IFRS 4 / 1

Knowledge sharing – IFRS 4Floris van Diest –Tim Schilders

IFRS 4 / 2

Agenda

Opening

1 The road to a new balance sheet

2 Case study: LifeCo

3 Expected impact

IFRS 4 / 3

1. The road to a new balance sheet

Where did this come from?

• 2001: IASB initiates IFRS 4 project

o No standard for insurance contracts in IAS

• 2005: IASB releases IFRS 4 Phase I:

o Interim standard: temporary exemption to IFRS principles

o Key definitions and enhanced disclosure requirements

o Still, IASB claims:”… current accounting practices are not true reflection of nature and extent

of the risks embedded in insurance contracts.”

o 2010, 2013: IASB releases first and second IFRS 4 Phase II Exposure Draft

IFRS 4 / 4

1. The road to a new balance sheet

Where is it going?

• 2016: IASB will release final exposure draft

o Add transitional measures for application IFRS 9 Financial Instruments

‘Overlay approach’

‘Temporary exemption’

• 2018: Implementation IFRS 9

o Implementation transitional measures

• 2020: Implementation IFRS 4 Phase II (exp.)

LA

B/S

2013

Exposure draft:

IFRS 4

2014

Publication:

IFRS 9

2017 20192015

Draft amendments:IFRS 4 vs . IFRS 9

2016

Publ ication:

IFRS 4 (exp.)

2020

Implementation:

IFRS 4 (exp.)

2018

Implementation: IFRS 9

End of transitional measures

IFRS 4 / 5IFRS 4 / 5

2. Case study: LifeCo - 2020

LifeCo introduction

• Owned by Tim Schilders and Floris van Diest

• (New) business strategy: issue life insurance contracts and invest in bonds

LifeCo issues 2 portfolios of life insurance contracts

• Tim and Floris issue one portfolio with 1,000 10-year contracts each on 31.12.2020

• Insurance contract:

o Provides death coverage (death capital = EUR 20,000)

o Requires one premium payment due on 01.01.2021

Tim’s contracts premium: EUR 10,000

Floris’ contracts premium: EUR 9,000

2020

Total 1,000Total 1,000

Cash 1,000 Equity 1,000

LifeCo B/S 30.12.2020 (in thousands)

IFRS 4 / 6

Definition and scope

LifeCo has to apply IFRS 4 Phase II because…

• IFRS 4 applies to all instruments defined as insurance contract for any company issuing them

IFRS 4 definition

• ‘A contract under which one party (e.g. LifeCo) accepts significant insurance risk from another party (e.g. policyholder) by agreeing to compensate the policyholder if a specified uncertain future event (e.g. death) adversely affects the policyholder’

In scope (upon significant risk) Not in scope

2020

2021

IFRS 4 / 7

Accounting model steps

IFRS 4 Phase II accounting model

LifeCo reporting steps timeline

Step 5Provide

disclosures

Step 4Present in financial

statements

Step 3Remeasure in subsequent

periods

Step 2Measure at

initial recognition

Step 1Identify and

recognise the contract

Step 1 Step 2 Step 3 Step 4 Step 5

2020

2021

…

2020

2021

IFRS 4 / 8

Accounting model steps

Step 1: Identify and recognise the contract

• An insurance contract is recognised at minimum of:

o Beginning of coverage period (for LifeCo portfolios: 31.12.2020)

o Date of first payment from policyholder (for LifeCo portfolios: 01.01.2021)

Unbundling

• Decompose (‘unbundle’) only if contract contains components that:

o would be within scope of other standard(s); and

o are not highly interrelated the host contract

• Example components:

o Insurance component

o Embedded derivatives

o Investment component

• N/A for LifeCo portfoliosUnbundling

Insurance component

Insurance contract

Investment component

Embedded derivative

2020

2021

54321

IFRS 4 / 9

Accounting model steps

Step 2: Measure at initial recognition

• Standard model of IFRS 4: Building Blocks Approach (BBA)

o Applicable to LifeCo portfolios

• Alternative models:

o Variable fee approach: insurance contracts with participation features

o Premium allocation approach: short duration contracts or long duration contracts meeting certain criteria (for pre-claim periods)

Ass

etLi

abili

ty

Block 1Future cash

flows

Block 2Time value of money

Block 3Risk

adjustment

Block 4Contractual

service margin

Re

po

rtin

g a

mo

un

t0

2020

2021

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IFRS 4 / 10

LifeCo portfolios

• Other than premiums, portfolios are identical

• B1 does not take into account the time value of money (B2). Hence, B1 typically results in a net liability.

