Insurance contracts can be grouped to simplify pricing. However, this approach may not reflect the economic characteristics of the contract. For example, laws may mandate a pricing structure that doesn't reflect the features of the risky group. An insurance standard may allow insurers to group contracts based on risk by considering policyholders in a set B as having more serious trouble than policyholders in set A. However, this standard may lead to an unfairly high premium for a profitable contract.
Under IFRS 17, an insurer can measure the profitability of an onerous insurance contract in units. Under this standard, the amount of coverage provided by an onerous insurance contract is measured in units. The granularity of an onerous insurance contract will affect how insurance revenue is recognized in the financial statements. As a result, the level of aggregation should be determined before the insurer starts evaluating the financial statements.
An insurer can profit from an insurance contract if it is profitable or not. In this case, the insurer may choose to group the contacts into groups based on their profitability. These groups are further divided into time cohorts - they cannot exceed a year-long horizon - and profitability groups. Within each group, insurers can classify insurance contracts as either onerous or low-risk based on their level of profitability.
The CSM of a group of insurance contracts is recognized in profit or loss. Under IFRS 17, an entity must identify units directly attributable to an insurance contract's fulfillment. In addition to units, insurers must assess the relative weighting of insurance coverage by the premium allocation approach. These considerations can have far-reaching implications for the presentation of financial statements. However, these decisions must be made carefully, as they could have a material impact on the valuation of a company's insurance business.
When a policyholder reaches the end of the coverage period, a CSM may be released in units. For instance, if a group receives 100EUR CSM for five years, each member can remove 20 EUR annually. In addition, the insurance company can introduce annual cohorts to monitor and identify trends in profitability over time. The CSM may also be measured in units higher than yearly cohorts.
The cost of a loss-making insurance contract is calculated in units. These units represent the expected future cash flows from the insurance contract, including premiums, claims, acquisition costs, and certain expenses. If these cash flows are material, they should be discounted and adjusted for the time value of money. Another consideration is the amount of non-financial risk. Loss-making insurance contracts can have different cost structures depending on their size.
The purpose of releasing CSM is to reflect the services provided in each coverage period. This is a challenge for insurers because there are no specific coverage units specified in IFRS 17. TRG members agreed to apply judgment in determining CSM allocation. Because CSM can be allocated for different levels of profitability, insurers must evaluate a systematic method for estimating services. In addition to considering insurance coverage, the amount of investment return service must be regarded in determining CSM allocation.
The CSM of a group of insurance contracts is recognized as a profit or loss. This is done by identifying the coverage units and determining their expected duration. Insurance companies must consider factors that affect the quality of their decisions in determining CSM allocation. They should also determine whether investment costs are directly related to fulfilling the insurance contract. If the answer is yes, they should recognize the worth of investment-related administrative costs in their profits.
The premium paid by each insurance contract is divided into two parts. The first is the pure premium, a component of the insurance premium determined by actuarial studies. The second component is the loading charge. This is the cost of the coverage that the insurer incurs. The cost of the premium is measured in units, and the premium for the unit of protection is the rate multiplied by the number of units of coverage purchased.
As per IFRS 17, the product portfolio of an insurance contract is divided into cohorts or time buckets. Open portfolios should be closed on a timely basis. Each cohort represents a coverage period, or time, for which the CSM is allocated. In addition, the portfolios can be divided into annual cohorts to identify trends in profitability and pricing. For example, a group with five coverage units will release twenty EUR per year over the contract period.
Under the new guidance, insurers will need to measure their products in similar risk and profitability groups. These portfolios are further subdivided by time cohorts, which cannot be more than one year, and profitability groups. Within these groups, insurers will split their contracts into onerous and non-onerous ones. In addition, they will need to determine the appropriate rate for aggregation.
A contract may be defined as onerous if it captures less valuable information. It might also be considered unfavorable if it believes the extent of service provided by one agreement over a more extended period. Then, the contract may not be fully insured, which may harm pricing and reported earnings. Hence, a contract should be analyzed by considering all this before investing.
The CSM may also be measured higher than the annual cohort. By doing so, insurers can achieve the same accounting outcome as a yearly cohort. However, IFRS 17 does not specify the methodology used to measure CSM at a higher level. Therefore, insurers should determine whether CSM for such contracts will be zero compared to its annual cohort. If this is the case, they should measure them at a higher level than a single yearly cohort.
Contracts with intergenerational risk sharing
One way to measure the risks involved in an overlapping-generations contract is to measure the contracts' profitability by dividing them into units. This way, a new generation could inherit an obligation from the previous generation, or an older adult could have to pay it off. In any case, the expected risk-adjusted return for each age is calculated. A company owner cannot extract more capital than the expected risk-adjusted return for that generation.
The new IFRS 17 guidance specifies the level of aggregation and annual cohort requirements for insurance contracts. In 1999, the International Financial Reporting Standards Board adopted IFRS 17. Some respondents supported the Board's decision, while others suggested that the Board consider an exemption for intergenerational risk-sharing. In a recent consultation document, the Insurance Board considered feedback from stakeholders to view the annual cohort requirement.
In contrast, CDC pension plans are designed to evolve more smoothly than IDC accounts. This is due to intergenerational risk-sharing. Another critical difference between the two pension models is the declaration rate process. The CDC pension model has an extra layer of stability because the CDC pension model uses a funding-ratio-linked declaration. The funding ratio-linked declaration is more stable than its IDC counterpart.
While the first generation may benefit more from the lower growth rate, the latter generations may also benefit from the lower rate of growth. While the difference is slight on an annual basis, it is substantial over the contract's life. The size of the cross-subsidization depends on several parameters. These parameters include the risk-free interest rate, the crediting rate of the bonus reserve, and asset allocation.