IFRS 17 Challenges for Reinsurance: Fitting a Square Peg in a Round Hole

IFRS 17 Challenges for Reinsurance: Fitting a Square Peg in a Round Hole

By Michael Winkler and Sunil Kansal

This article provides an overview of the challenges encountered by the insurance industry when applying the requirements of IFRS 17 to reinsurance contracts—the complexities and difficulties that arise when adapting existing accounting practices for reinsurance contracts to comply with the new standard. Insurance companies face unique challenges in the accounting of passive reinsurance. By delving into specific challenges and offering potential solutions, the article aims to shed light on the intricacies of implementing IFRS 17 and the resulting mismatches in financial reporting, including their impact on Solvency II practices.

The new IFRS 17 standard for the accounting of insurance contracts is mandatory for IFRS accounts from this year onward. In the time since its publication, we all learned that it creates significant challenges in reassessing margin expectations and reflecting the outcome in financial statements. This applies in particular to ceded reinsurance—an area many companies have not paid enough attention to so far.

Distribution of Profits

The profit margins are distributed over the lifetime of the portfolio cohorts and are kept in the so-called Contractual Service Margin (CSM). The CSM at the inception of a cohort is determined in a way that there is no initial gain. The amortization thereafter runs in line with so-called Coverage Units reflecting the amount of insurance services provided to the corresponding group of contracts.

In the Variable Fee Approach (VFA) for participating contracts, the changes in the fair value of the shareholders’ part of the underlying items as well as current interest rates are flowing into the CSM. IFRS 17 also requires an explicit margin for insurance risk (potential adverse deviations), the so-called Risk Adjustment for non-financial risk (RA). As a consequence, the margin between the present values of premiums and expected service expenses (claims and cost) actually consists of two parts: CSM and RA, whereas the CSM is the profit reserve and the RA is the allowance for adverse deviations, reflecting the risk appetite of the company. The periodic releases of these two items are mainly driving the results.

Reinsurance Held

Reinsurance assumed is treated exactly in line with primary insurance; so, there are no additional challenges in this area. However, reinsurance ceded—or “Reinsurance Held,” as it is called in IFRS 17—is causing a series of difficulties.

Primary insurance payments have never been and will never be reduced due to any failure of a reinsurer to pay his part of the claims (the primary insurers bear the corresponding counterparty default risk). From this—unarguably correct—as a matter of fact, IFRS 17 derives the fundamental principle that Reinsurance Held is always booked separately from the underlying business (which is therefore gross of reinsurance), and corresponding positions can never be offset against each other.

This is a fundamentally different approach than the treatment of reinsurance in Solvency II, where the projected cash flows are always net of reinsurance. As a result, reinsurance is not providing any reserve release under IFRS 17. Furthermore, the separation of Reinsurance Held from the corresponding underlying business creates a series of significant mismatches, as we describe in the following section.


Under IFRS 17, reinsurance contracts held are to be recognized either at the beginning of the coverage or when the underlying contract is recognized, whichever is later. Measurement of these contracts requires consistent assumptions to predict future cash flows for both reinsurance and the underlying insurance contracts while taking into account the risk of the reinsurer failing to fulfill its obligations.

Non-financial risk adjustments are calculated based on the risk transferred from the holder to the reinsurer. Initial recognition results in either a net cost or gain that is recognized as part of CSM, rather than an unearned profit. Any reinsurance costs related to past events are immediately recognized as an expense.

The contractual service margin is then updated for things like new contracts added, changes in cash flow, interest, currency fluctuations, and services received by the end of the reporting period. Changes in cash flow projections due to the reinsurer’s risk of non-­fulfillment do not impact the CSM, and reinsurance contracts can’t be onerous, so there’s no need for immediate loss recognition.

CSM Mismatch

As explained above, the CSM is the residual amount between the present values of premiums and expected services expenses (claims and cost) including the RA. For Reinsurance Held, it can therefore be positive or negative, depending on the comparison of the reinsurance premiums with expected services expenses and RA. However, for the underlying business, the CSM is always positive (a negative CSM would mean that the business is “onerous,” and the corresponding difference is recognized as an immediate loss in the profit and loss statement.

The timing of entering the reinsurance contract has an impact on the CSM as well: The corresponding present values may be based on different prevailing discount rates than the ones used for determining the CSM of the underlying business.

Furthermore, reinsurers usually do not participate in the acquisition cost of the underlying business, leading to a further deviation of the CSM.

Therefore, in general, the CSM for Reinsurance Held is different from the one of the corresponding underlying businesses. Without adjustments, these differences in CSM would lead to odd effects in the profit and loss statements. Here lies the reason for introducing the additional rule that the CSM of Reinsurance Held is only adjusted to an adverse development of the assumptions as long as the CSM of the underlying business remains positive. As soon as the CSM of the underlying business reaches zero, the CSM of Reinsurance Held is not adjusted any longer.