Building Block Approach

FloTim

Acquisition costs

Costs

Lapses

Claims: Death

Maturities

2021 2022 ... 2030

Cas

h in

flo

ws

(-)

Cas

h o

utf

low

s (+

)

BBA Block 1: Future cash flows

• Sum of (undiscounted) probability weighted cash inflows and outflows estimated at moment of reporting

Totals Tim Floris

Cash outflow 11,000,000 11,000,000

Cash inflow -10,000,000 -9,000,000

Block 1 1,000,000 2,000,000 Costs

Lapses

Claims: Death

Costs

Lapses

Claims: Death

Premiums

Received on 01.01.2021

2020

2021

1

42

3

54321

IFRS 4 / 11

Building Block Approach

Yield curve of actual or reference

asset portfolio

Credit risk premiums

Discount curve IFRS 4

Illiquidity premium

Top down approach

BBA Block 2: Time value of money (1/2)

• Discounting of future cash flows with market consistent discount curve

• Curve reflects currency and liquidity of contract and timing of cash flows

Two approaches:

• Top down approach: asset yield curve excluding factors irrelevant for insurance contract

• Bottom up approach: risk-free curve including factors relevant for insurance contract(No further guidance on how to determine adjustments)

Risk-free curve

Timing mismatch

Bottom up approach

2020

2021

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3

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IFRS 4 / 12

Block 1LifeCo portfolios

• Given portfolios are identical, portfolios have same discount curve

• Value block 2 equals difference between Block 1 and discounted value of Block 1

Building Block Approach

BBA Block 2: Time value of money (2/2)

Totals Tim Floris

Block 1 1,000,000 2,000,000

Block 2 -1,550,000 -1,550,000

Block 1 + 2 -550,000 450,000

Block 2

PV(Block 1)

Block 1

PV(Block 1)

Block 2

Ass

etLi

abili

tyA

sset

Liab

ility

Floris’ portfolio

Tim’s portfolio

2020

2021

1

42

3

54321

-550,000

450,000

IFRS 4 / 13

Building Block Approach

BBA Block 3: Risk adjustment (1/3)

• “Compensation entity requires for risk of bearing uncertainty about amount and

timing of cash flows arising as entity fulfils the insurance contract.”

• Incorporating risk diversification and favourable vs. unfavourable outcomes of

uncertainty in line with entity’s risk aversion

Range of calculation techniques

• IFRS 4 doesn’t prescribe particular techniques

E(BE Liability) VaRα

RA

Pro

bability

Confidence level approach (VaR)

VaRα TVaRα

Pro

bability

Conditional Tail Expectation (CTE)

RA

T=0 T=1 T=2 T=n…

…

RA

= capital required

= capital charge ∙ capital required

Cost of capital approach

𝑃𝑉

2020

2021

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3

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E(BE Liability)

IFRS 4 / 14

Building Block Approach

BBA Block 3: Risk adjustment (2/3)

Costs

Lapses

Claims: Death

Claims: Death

Costs

Lapses

Claims: Death

Lapses

Costs

Lapses

Claims: Death

Costs

Mortality shock Lapses shock Expenses shock

2021 2022 ... 2030

CostsLapses

Claims: Death

Cost of capital approach:

• Mortality rates, lapses rates and expenses are shocked by predefined percentages

• For all future cash outflows

Cost of capital approach:

