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The fair value approach is a method of determining the CSM at transition using the fair value of the insurance contracts less IFRS 17 fulfilment cash flows at the transition date. The fair value approach is the only approach that can be used where the insurer does not have the cash flow information needed to apply other approaches.
An entity can elect to use the fair value approach if the full retrospective approach is impracticable, and it is required to use the fair value approach if the modified retrospective approach is impracticable. An entity can also elect to use the fair value approach for a group of insurance contracts with direct participation features to which it could apply IFRS 17 retrospectively if, and only if:
  1. the entity chooses to apply the risk mitigation option in paragraph B115 of IFRS 17 to the group of insurance contracts prospectively from the transition date; and
  2. the entity has used derivatives, reinsurance contracts held, or non-derivative financial instruments measured at fair value through profit or loss to mitigate financial risk arising from the group of insurance contracts before the transition date.
FAQs on eligibility to use the fair value approach
When can the fair value approach be used?
5.1 Does an entity have a free choice to use the fair value approach on transition?
No. The full retrospective approach must be used on transition, unless it is impracticable to do so, in which case the entity can choose between applying the modified retrospective approach and the fair value approach to calculate the CSM or the loss component for each group of insurance contracts. If the modified retrospective approach is also impracticable, the fair value approach must be used.
Outcome of applying fair value approach
5.2 Will the fair value approach on transition provide an outcome comparable with the other two transition approaches?
No. The objective of the fair value approach is different from that of the modified retrospective approach:
  • The objective of the modified retrospective approach is to achieve an outcome closer to the full retrospective approach using specified simplifications.
  • The objective of the fair value approach is to determine the CSM in the absence of historical cash flow information
Under the fair value approach, the CSM is calculated as the difference between what a market participant would demand as at the transition date to assume the unexpired risk in the group of contracts, including how much profit it would require, and the fulfilment cash flows of that group measured under the general principles of IFRS 17. The fair value approach might be less burdensome, because it requires no historical data or retrospective tracking of the CSM.
Similar to the modified retrospective approach, entities using the fair value approach are allowed to identify groups of insurance contracts using reasonable and supportable information available on the date of transition, and there is no need to divide contracts issued before the date of transition into annual cohorts. Similarly, reasonable and supportable information available on the date of transition can be used to determine whether an insurance contract meets the definition of an insurance contract with direct participation features, to determine the discretionary cash flows for insurance contracts without direct participation features, and to determine whether a contract meets the definition of an investment contract with discretionary participation features. Under the fair value approach, these accommodations are available unconditionally, whereas under the modified retrospective approach an entity is permitted to use each of these modifications only to the extent that reasonable and supportable information is not available.
Although IFRS Standards have, for many years, required insurers to determine the fair value of insurance contracts in business combinations or portfolio transfers, there is likely to be diversity within the insurance industry in determining the fair value for insurance contracts. This is because of the lack of observable information for many insurance contracts and relatively limited market transaction data available to directly calibrate a fair value. Many companies are considering how to leverage existing information where possible - for example, regulatory requirements such as Solvency II in Europe, embedded value-based approaches, discounted dividend models, historical acquisitions data, and sales or pricing information.
PwC Observations: Differences between IFRS 13 fair value and IFRS 17 fulfilment cash flows
There could be differences between the IFRS 13 fair value and the IFRS 17 measurement of fulfilment cash flows.
Fair value measurement applying IFRS 13 reflects how the current market would be expected to price the asset or liability by incorporating the factors that market participants would consider in agreeing to a price. The entity is not required to identify specific market participants; instead, it should develop a profile of hypothetical market participants. The profile should consider factors specific to the group of contracts being fair valued, the principal (or, in its absence, the most advantageous) market for it, and market participants with whom the entity would be able to transact in that market.
Estimation of the market participant’s view of the expected profit from holding a group of contracts requires judgement. Paragraph 22 of IFRS 13 requires an entity measuring the fair value, when using a valuation technique, to assume that market participants act in their economic best interest. Irrespective of the estimation approach used, an entity would consider observable market data from comparable market transactions, including portfolio transfers, acquisitions or reinsurance, if it is reasonable that market participants would use this data.
