The fourth element of the building blocks in the general model (see ‘General model of measurement of insurance contracts‘) is the contractual service margin (the CSM). This is a component of the asset or liability for the group of insurance contracts that represents the unearned profit the entity will recognise as it provides services in the future.
1. Initial recognition
An entity should measure the CSM on initial recognition of a group of insurance contracts at an amount that, unless the group of contracts is onerous (see ‘Onerous insurance contracts’), results in no income or expenses arising from [IFRS 17 38]:
- Initial recognition of an amount for the fulfilment cash flows (see ‘Estimates of future cash flows‘)
- Derecognition at the date of initial recognition of any asset or liability recognised for insurance acquisition cash flows (see ‘Derecognition of insurance contracts’)
- Any cash flows arising from the contracts in the group at that date
Therefore, the CSM on initial recognition, assuming a contract is not onerous, is no more than the balancing number needed to avoid a day 1 profit. The CSM cannot depict unearned losses. Instead, IFRS 17 requires an entity to recognise a loss in profit or loss for onerous groups of contracts (see ‘Onerous insurance contracts’).
The approach above on initial recognition applies to contracts with and without participation features, including investment contracts with discretionary participation features.
For groups of reinsurance contracts held, the calculation of the CSM at initial recognition is modified to take into account the fact such groups are usually assets rather than liabilities and that a margin payable to the reinsurer, rather than making profits, is an implicit part of the premium (see ‘Initial measurement of reinsurance contracts’).
A CSM is not specifically identified for contracts subject to the premium allocation approach, although the same underlying principle of profit recognition (i.e., no day 1 profit) applies (see ‘Measurement of remaining coverage’).
For insurance contracts acquired in a business combination or transfer, the CSM at initial recognition is calculated as the difference between the consideration and the fulfilment cash flows (see ‘Business combinations’ in ‘Acquisition of insurance contracts’).
Contracts accounted for under IFRS 17 will be the only type of contracts under IFRS that will explicitly disclose the expected remaining profitability. The notion of the CSM is a unique feature of the standard. The way users will evaluate and appreciate the CSM may be a critical aspect of the decision-usefulness of the IFRS 17 accounting model.
The CSM at the end of the reporting period represents the profit in the group of insurance contracts that has not yet been recognised in profit or loss, because it relates to the future service to be provided under the contracts in the group.
For a group of insurance contracts without direct participation features, the carrying amount of the CSM of the group at the end of the reporting period equals the carrying amount at the beginning of the reporting period adjusted, as follows [IFRS 17 44]:
Example – movement in the carrying amount of the CSM in a period
A) CSM at the beginning of the period
B) Effect of new contracts added to the group
C) Interest accreted on the CSM in the period
D) Change in fulfilment cash flows relating to future service
X or (X)
E) Effect of currency exchange differences
X or (X)
F) Amount of CSM recognised in profit or loss as insurance revenue because of the transfer of services in the period
G) CSM at the end of the period
2.1 Interest accretion
For insurance contracts without direct participation features, interest is accreted on the carrying amount of the CSM at discount rates determined at the date of initial recognition (“locked-in discount rate”) of a group of contracts applicable to nominal cash flows that do not vary based on the returns on any underlying items.
The locked-in discount rate applicable to a group of contracts can be the weighted average of the rates applicable at the date of initial recognition of contracts that can join a group over a 12-month period (see ‘Discount rates‘).
The requirement to accrete interest on the CSM at historic rates for groups of contracts without direct participation features creates a data challenge for entities because they need to store and accurately apply a potentially large number of discount rates. Some would prefer to accrete interest on the CSM at current rates to avoid the need to track historic rates. Accreting the CSM at current rates, however, would create theoretical and practical issues and would not ease the data burden for entities that choose to disaggregate insurance finance expense between profit or loss and other comprehensive income.
As noted below, the number of historic discount rates that need to be tracked is greater for participating contracts without direct participation features. The reason is that the rate applied to adjust the CSM for changes in fulfilment cash flows is likely to differ from the rate to accrete interest on the CSM as the former should reflect the characteristics of the specific liabilities rather than a risk-free rate.
2.2. Adjust CSM for changes in fulfilment cash flows relating to future service
An entity adjusts the CSM for changes in fulfilment cash flows relating to future service, except to the extent that [IFRS 17 44]:
- Such increases in the fulfilment cash flows exceed the carrying amount of the CSM, giving rise to a loss
- Such decreases in the fulfilment cash flows are allocated to the loss component of the liability for remaining coverage (see ‘Onerous insurance contracts’).
For insurance contracts without direct participation features, changes in fulfilment cash flows relating to future service that adjust the CSM comprise [IFRS 17 B96]:
- Experience adjustments arising from premiums received in the period that relate to future service (and related cash flows, such as insurance acquisition cash flows and premium-based taxes).