• Capital at Risk (CaR) = aggregated delta change in shock scenarios

• Discounted by a discount curve

Capital at risk Capital at risk Capital at risk

CostsLapses

Claims: Death

CostsLapses

Claims: Death

2020

2021

1

42

3

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IFRS 4 / 15

LifeCo portfolios

• Given portfolios are identical, portfolios have same risk adjustment

• Cost of capital approach (6% charge) assuming mortality, lapse and expense shocks and diversification

• Block 1-3 defined as fulfilment cash flows

Building Block Approach

BBA Block 3: Risk adjustment (3/3)

Totals Tim Floris

Block 1 + 2 -550,000 450,000

Block 3 50,000 50,000

Block 1 - 3 -500,000 500,000

FloTim

Premiums

2020 2021 2022 ... 2030

Cas

h in

flo

ws

(-)

Cas

h o

utf

low

s (+

)

Costs

Lapses

Claims: Death

Maturities

Costs

Lapses

Claims: Death

Costs

Lapses

Claims: Death

Risk adjustment Risk adjustment

Risk adjustment

Acquisition costs

2020

2021

1

42

3

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IFRS 4 / 16

Building Block Approach

BBA Block 4: Contractual Service Margin (CSM)

• “A component of measurement of the insurance contract representing the unearned

profit that the entity recognises as it provides services under the insurance contract.”

• Recognised on portfolio level for contracts with ‘similar’ date of inception

• Periodically ‘released’ (revenue in P/L) in accordance with insurance coverage provided

Recognition

• If [Block 1 + Block 2 + Block 3] < 0 then CSM = - [Block 1 + Block 2 + Block 3]

o CSM eliminates ‘Day One Gain’

• Else CSM = 0

o Portfolio is onerous – Report ‘Day One Loss’ in P/L equal to [Block 1 + Block 2 + Block 3]

LifeCoA

sset

Lia

bil

ity

Block 2

Block 3

Block 4

Block 1

Re

po

rtin

g a

mo

un

t

0

Ass

etLi

abil

ity

Block 2

Block 3

Block 1

Rep

ort

ing

amo

un

t

0

Totals Tim Floris

Block 1 - 3 -500,000 500,000

Block 4 500,000 0

Block 1 - 4 0 500,000Tim’s portfolio Floris’ portfolio

2020

2021

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42

3

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IFRS 4 / 17

Total 1,000Total 1,000

Accounting model steps

Step 4: Present results in financial statements

• Reporting (re)measured carrying amounts on B/S

• Reporting of P/L and OCI

LifeCo: 2020 Financial statements

• P/L & OCI: Recognition of onerous portfolio

o ‘Day One Loss’ reported as expense in underwriting result

• B/S: ‘Day One Loss’ eats capital via retained earnings

2020

Total comprehensive income -500

Change to OCI 0

Floris portfolio 500Cash 1,000

Equity 500

LifeCo B/S 31.12.2020 (in thousands)

LifeCo P/L and OCI For 12 Months Ended 31.12.2020 (in thousands)

Underwriting result -500Insurance contract revenue 0Insurance contract expense -500

Investment result 0

Profit or Loss -500

2020

2021

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IFRS 4 / 18

Accounting model steps

Step 5: Provide disclosures

• “Disclose qualitative and quantitative information that should enable the users of the financial statements to interpret the nature, amount, timing and uncertainty of the future cash flows of the issued insurance contracts”

3 broad categories

• Explanation of recognised amounts

o To enable user to make reconciliations

• Significant judgements applied

o (Changes in) Judgements in measurements and estimations

• Nature and extent of risk arising from insurance contracts

o Exposures, how risks arise and how risks are managed

2020

2021

54321

IFRS 4 / 19IFRS 4 / 19

2. Case study: LifeCo - 2021

Bond acquisition

• Part of premiums received (minus acquisition costs) invested in 2 bonds:

o Floris’ bond (10Y, 7 mln., 4.3%, p.a.) measured at amortised cost

o Tim’s bond (10Y, 8 mln., 3.8%, p.a.) measured at FVTOCI

2021

Claims underestimated

• Incurred claims higher than expected

o Change in estimates of future cash flows

o Change in risk adjustment

Lower interest rate environment

• Discount curves of assets and insurance liabilities lower

IFRS 4 / 20

2.2 Accounting model steps

Step 3: Re-measure in subsequent periods

• Re-measurement of insurance contracts given all newly available information

• Changes in estimates respective blocks reported in P/L, OCI, or against CSM

BBA Block 1: Future cash flows

• Future cash flows increase:

o Premiums (-) have been received

o Expected future claims increased

FloTim

Premiums

Acquisition costs

2021 2022 ... 2030

Cas

h in

flo

ws

(-)