In the absence of recent market transactions of similar contracts, some form of a present value technique will typically be used to value a group of contracts. Where the expected cash flows approach is used, a starting point is a set of cash flows that represents the probability-weighted average of all possible future cash flows, adjusted to incorporate uncertainties with respect to the amount and timing of projected cash flows. Cash flows included in the fair value measurement are limited to those falling within the boundaries of the respective contracts under IFRS 17 although market participants might have different assumptions about those cash flows (for example, different policyholder or mortality assumptions). The cash flows should therefore exclude future renewals and new business that would be outside the boundaries of the contracts under IFRS 17.
Under IFRS 13, the fair value of a financial liability with a demand feature (such as a demand deposit) is not less than the amount payable on demand, discounted from the first date when the amount could be required to be paid (sometimes referred to as the ‘deposit floor’). Paragraph B94 of IFRS 17 states that the deposit floor does not apply when measuring the fair value of contracts in a business combination. Similarly, paragraph C20 notes that the deposit floor does not apply when applying the fair value approach on transition. For further guidance on the inclusion of the deposit floor when determining eligibility for the variable fee approach and the measurement of the fair value of underlying items in that approach, please refer to FAQ 50A.167.1. In addition, paragraph 132(c) of IFRS 17 requires entities to disclose the amount payable on demand in a way that highlights the relationship between such amounts and the carrying amount of the related contracts.
Examples of some potential differences between the IFRS 13 and the IFRS 17 measurements could include the following:
  1. Expected cash flows under IFRS 17 might include some entity-specific assumptions outside an industry range that would be adjusted in determining the fair value using the market participant’s view. For example, an entity might assume a level of future expenses that is not consistent with the market expectation, due to entity-specific economies of scale. Another example could be differences in expected settlement of claims to protect the brand (such as payment of claims on items similar to those covered by the policy).
  2. Those expenses and income taxes that are not part of the fulfilment cash flows under IFRS 17 and that will be expensed as incurred might still be considered by a market participant in pricing a group of contracts, and thus adjust the fair value measurement.
  3. The IFRS 17 measurement reflects the compensation that an entity requires for bearing the uncertainty about the amount and timing of the cash flows that arise from non-financial risks. Typically, this is an entity-specific assessment. For the purpose of an IFRS 13 measurement, a risk adjustment needs to reflect the risks and a degree of risk aversion consistent with a market view. A market participant might use a different method, assume different diversification benefits or require a different level of compensation.
  4. In some markets, where investment returns are part of the embedded profit in a contract, and premiums take this into account, market participants could include the estimates of those returns in pricing the group of contracts. The profit component could also include an adjustment for the asset- liability mismatch risk (being a financial risk, such an adjustment would not be part of the risk adjustment under IFRS 17).
  5. In some territories, regulatory capital requirements and associated funding costs are considered by market participants in pricing respective groups of contracts. In those cases, the fair value of an insurance liability might include such costs of holding required solvency capital.
FAQs on how to apply the fair value approach
Using existing measures of economic value to determine fair value
5.3 Can an alternative existing measure of economic value be used as the fair value of contracts for the purposes of transition to IFRS 17?
Historically, many insurers issuing long-term contracts applied Market Consistent Embedded Value (MCEV) or European Embedded Value (EEV) Principles, issued by the European Insurance CFO Forum, to measure insurance contracts for supplementary reporting purposes. Entities will be able to use these measurements, where still produced, or other economic-based regulatory measures (such as Solvency II in Europe) as a starting point for the fair value approach on transition to IFRS 17. However, entities should ensure that such measurement is consistent with the IFRS 13 requirements, and they should adjust it for any differences.
What cash flows are included in fair value measurement on transition?
5.4 In determining the CSM, what cash flows are included in the fair value measurement of a group of insurance contracts where the fair value approach is used on transition to IFRS 17?
For the purpose of determining the CSM at the transition date where the fair value approach is used on transition, groups of insurance contracts in force as at that date are subject to fair value measurement. Cash flows included in the fair value measurement are limited to those falling within the boundaries of the respective contracts under IFRS 17, and they should therefore exclude future renewals and new business that would be outside the boundaries of the contracts under IFRS 17.