Sometimes reinsurance contracts cover multiple years of underlying business. The International Accounting Standards Board (IASB) argues that, in this case, the liability of the reinsurer is actually much bigger than just the reinsurance for the current portfolio as it comprises future new business. As a matter of fact, the standard requires in this case to account for the business of future years in Reinsurance Held, for business that is not yet written!

It is a unique feature of IFRS 17 that there is accounting for business which is not yet concluded; however, this is a direct consequence of the separation of Reinsurance Held from the underlying business.

Furthermore, it is driven by the definition of contract boundaries, which are close to the legal contract wording and much less based on economic reality. Given the administrative hassle of the above issue, companies might consider a change of the treaty wording in order to eliminate the problem.

Mismatch of Coverage Units

As described earlier, the periodic release of the CSM happens in line with the Coverage Units, reflecting the amount of insurance service provided in the corresponding period.

The services provided by the reinsurance are not necessarily in line with those provided for the underlying business. Therefore, the Coverage Units for Reinsurance Held may deviate accordingly.

Most companies actually choose a much simpler definition for the reinsurance Coverage Units—e.g., a linear decrease over the contract term. The difference between the CSM release patterns will have a direct impact on the result.

Mismatch of Risk Adjustment

There are good reasons to opt for a different definition of the RA for Reinsurance Held: different diversification, different impact of adverse developments, etc.

Based on the explicit RA definitions, the release pattern will deviate in such cases, which will have a similar impact on the profit and loss statements as the aforementioned CSM releases.

Mismatch of Accounting Models

The VFA for participating contracts is not allowed for Reinsurance Held, which has to be accounted for using the General model. This leads to a mismatch for the reinsurance of participating and unit-linked businesses.

This issue has been escalated by insurance companies during the implementation phase. However, the IASB argued that reinsurers would not be participating in the performance of the underlying asset pool and therefore the VFA would not be applicable.

This argument works for traditional reinsurance contracts; however, it fails for asset-intensive reinsurance as well as for financing contracts for unit-linked businesses. In those cases, a detailed quantitative analysis is recommended in order to determine the impact of the mismatch on the results and identify potential remedies.

Mismatch on Onerous Business

Based on the principles of IFRS 17, profits must be spread over the lifetime of the contracts. For the reinsurance of onerous business, this implies that the insurance company has to realize the immediate loss on the underlying business whereas it does not get any immediate relief from the reinsurer due to the fact that the corresponding profits are spread over time.

Taking into account the feedback from the insurance industry, a significant adjustment has been made in the amendments to the standard: If a company writes a quota share treaty over various business lines which also contain onerous parts, the Reinsurance Held can mitigate the corresponding share of those losses through a so-called loss-recovery position.

However, the amendment specifically focuses on quota share reinsurance only; any other types of reinsurance treaties cannot benefit from the exception.

Fronting / Intra-group Reinsurance

Given the above mismatches, fronting arrangements—i.e., 100% cession of the assumed risks retaining a small overrider fee—become extremely challenging. In the past, most companies accounted for the fee and ignored the (offsetting) risk part.

Under IFRS 17, however, the fronting business has to be accounted for on a gross basis, modeling the business exactly like the business the company retains on its balance sheet. Considering all the aforementioned mismatches, achieving the net result of the overrider fee may be challenging.

A similar challenge applies to intra-group reinsurance: In the consolidated accounts, all corresponding positions have to be zero—which is certainly challenging given the mismatches between the underlying business, the Reinsurance Held, and the reinsurance assumed.

Reinsurance Solutions

In the Solvency II environment, reinsurance solutions providing a solvency benefit to ceding companies are actually not simple, but they are quite straightforward compared to IFRS 17—due to the fact that the projected cash flows are net of reinsurance.

Tailoring the impact of reinsurance solutions under IFRS 17 is far more complex due to the separation of underlying business and Reinsurance Held as well as the above-mentioned mismatches.

With the exception of the explicitly addressed reinsurance of onerous business, reinsurance cannot accelerate profits in IFRS 17. However, given the differences in the amounts of CSM and RA as well as in the corresponding release patterns, reinsurance can finally shape the pattern of the arising net profits. In order to make use of that in practice, an in-depth quantitative understanding of the profit patterns in both the underlying business and Reinsurance Held is required.

The near-term activities of reinsurers will likely focus more on fixing some unwanted issues stemming from reinsurance before investigating any use of reinsurance for shaping future profit patterns.

MICHAEL WINKLER is an actuary (SAA/DAV) at Shasat Consulting and previously in leading actuarial positions at Swiss Re, Munich Re/New Re, and Winterthur Group. SUNIL KANSAL, head of consulting at Shasat, is a Chartered Accountant and a Fellow of the Institute of Chartered Accountants in England and Wales.

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