Cas

h o

utf

low

s (+

)

Costs

Lapses

Maturities

Costs

Lapses

Claims: Death

Costs

Lapses

Claims: Death

2020

2021

Claims: Death

Totals Tim Floris

Block 1 - 2020 1,000,000 2,000,000

Realised CFs +9,400,000 +8,400,000

Est. change +90,000 +90,000

Block 1 10,490,000 10,490,000

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42

3

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IFRS 4 / 21

2.2 Accounting model steps

BBA Block 2: Time value of money

• Time value of money decreases

o Unwind of time value based on 2020 discount curve

o Lower 2021 discount curve

BBA Block 3: Risk adjustment

• Risk adjustment is periodically released in accordance with services provided

• Due to inaccurate estimations, chosen to be more conservative by raising the shocks

2020

2021

Costs

Lapses

Claims: Death

Maturities

Costs

Lapses

Claims: Death

2021 2022 ... 2030

Totals Tim Floris

Block 2 – 2020 -1,550,000 -1,550,000

Unwind +250,000 +250,000

Lower curve +100,000 +100,000

Block 2 -1,200,000 -1,200,000

Totals Tim Floris

Block 3 – 2020 50,000 50,000

Release -5,000 -5,000

Change +10,000 +10,000

Block 3 55,000 55,000

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3

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1

42

3

IFRS 4 / 22

2.2 Accounting model steps

BBA Block 4: Contractual Service Margin

• CSM is periodically released in accordance with services provided

• CSM accretes interest to reflect time value against lock-in discount curve

‘Unlocking’ the CSM

• Changes in estimates of the B1 and B3 are recognised

against the CSM (if available):

o If changes are favourable then

CSMt+1 = CSMt + PV(Change B1 + B3)

o If changes are unfavourable then

CSMt+1 = max{CSMt - PV(Change B1 + B3), 0}

• Hence:

o If CSM is not exhausted, changes in future cash flows are not recognised in P/L

o If CSM is exhausted, PV(Change) – CSMt recognised as loss in P/L as insurance contract becomes onerous

2020

2021

CSM Tim Floris

Block 4 - 2020 500,000 0

Periodic release -50,000 0

Interest accretion +5,000 0

PV(Change B1+B3) -90,000 0

Block 4 - 2021 365,000 0

BBA Tim Floris

Block 1 10,490,000 10,490,000

Block 2 -1,200,000 -1,200,000

Block 3 55,000 55,000

Block 4 365,000 0

Total 9,710,000 9,345,000

Tim Floris

Block 1 1,000,000 2,000,000

Block 2 -1,550,000 -1,550,000

Block 3 50,000 50,000

Block 4 500,000 0

Total 0 500,000

2020

1

42

3

54321

IFRS 4 / 23

2.2 Accounting model steps

Step 4: Present results in financial statements

LifeCo: 2021 P/L and OCI

• Underwriting result: Earned Premium Approach

FloTim

Premiums

Acquisition costs

2021 2022 ... 2030

Costs

Lapses

Claims: Death

Maturities

Costs

Lapses

Claims: Death

Costs

Lapses

Claims: Death

Risk adjustment Risk adjustmentLifeCo P/L and OCI For 12 Months Ended 31.12.2021 (in thousands)

Underwriting result -70

Insurance contract revenue 720Amortisation of acquisition costs 60Release in RA +10Release of CSM 50Expected claims and expenses 600

Insurance contract expense -790Incurred claims and expenses -620Incurred acquisition costs -60Losses onerous contracts -90Unexpected changes to IL -20