In addition, IFRS 17 does not require or allow the application of a deposit floor when measuring insurance contracts using the fair value approach on transition.
IFRS 13 stipulates that fair value measurement assumes that a liability is transferred to a market participant at the measurement date, and not settled or extinguished. The price paid to a third party might differ from the settlement value that the direct counterparty would be willing to accept, for example, in a structured settlement arrangement. In measuring the fair value, an entity would assume that the insurance contract liability remains outstanding and the market participant transferee would be required to fulfil the obligation under the insurance contracts. The fair value of an insurance liability would therefore be the price that a market participant would be willing to pay to assume the obligation and the remaining risks of the in-force contracts as at the transition date.
Insurance acquisition cash flows when using fair value approach at transition
5.5 When applying the fair value transition approach, for reporting periods subsequent to the transition date, should insurance acquisition cash flows that occurred prior to the transition date be included in the CSM, and so be recognised as revenue and expense in the statement of profit or loss after transition?
Yes.
When applying the fair value approach on transition, paragraph C20 of IFRS 17 requires an entity to determine the CSM on transition by comparing the fair value of the group with the fulfilment cash flows.
Paragraph C24A of IFRS 17 require an entity, in applying the fair value approach, to determine an asset for insurance acquisition cash flows at the transition date at an amount equal to the amount of insurance acquisition cash flows that the entity would incur at the transition date for rights to obtain:
a) recoveries of insurance acquisition cash flows from premiums of insurance contracts issued before the transition date but not yet recognised at the transition date;
b) future insurance contracts that are renewals of insurance contracts recognised at the transition date and insurance contracts described in (a); and
c) future renewals of insurance contracts, other than those in (b), after the transition date without paying again insurance acquisition cash flows that the entity has already paid that are directly attributable to the related portfolio of insurance contracts.
At the transition date, the entity should exclude any asset for insurance acquisition cash flows from the measurement of a group of contracts.
The asset for insurance acquisition cash flows should be derecognised, subsequent to the transition date, on initial measurement of the related group of insurance contracts.
Discount rate for fair value measurement
5.6 Would the discount rate used for fair value measurement on transition always equal the rate used in calculating the IFRS 17 fulfilment value of the contracts under IFRS 17?
No. The nature of insurance and investment products, the local regulatory regime, risk appetite and diversification strategies could impact a market participant’s view of the appropriate discount rate to be applied in measuring fair value on transition.
A market participant would use a discount rate that could include financial risks. That discount rate could differ from the discount rate used under IFRS 17, because paragraph 36 of IFRS 17 allows financial risks to be reflected either in the discount rate or in the cash flows. The discount rate used for fair value measurement would include a provision for the non- performance risk (including insurer’s credit risk) of the insurer. Under IFRS 13, non-performance risk is assumed to be the same before and after the transfer of the liability. The assertion is that the liability would transfer to a credit-equivalent entity.
Where consistent with market practice, discount rates used for fair value measurement will reflect the perspective of market participants on the liquidity characteristics of the group of insurance contracts. In addition, in pricing a transaction, a market participant would typically include profit arising from investment management, either by adjusting the discount rate or by incorporating this into future cash flows.
Contracts onerous immediately prior to the transition date
5.7 How will the fair value approach on transition apply for groups of contracts that are onerous immediately prior to the transition date?
When measuring groups of contracts that were onerous immediately prior to transition, the application of the market participant’s view under the fair value approach is likely to result in a CSM, because a market participant would require compensation in profit margin above a risk adjustment to take on the obligations. Accordingly, future profits would then be recorded on these previously onerous groups of contracts, whereas such profits would not occur if a full retrospective approach is followed.
Onerous contracts at the transition date
5.8 How will the fair value approach on transition apply for groups of contracts that are onerous at the transition date? How is subsequent accounting impacted?