- Changes in estimates of the present value of the future cash flows in the liability for remaining coverage, except those relating to the time value of money and changes in financial risk (recognised in the statement of profit or loss and other comprehensive income rather than adjusting the CSM).
- Differences between any investment component expected to become payable in the period and the actual investment component that becomes payable in the period.
- Changes in the risk adjustment for non-financial risk that relate to future service.
Except for changes in the risk adjustment, adjustments to the CSM noted above are measured at discount rates that reflect the characteristics of the cash flows of the group of insurance contracts at initial recognition (see ‘Discount rates‘).
For participating contracts without direct participation features this discount rate (i.e., the rate that reflects the characteristics of the cash-flows on initial recognition) will be made up of a mix of an asset-based discount rate (for asset-dependent cash flows) and a rate for cash flows that are not asset-dependant (calculated using either the “top down” or “bottom-up” approaches). This rate will therefore be different from the rate used to accrete interest on the carrying amount of the CSM. Interest is accreted in the CSM using either the top down or bottom-up approach locked in at inception.
An experience adjustment is a difference between:
- For premium receipts (and any related cash flows such as insurance acquisition cash flows and insurance premium taxes), the estimate at the beginning of the period of the amounts expected in the period and the actual cash flows in the period
- For insurance service expenses (excluding insurance acquisition expenses) — the estimate at the beginning of the period of the amounts expected to be incurred in the period and the actual amounts incurred in the period
Experience adjustments generally relate to current or past service and are recognised immediately in profit or loss. However, experience adjustments for premiums received (or due) for future coverage relate to future service and consequently adjust the CSM.
Deciding whether a premium experience adjustment relates to future service or is part of the coverage in current and past periods is not always clear and may require judgement. Premiums tend to be due in advance of the related service. However, this is clearly not the case, for example, with adjustment premiums in reinsurance contracts that are often determined after the end of a coverage period. Attributing expected premium receipts that are overdue to past or future coverage might not be obvious.
As noted in IFRS Jargon, investment components are amounts that an insurance contract requires the entity to repay to a policyholder even if an insured event does not occur. IFRS 17 requires any unexpected repayment of an investment component to adjust the CSM (see ‘Contractual service margin‘). The CSM also will be adjusted for changes in future estimates of cash flows which will include (but not separately identify) the reduction in future repayments of investment components.
Consequently, the net effect on the CSM of a delay or acceleration of repayment of an investment component is the effect of the change in timing of the repayment.
The terms of some insurance contracts without direct participation features give an entity discretion over the payments to policyholders. A change in the discretionary cash flows is regarded as relating to future service and, therefore, adjusts the CSM and will be reflected in profit or loss over time. Discretionary cash flows are discussed further in ‘Investment contracts with discretionary participation features’.
2.3. Currency exchange differences
The carrying amount of a group of insurance contracts that generate cash flows in a foreign currency, including the CSM, is treated as a monetary item when applying IAS 21 The Effects of Changes in Foreign Exchange Rates.93 Treating insurance contracts as monetary items means that groups of insurance contracts in a foreign currency are retranslated to the entity’s functional currency using the exchange rate applying at each reporting date. Exchange differences arising on retranslation are accounted for in profit or loss and are accounted for under IAS 21 The effects of Changes in Foreign Exchange Rates.
2.4. Release of the CSM in profit or loss
An amount of the CSM for a group of insurance contracts is recognised in profit or loss in each period to reflect the services provided under the group of insurance contracts in that period. The amount is determined by [IFRS 17 B119]:
- Identifying the coverage units in the group
- Allocating the CSM at the end of the period (before recognising any amounts in profit or loss to reflect the services provided in the period) equally to each coverage unit provided in the current period and expected to be provided in the future
- Recognising in profit or loss the amount allocated to coverage units provided in the period
The number of coverage units in a group is the quantity of coverage provided by the contracts in the group, determined by considering for each contract the quantity of the benefits provided under a contract and its expected coverage duration.
The CSM is recognised over the expected period of coverage for a group of contracts. The CSM remaining at the end of the reporting period is allocated to the services provided in the current period and the services expected to be provided in future periods based on coverage units. IFRS 17 does not specify whether an entity should consider the time value of money in determining the allocation and, consequently, does not specify whether the allocation should reflect the timing of the expected provision of the coverage units. For example, an entity could place more weight on the current period of coverage compared with expected coverage in the future, by reflecting the time value. The Board concluded it should be a matter of judgement [IFRS 17 BC282}.
