approach to target a particular internal rate of return (IRR) on future cash flows. We have seen that when applying sensitivities to the IRR, under severe market conditions in which the IRR falls below a certain threshold, some policies become onerous.
In conclusion, although a fair value calculation is generally expected to result in a CSM at transition, there are circumstances that would give rise to a loss component, at least in theory.
MBE is equipped to work with clients at every step of their IFRS 17 implementation process. If you’d like to discuss any of the points raised in this article, then please contact us at email@example.com.
Image (c) Shutterstock | Wally Stemberger
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