# IAS 36 Impairment

# Complete beginners' guide

## IFRS 17 to the complete beginner…

The objective of this article is to provide you with a bigger-picture view of how IFRS 17 wants to capture the insurance contracts in financial statements. We’ll achieve this without going into too many details and technicalities.

I’m not going to needlessly drag you through the definitions, scope, and exclusions of IFRS 17 even before you know what we are talking about.

Insurance contracts are like beasts. They are untamable, difficult to predict, and can have drastic impacts on financial statements. How do you capture such a creature?

*Expected Cash Flows*

## Let’s start by understanding the cash flows that arise in a typical insurance contract

Let’s say we issued 100 insurance contracts today with a term of 3 years. From each, we are to receive a premium of $10 at the start of each of the 3 years. So we’ll receive $1,000 at the start of year 1, $1,000 at the start of year 2, and $1,000 at the start of year 3.

This premium which we expect to receive is not without a promise. There is no such thing as a free lunch.

The promise in an insurance contract is to make compensation to the policyholder or his beneficiary in case of an event adversely affecting the policyholder. If you remember contingent payments do not even qualify for the definition of Provision under IAS 37.

However, for every group of insurance contracts, these contingent payments are “expected”. In fact, they are substantial. But hey, we are not going into the details of the technical definition of Insurance contrast in IFRS 17 at this stage. Rights now, we have bigger matters at hand. Today, we have a beast to slay.

Imagine the insurance contract under discussion is actually a term life insurance which obliges us to make compensation payments of $1,000 to the beneficiaries of the policyholder in case of policyholder’s death within the contract period of 3 years.

What kind of cash outflows would be expected to fulfill these promises?

The most prominent ones are as follows:

- The administrative expenses expected to be incurred in managing these policies
- The expected claims payment.

But how on earth do we know how many of those policyholders will die?

If you are an Avengers’ fan, the answer is very obvious. Dr. Strange (aka actuaries). It is the actuaries’ job to find out the best estimates of future uncertain events. Somewhat like Dr. Strange predicted 14 million six hundred and five scenarios using his magical powers in “infinity wars”

So, let’s say that the actuaries estimate that we would incur an administrative cost of $50 at the end of each year and they also predict that 2 out of the 100 policyholders will die. They don’t stop there. They also predict that one of them will die at the end of year two and the other will die at the end of year three.

Exactly which policyholders will die, they refuse to tell. They always do. And this doesn’t affect the cash flows in our example.

So, based on the actuary’s best estimate (which, in practice, is not as epic as demonstrated in this simple example) our cash outflows will be $50, $1050, and $1050 at the end of the year 1,2, and 3 respectively.

### The key objection in IFRS 17: In contrast with IFRS 4

So far, it’s simple, right? Actuaries do all the work and accountants sit back and relax.

True, life’s good unless you ask the question of what to do about these contracts. Think in terms of journal entries.

Let’s say, I sold a policy. Should I record something in my books at the time of selling it?

If you have any background in quantitative finance, something is already hovering over your mind.

“Why not just present value these expected future cash flows.” You might say.

Brilliant. I have already done that for you assuming a discount rate of 5%. The present value of $1,000 cash inflows at the start of each year is $2,859. The present value of all the cash outflows is $1,907. The present value of cash inflows exceeds the present value of cash outflows by $952.

You got your answer. What next? What does this $952 represent?

So basically $952 represents the present value of profit I expect to earn on these 100 contracts.

In the context of IFRS 17 this number is called “present value of expected cash flows.”

Should I record this entire amount as profit in the year the contracts were signed?

This is the key objection in IFRS 17. I can not recognize the present value of expected cash flows as profit in P&L on the date of initial recognition.

To reassure our primitive accountant minds, IFRS 17 does not allow me to make the following accounting entry on initial recognition:

Insurance Contract (Asset) $952

Profit and Loss $952

“Why should I not record the initial profit”, you might ask, “I sold the policy. This is my selling profit.” You have all the right to exclaim… but to no use.

*Contractual Service Margin*

## Here’s how comparability and matching are achieved:

One of the objectives of IFRS 17 is to make the financial statements of insurance companies comparable. Not just across the companies in the same industry but, hopefully, also with companies across the industry.

This makes it important to have a quick look at IFRS 15 to get a feel of what IFRS 17 is trying to achieve.

Bear with me this example will be super brief and totally worth the time.

Consider a construction contract a company signs with a landowner.

At the time of signing the contract, the construction company may be able to predict the future cash inflows (stage payments) to be received from the client and also the cash outflows to be made in terms of expenditure on construction of the house.

Arguably a construction company’s cash inflows and outflows are more reliably predictable than an insurance company, the latter being more prone to fluctuations.

Having considered this, should the construction company be allowed to recognize the present value of cash flows as profits on day one?

### Gotcha!

IFRS 15 objects. Revenue should only be recognized when the matching “performance obligation” is satisfied. In the case of a construction project, performance obligation can be measured in terms of percentage of completion or proportion of total costs incurred.