The movements in the CSM for subsequent measurement are summarised below1:
(Amounts in CU’000)
Contractual service margin (CSM)
|Changes that relate to future services:|
Contracts initially recognised in the period
Changes in estimates reflected in the CSM Contractual service margin
Changes that relate to current services:
CSM recognised in profit or loss Contractual service margin
Changes that relate to past services
Insurance service result
Insurance finance expenses
Total changes in the statement of comprehensive income
Cash flows Contractual service margin
Currency exchange differences Contractual service margin
Closing balance Contractual service margin
The wording in IFRS 17 suggests that the allocation of the CSM to profit or loss for groups of insurance contracts should be based solely on insurance coverage. The allocation disregards other services provided to policyholders. This approach can lead to surprising patterns of profit recognition in contracts that provide insurance coverage for only part of a contract’s term. Some also question whether this approach faithfully represents profit for contracts with direct participation features that the standard describes as substantially investment-related service contracts. It also creates a difference with the approach that will be followed for investment contracts with discretionary participation contracts that are also in the scope of the standard. For these groups of contracts, the CSM will be spread on the basis of investment services.
Whether an entity allocates the CSM to profit or loss to reflect the time value of money is a matter of judgement. In our view, both methods (i.e., considering time value of money and not considering it) are acceptable, but an entity must apply the method consistently.
We expect practitioners will ask for more guidance on how to determine coverage units and the meaning of the quantity of benefits. For example, does a contract that would pay a large amount in relation to a very unlikely insured event provide a greater quantity of benefit than a similar contract that pays a smaller amount for a more likely event?
2.5. Subsequent measurement of the CSM and interim reporting Contractual service margin
The CSM is adjusted for changes in estimates of future fulfilment cash flows, whereas experience adjustments relating to current or past service are recognised in profit or loss instead of the CSM. One of the consequences is that the total liability and profit reported will be influenced by the frequency of reporting and the reporting date. An entity that publishes interim financial statements (see Example – CSM and Interim reporting below) would therefore ordinarily need to maintain separate carrying amounts for CSMs for purposes of interim and annual financial statements to meet the requirement in IAS 34 Interim Financial Reporting that the frequency of an entity’s reporting should not affect the measurement of its annual results [IAS 34.28 and IFRIC 10.9]. IFRS 17 avoids a requirement to maintain separate CSMs for annual and interim reporting, by making an exception to the requirement of IAS 34. It prohibits entities from changing the treatment of accounting estimates made in previous interim financial statements when applying IFRS 17 in subsequent interim financial statements or in the annual reporting period [IFRS 17 B136 BC236].
Example – CSM and Interim reporting
An entity with an annual reporting period ending on 31 December publishes half-yearly interim financial statements. Contractual service margin
- At 31 December 20X0, the entity has issued a group of insurance contracts with a CSM of CU1,200 and an expected remaining coverage period of two years. The entity expects to provide coverage evenly over the remaining coverage period, and expects to incur claims in H2 20X1 of CU300. Contractual service margin
- At the end of H1 20X1, the entity increases its estimate of claims to be incurred in H2 of 20X1 by CU200 to CU500. The entity adjusts (reduces) the related CSM by CU200 and releases CSM of CU250 for services provided in H1 (CU1,200 – CU200)/4. At the end of H1 20X1, the entity carries forward a CSM of CU750.
- The entity incurs claims in H2 20X1 of CU300 (as originally expected) and, consequently, recognises a favourable experience adjustment in profit or loss of CU200 in its H2 interim financial statements. Contractual service margin
- The entity releases CU250 from the CSM to profit or loss in H2 and carries forward a CSM of CU500 (CU750 – CU250) at 31 December 20X1 in the interim financial statements.
In summary, in 20X1 the entity recognises revenue of CU500, a positive experience adjustment in profit or loss of CU200 and carries forward a carrying amount for CSM of CU500 in both its interim financial statements for H2 20X1, as well as its annual financial statements for that year. Contractual service margin
If the entity maintained a CSM for annual reporting purposes independent of the CSM for interim reporting: Contractual service margin
- There is no experience adjustment in the year — claims in 20X1 are as expected at 31 December 20X0. Contractual service margin
- The entity would release CSM to profit or loss in the calendar year 20X1 of CU600 and would carry forward a CSM of CU600 (CU1,200 brought forward — CU600 release to P&L = CU600 ).
In summary, the entity would recognise revenue of CU600 in 20X1 and carry forward a CSM of CU600 at 31 December 20X1. Contractual service margin
IFRS 17 requires the entity in this example to include the change in estimate made in H1 for the purposes of its annual financial statements. The entity would have the same result and amount of CSM at 31 December 20X1 in its interim and annual financial statements. Contractual service margin
[The example assumes there are no other changes in expectations and ignores accretion of interest for simplicity] Contractual service margin
The requirement not to change the treatment of accounting estimates made in previous interim financial statements is a significant exception from the requirements in IAS 34 Interim Financial Reporting. Entities may welcome this exception as a simplification that allows them to maintain a single CSM for interim and annual reporting. However, the consequence is that entities with different interim reporting periods, but are equal in all other aspects, are likely to report different results. Furthermore, for subsidiaries issuing their own IFRS financial statements, differences with the numbers reported for consolidation purposes are likely to emerge if the frequency of the reporting of a subsidiary’s own financial statements differs from the reporting frequency of the consolidated accounts of the group.