Contract modification and derecognition

A contract that qualifies as an insurance contract remains so until all rights and obligations are extinguished (i.e., discharged, cancelled or expired) unless the contract is derecognised because of a contract modification [IFRS 17 B25].

IFRS 4 contained no guidance on when or whether a modification of an insurance contract might cause derecognition of that contract. Therefore, prior to IFRS 17, most insurers would have applied the requirements, if any, contained in local GAAP.

1. Modifications of insurance contracts

An insurance contract may be modified, either by agreement between the parties or as result of regulation. If the terms are modified, an entity must derecognise the original insurance contract and recognise the modified contract as a new contract, if and only if, any of the conditions listed below are satisfied [IFRS 17 72].

  • If the modified terms were included at contract inception:
    • The modified contract would have been excluded from the scope of IFRS 17.
    • An entity would have separated different components from the host insurance contract (see ‘Separation of insurance contracts‘) resulting in a different insurance contract to which IFRS 17 would have applied.
    • The modified contract would have had a substantially different contract boundary (see ‘Contract boundary‘).
    • The modified contract would have been included in a different group of contracts at initial recognition (e.g., the contracts would have been onerous at initial recognition rather than having no significant possibility of being onerous subsequently (see ‘Portfolio of insurance contracts‘).
  • The original contract met the definition of an insurance contract with direct participation features, but the modified contract no longer meets that definition or vice versa.
  • The entity applied the premium allocation approach (see  ‘Premium allocation approach‘) to the original contract, but the modifications mean that the contract no longer meets the eligibility criteria for that approach.

In summary, any contract modification that changes the accounting model or the applicable standard for measuring the components of the insurance contract, is likely to result in derecognition. The standard clarifies that the exercise of a right included in the terms of a contract is not a modification.

If a contract modification meets none of the conditions above for derecognition, the entity should treat any changes in cash flows caused by the modification as changes in the estimates of the fulfilment cash flows. See Onerous contracts and Mitigating financial risks with derivatives for the accounting for changes in the fulfilment cash flows. Accounting for derecognition of a modified contract is discussed in 3 below.

Consideration

The guidance on contract modification and derecognition under IFRS 17 is likely to be different from current practices applied under IFRS 4. Entities should also consider whether changes to the terms and conditions of contracts prior to the transition date exist that would result in modification or derecognition of that contract. Such events could have a significant impact on the CSM on transition.

2. Derecognition of insurance contracts

An insurance contract is derecognised when, and only when [IFRS 17 74]:

  • It is extinguished, i.e., when the obligation specified in the insurance contract expires or is discharged or cancelled Contract modification and derecognition
    Or Contract modification and derecognition
  • Any of the conditions for modifications which result in derecognition are met (see 1) Contract modification and derecognition

When an insurance contract is extinguished, the entity is no longer at risk and not required to transfer economic resources to satisfy the contract. Therefore, the settlement of the last claim outstanding on a contract does not necessarily result in derecognition of the contract per se, although it may result in the remaining fulfilment cash flows under a contract being immaterial. For derecognition to occur, all obligations must be discharged or cancelled. When an entity purchases reinsurance, it should derecognise the underlying insurance contracts only when those underlying insurance contracts are extinguished [IFRS 17 75].

3. Accounting for derecognition Contract modification and derecognition

There are three different ways to treat the derecognition of a contract, depending on the circumstances: extinguishment (see 3.1), transfer (see 3.2) or modification (see 3.3).

3.1. Derecognition resulting from extinguishment

An entity derecognises an insurance contract from within a group of insurance contracts by applying the following requirements [IFRS 17 76]:

  • Fulfilment cash flows allocated to the group for both the liability for remaining coverage and the liability for incurred claims are adjusted to eliminate the present value of the future cash flows and risk adjustment for non-financial risk relating to the rights and obligations that have been derecognised from the group.
  • The CSM of the group is adjusted for the change in fulfilment cash flows described above, to the extent required by the general model, as discussed in this section (for contracts without direct participation features) and this section (for contracts with direct participation features).
  • The number of coverage units for expected remaining coverage is adjusted to reflect the coverage units derecognised from the group, and the amount of the CSM recognised in profit or loss in the period is based on that adjusted number to reflect services provided in the period.