Now let’s try to carry this understanding of satisfying “performance obligations” to our group of 100 insurance contracts.

When do we satisfy “performance obligation” in our three-year insurance contract? What is our performance obligation in the first place?

Our performance obligation is “coverage of insurance risk”. So, one way of looking at this might be in terms of the coverage period.

What we can conclude here is that our unearned profit of $952 should be spread over three years. Given our limited knowledge (still not fully compliant with IFRS 17) the accounting entry may be as follows:

Insurance Contract (Asset) $952

Unearned income (liability) $952

As you can see above, rather than crediting the difference in P&L, I have credited the liability.

This unearned income can be released in P&L in each of the following years as follows:

**End of year 1**

Unearned income (liability) $317

Profit or loss $317

**End of year 2**

Unearned income (liability) $317

Profit or loss $317

**End of year 3**

Unearned income (liability) $317

Profit or loss $317

The above entries ignore the effect of discounting and assumes there was no change in assumptions in any of the future years.

This unearned income which is released in P&L over coverage period is called contractual service margin in IFRS 17

We will zoom in on contractual service margin in great detail in future articles. For now, it is important to know that CSM is an unearned income that is released in profit or loss over the coverage period.

### Caution

It is important to understand what could go wrong if we do not delay recognizing profit sufficiently. If, say, we recognize 90% of the profit in the first 2 years and in the third year 4 out of 100 policyholders die, the profit or loss will show higher profits in first 2 years and heavy losses in 3rd year.

This would make financial profits fluctuate and financial statements unreliable for investors’ decision-making.

So, we conclude that it is important to sufficiently delay releasing the unearned income in profit or loss.

*Risk Adjustment*

## The final piece of the puzzle:

So far so good. Do I know IFRS 17 already?

Well, you are about have a zoomed-out version of the entire standard so later we can independently zoom in on each area.

But one major plot twist is yet to come. Remember Dr. Strange? He is really strange.

When actuaries tell you expected cash flows, they are actually telling you the “expected value” of cash flows.

What’s the difference you might ask?

Our actuary told us that we will have to pay $1000 at the end of years 2 and 3 each. That’s because he believed that 1 policyholder will die in each of those years.

But did we even ask him what was the standard deviation of his belief?

Relax, just consider this. Actuary considers multiple scenarios when coming up with a value. Unlike doctor strange we can not consider 14 million scenarios, so let’s reduce them to two scenarios for our example.

If an actuary says that the number of deaths in year 2 is 1 he could mean that:

- scenario one has a 40% probability of occurring and if that happens .85 people will die and
- scenario two has a 60% probability of occurring and if that happens 1.1 people will die

Given the above analysis in year 2:

- the “expected” (be careful) number of deaths are: (40%*.85+60%*1.1)=1
- the “expected” cash outflow in claim is: (40%*.85*1000 +60%*1.1* 1000)= $1,000

Finally, consider we have another group (let’s say group B) of 100 term life insurance policies with all the characteristics and terms exactly the same as group one that we discussed so far.

The only difference in group B is that the expected value of 1 death in year 2 is computed as follows:

- scenario one has a 50% probability of occurring and if that happens .1 people will die and
- scenario two also has a 50% probability of occurring and if that happens 1.9 people will die

Note that the expected number of deaths in group two is also 1 in group B and the expected claims payment is also $1,000. Don’t trust me? Check yourself!

My question to you now is, should we delay releasing unearned profit to profit or loss more for group 1 or group 2? For which group should we delay releasing the profit more?

Think about the worst-case scenario. For group 2 we might have to incur claims for upto 1.9 policies, while for group 1 we may only have to pay claims on a maximum of 1.1 policies in the worst case.

Because of higher expected fluctuation, group 2 is exposed to higher risks.

To deal with this we can set aside a portion of unearned income as a risk buffer or margin. So that contractual service margin or CSM is released in smaller amounts.

The buffer set aside may itself be released to P&L when the dispersion in the two scenarios is reduced.

### Think over.

This risk buffer or risk margin is called Risk Adjustment in IFRS 17. There are more than one ways to conceptualize it.

Let’s quickly put together all the moving parts

**Present Value of Expected Cash Flows:** Present value of all expected future cash flows and outflows

**Contractual Service Margin:** The unearned income is initially recognized as a liability and gradually released to profit or loss as coverage is satisfied.

**Risk Adjustment:** The amount of unearned income not to be released in profits unless the estimated is volatility is reduced.

The above three are the core components of the general measurement model under IFRS 17 also called the building block approach.

**What we haven’t covered:**

There are modifications to the building block approach for insurance contracts smaller than 1 year called the principal allocation approach and for insurance contracts with direct participation features. Plus, we can not ignore the technical definitions and details for each of the concepts discussed. Finally, we have yet to see how each of these moving parts works together and how they are presented in the line items in the financials.

Nevertheless, you now have a Conceptual Understanding of IFRS 17.

**Cheers!**