2020

2021

Risk adjustment

Experienceadjustment

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IFRS 4 / 24

2.2 Accounting model steps

Step 4: Present results in financial statements

LifeCo: 2021 P/L and OCI

• Investment result

LifeCo P/L and OCI For 12 Months Ended 31.12.2021 (in thousands)

Investment result 95

Interest income 600On bonds 600

Interest expense -505On insurance liability -500On CSM -5

Underwriting result -70

Profit or Loss 25

FloTim

Premiums

Acquisition costs

Costs

Lapses

Claims: Death

Maturities

Costs

Lapses

Claims: Death

Costs

Lapses

Claims: Death

2021 2022 ... 2030

Unwind of timevalue based on 2020discount curve

2020

2021

54321

IFRS 4 / 25

2.2 Accounting model steps

Step 4: Present results in financial statements

LifeCo: 2021 P/L and OCI

• Change to OCI

LifeCo P/L and OCI For 12 Months Ended 31.12.2021 (in thousands)

Investment result 95

Underwriting result -70

Total comprehensive income -5

Change to OCI -30

Profit or Loss 25

Discount curve changes on insurance liability -200

Fair value change of FVTOCI bond 170

Coupon

Notional

Coupon

2021 2022 ... 2030

Coupon

Premiums

Costs

Lapses

Claims: Death

Maturities

Costs

Lapses

Claims: Death

Risk adjustment

Risk adjustment

2021 2022 ... 2030

2020

2021

54321

IFRS 4 / 26

Tim’s bond 8,170(FVTOCI)

Floris’ bond 7,000(AC)

Tim portfolio 9,720

2.2 Accounting model steps

Step 4: Present results in financial statements

LifeCo: Balance sheet

Floris’ portfolio 9,345

Cash 4,380Equity 495

LifeCo B/S 31.12.2021 (in thousands)

Total 19,550Total 19,550

2021

2020

2020

2021

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IFRS 4 / 27IFRS 4 / 27

3. Expected impact

4.1 Solvency II vs. IFRS 4

4.2 IFRS 4 Phase I vs. IFRS 4 Phase II

4.3 Conclusion

IFRS 4 / 28

4.1 Solvency II vs. IFRS 4

MV Assets

Best estimateliabilities

Risk Margin

MCR

SCR

Mark

et-c

onsis

tent v

alu

atio

nof

liabilitie

s

Excesscapital

Best estimateliabilities

Risk Adjustment

PV o

f best e

stim

ate

cash flo

ws

CSM

Equity

Solvency IIIFRS 4 –phase II

Premiums

Acquisition costs

Costs

Lapses

Claims: Death

Maturities

Costs

Lapses

Claims: Death

Costs

Lapses

Claims: Death

Risk adjustment Risk adjustment

Risk adjustment

2021 2022 ... 2030

VA

CSM

MA

B4

Comparison on balance sheet level Comparison on cashflow level

IFRS 4 / 29

4.2 IFRS 4 Phase I vs. Phase II: Dutch insurer case

Dutch insurer case

• Comparison of IFRS 4 Phase I vs. Phase II based on Dutch insurer’s annual report (notes)

Step 5Provide

disclosures

Step 4Present in financial

statements

Step 3Remeasure in subsequent

periods

Step 2Measure at

initial recognition

Step 1Identify and

recognise the contract

B1

B2

B3

B4

B1

B2

B3

B4

IFRS 4 / 30

4.3 Conclusion

An operational challenge

• Maintain a break-down of building blocks over lifetime

• Reporting of changes to blocks in P/L or OCI or via ‘unlocking’ of CSM

A conceptual relief

• Certain elements of IFRS 4 (e.g. risk adjustment, discount curves) are new from an accounting perspective…

• … but may be reused from Solvency II and the Liability Adequacy Test

A reassessment of the ALM strategy

• P/L and OCI reporting might be shaken by new elements (e.g. changes to blocks, EPA) and entries

• Additionally, reclassification of assets under IFRS 9 can strongly impact results

• An ex-ante reassessment of the ALM strategy might be required.