In practice, derecognition resulting from extinguishment will mostly occur on contracts where a CSM (or liability for remaining coverage) no longer exists. In these circumstances, extinguishment will result in the elimination of any fulfilment cash flows for the liability for incurred claims with a corresponding adjustment to profit or loss. An entity might not know whether a liability has been extinguished because claims are sometimes reported years after the end of the coverage period, and it may be unable to derecognise those liabilities. In the IASB’s view, ignoring contractual obligations that remain in existence and may generate valid claims would not give a faithful representation of an entity’s financial position. However, when the entity has no information to suggest there are unasserted claims on a contract with an expired coverage period, it is expected that the entity would measure the insurance contract liability at a very low amount. Accordingly, there may be little practical difference between recognising an insurance liability measured at a very low amount and derecognising the liability [IFRS 17 BC322].

3.2. Derecognition resulting from transfer Contract modification and derecognition

When an entity derecognises an insurance contract because it transfers the contract to a third party, the entity must [IFRS 17 77]:

  • Adjust the fulfilment cash flows allocated to the group for the rights and obligations that have been derecognised, as discussed at 3.1.
  • Adjust the CSM of the group from which the contract has been derecognised for the difference between the change in the contractual cash flows resulting from derecognition and the premium charged by the third party (unless the decrease in fulfilment cash flows is allocated to the loss component of the liability for remaining coverage).

If there is no CSM to be adjusted, then the difference between the fulfilment cash flows derecognised and the premium charged by the third party is recognised in profit or loss.

In addition, when an entity derecognises an insurance contract because it transfers that contract to a third party:

  • It must reclassify to profit or loss any remaining amounts for the group (or contract) that were previously recognised in other comprehensive income as a result of its accounting policy choice to disaggregate the finance income or expenses of a group of insurance contracts. This means that the OCI balance remaining is released to profit and loss.
  • However, if an entity holds the underlying items and, accordingly, uses the current period book yield approach for contracts with direct participation features (see  ‘Disaggregating insurance finance result’), it must not make any reclassification to profit and loss of remaining amounts for the group (or contract) that were previously recognised in other comprehensive income [IFRS 17 91] Contract modification and derecognition

3.3. Derecognition resulting from modification Contract modification and derecognition

When an entity derecognises an insurance contract and recognises a new insurance contract as a result of a modification described in 1 above, the entity must [IFRS 17 77]:

  • Adjust the fulfilment cash flows allocated to the group relating to the rights and obligations that have been derecognised, as discussed in 3.1 above.
  • Adjust the CSM of the group, from which the contract has been derecognised for the difference between the change in the contractual cash flows resulting from derecognition and the hypothetical premium the entity would have charged, had it entered into a contract with terms equivalent to the new contract at the date of the contract modification, less any additional premium charged for the modification (unless the decrease in fulfilment cash flows is allocated to the loss component of the liability for remaining coverage).
  • Measure the new contract recognised, assuming that the entity received the hypothetical premium that it would have charged, had it entered into the modified contract at the date of the contract modification. Contract modification and derecognition

Example – Contract derecognition resulting from modification

An entity modifies an insurance contract issued such that the modified contract would have been included in a different group of contracts and, applying the guidance in IFRS 17, determines that the contract should be derecognised and replaced by a new contract. The original contract was part of a group of insurance contracts that was not onerous. The group of contracts that the modified contract joins is also not onerous.

At the date of modification, the fulfilment cash flows of the contract were CU100 and the additional premium received at that date for the contract modification is CU20. The entity estimates that a hypothetical premium that it would have charged had it entered into the modified contract at that date was CU112. The fulfilment cash flows of the newly recognised contract were CU105.

This gives rise to the following accounting entries: Contract modification and derecognition

(Amounts in CU) Contract modification and derecognition

DR

CR

Cash

20

Derecognition of fulfilment cash flows in the group from which the contract is derecognised

100

Adjustment to CSM of the group from which the modified contract is derecognised (20 + 100 — 112)

8

Recognition of fulfilment cash flows of modified contract

105

Adjustment to the CSM of the group that the modified contract joins (112 — 105)

7

When an entity derecognises an insurance contract due to a modification and recognises a new one, it should treat any remaining amounts for the group (or contract) that were previously recognised in other comprehensive income in the same way as described for derecognitions resulting from transfer (see 3.2). Contract modification and derecognition

Consideration

The guidance on contract modification and derecognition under IFRS 17 is likely to be different from current practices applied under IFRS 4. Entities should also consider whether changes to the terms and conditions of contracts prior to the transition date exist that would result in modification or derecognition of that contract. Such events could have a significant impact on the CSM on transition.

IFRS 17 does not explicitly provide guidance on derecognition and modification of contracts in a group to which the entity applies the premium allocation approach. Therefore it appears that the principles relating to groups of contracts accounted for under the general model would be applied by analogy. Contract modification and derecognition

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