Generally, the fair value of a group of existing contracts (that is, the potential amount that a market participant would demand to assume the liabilities) is likely to be more than the IFRS 17 liability measurement, resulting in the recognition of a CSM at transition. For example, a market participant might demand CU105 to assume liabilities that have an IFRS 17 liability for remaining coverage measurement of CU100. In this example, a liability for remaining coverage of CU100 and a positive CSM of CU5 would be recorded at transition.
However, in some circumstances, application of the fair value approach might result in a fair value of a group of existing contracts that is less than the liability fulfilment cash flows under IFRS 17. For example, the fair value might be CU95 and the IFRS 17 measurement might be a liability of CU100. In these cases, the fulfilment cash flows should be recorded (CU100 in this example), and the difference between the fair value and the fulfilment cash flows (CU5 in this example) would not be recorded (because negative CSM is not permissible). Rather, the excess of fulfilment cash flows over fair value would be identified as a loss component of the liability for remaining coverage.
Subsequent to transition, an entity should apply paragraphs 49–52 of IFRS 17 to allocate subsequent changes in fulfilment cash flows to that loss component. For example, if the liability for remaining coverage was subsequently re-estimated to be CU93, the liability would be reduced by CU7, profit or loss would be credited for CU5, and a CSM would be established for CU2.
Determining the fair value of reinsurance contracts held
5.9 IFRS 17 requires the fair value of reinsurance contracts held (‘RCHs’) to be determined both on transition to IFRS 17, where an entity uses the fair value approach, and in a business combination.
What is the fair value of the RCHs from the perspective of the cedant?
Consider the following example:
Entity A (the cedant) has RCHs that cover a single underlying insurance contract on a fully proportionate basis. The premium has already been paid to the reinsurer, and hence the RCHs are an asset for entity A. The underlying contract covers a single event for which probability of a claim is 50%. If the event occurs, the amount of the claim will be CU500. If there is no claim, there is no further cash flow under the contract. The contract is short term, and so the impact of discounting is immaterial and, for the purposes of this example, it has been ignored.
As such, the present value of the RCHs’ expected cash flow to the cedant is: 50% × CU500 + 50% × CU0 = CU250.
Assume that, in this situation, the reinsurer would require a risk premium of CU20 for taking on this risk (for example, a reinsurer would charge a premium of CU270 – CU250 plus the CU20 premium for writing such a contract).
The fair value of the RCHs is CU270. IFRS 13 does not specify the unit of account for measuring fair value, but it refers to other standards that require or permit the use of fair value. [IFRS 13 para 14].
Under IFRS 17, RCHs are treated as a separate unit of account from the related underlying insurance contracts (see paras B93, C20 of IFRS 17 and BC 298 of the Basis for Conclusions on IFRS 17). In particular, paragraph BC 298 states that IFRS 17 requires RCHs subsequently to be accounted for separately from the underlying insurance contracts to which they relate.
However, when determining fair value under IFRS 13, it is necessary to identify the amount that a market participant would be willing to pay to acquire this asset. For this purpose, it is necessary to assume that a market participant would also be exposed to the same underlying risk, or else the transaction would not occur, because any counterparty/reinsurer would require a premium of CU270. Such a participant would be willing to pay CU270 in recognition of those underlying risks essentially being transferred to the reinsurer through RCHs. The cedant of the underlying risk would be willing to pay the same amount to dispose of the risk as the reinsurer would demand for assuming it.
Date for assessing information needed to apply the fair value approach
5.10 In applying the fair value approach on transition, paragraph C21 of IFRS 17 sets out four assessments to be performed. These relate to identifying groups of insurance contracts, assessing eligibility for the variable fee approach, determining discretionary cash flows under the general measurement model, and assessing whether an investment contract has a discretionary participation feature. In performing these assessments, paragraph C22 of IFRS 17 allows the insurer to use ‘reasonable and supportable’ information either at the date of inception (or initial recognition) or at the transition date.
Can an entity select different dates for each of the four assessments listed in paragraph C21 of IFRS 17?
Yes.
An entity can use different dates for each of the four assessments in paragraph C21 of IFRS 17, depending on when it has ‘reasonable and supportable’ information.
If, for one of the assessments, an insurer has ‘reasonable and supportable’ information at both the date of inception and the transition date, the entity has a choice over which date to use.
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