IFRS 17 for Mutual Entities

If you are trying to understand IFRS 17 for Takaful (Islamic Insurance) without understanding mutual entities, you are committing a major sin.

Let's sincerely repent and pray for the right accounting guidance.

Some accountants believe prayers can also be accepted retrospectively, and thus, as an answer to your prayers, in July 2018 IFRS Foundation published guidance on the application of IFRS 17 to Insurance contracts issued by mutual entities.

What Are Mutual Entities

Mutual entities are a type of insurance company that is owned by its policyholders rather than shareholders.

In a mutual entity, the policyholders are also the owners, and they have a direct say in the management and governance of the company.

It's all about residual interest...

Mutual entities issue insurance contracts that provide policyholders with a residual interest in the mutual entity. Residual interest refers to the policyholder's share of the company's surplus, which is the amount by which the company's assets exceed its liabilities.

Mutual entities may also issue conventional insurance contracts (contracts that do not provide the policyholder with a residual interest in the mutual entity)"

How do policyholders benefit from a surplus?

Policyholders in a mutual entity typically receive a portion of the surplus in the form of:

• dividends or surplus which may be distributed to the policyholders, rather than to shareholders or
• policy credits, which can be used to reduce future premiums or to purchase additional insurance coverage.

How IFRS 17 applies to mutual entities?

Let's talk about scope first...

IFRS 17 applies to all insurance contracts within its scope, regardless of the legal form of the issuing entity. Consequently, in a mutual entity, IFRS 17 applies to both:

• Conventional insurance contracts issued by a mutual entity
• Insurance contracts that provide the policyholder with a residual interest in the mutual ?

Mutual... So what?

Here's the thing. In mutual entities, the cash flows of one group of contracts may be affected by the cash flows of another group of contracts. The other group may be within the same portfolio or even outside.

This should be taken into account when estimating fulfillment cash flows.

How exactly do these cash flows affect each other?

The returns on the underlying pool of assets are shared with policyholders of another group. As a result,

• the policyholder of one group may be required to bear a reduction in their share of the returns on the underlying items because of payments made to policyholders of other contracts that share in that pool. (This reduction may occur due to payments arising under guarantees made to policyholders of those other groups. This means that if other policyholders experience losses, the policyholder may receive a smaller return than they would have otherwise received.) or
• policyholders of other contracts may be required to bear a reduction in their share of returns on the underlying items because of payments made to the policyholder of a given group.

How to estimate FCFs for a particular contract in this scenario?

The?fulfillment cash flows?of each group reflect the extent to which the contracts in the group cause the entity to be affected by expected cash flows, whether to policyholders in that group or to policyholders in another group.

What does that even mean?

Let's understand with the help of an example.

Let's say that there are 2 groups A and B. Total underlying items are expected to have a value of $500 in 1 year's time. The total share of group A in underlying is estimated to be $350. The total share of group B is expected to be $150.

However, both groups have a minimum value guarantee of receiving $250 at maturity which is in 1 year's time.

To honor the guarantee, group A will have to pay $100 to the participants of group B. Consequently:

• The expected cash flow of Group A in 1 year would be 350 (although only $250 is being paid to the policyholders of group A.)
• The expected cash flow of Group B in 1 year would be 150 (although in reality $250 is being paid to the policyholders of group B as well.)

To sum up, the fulfillment cash flows for a group:

(a) include payments arising from the terms of existing contracts to policyholders of contracts in other groups, regardless of whether those payments are expected to be made to current or future policyholders; and

(b) exclude payments to policyholders in the group that, applying (a), have been included in the fulfillment cash flows of another group.

In some cases, an entity might be able to identify the change in the?underlying items?and the resulting change in the cash flows only at a higher level of aggregation than the groups. In such cases, the entity shall allocate the effect of the change in the underlying items to each group on a systematic and rational basis.

Love never dies...

Even after complete coverage has been provided to all the contracts in a group, the group may still have expected cash outflows to the policyholders of other groups.

At this point is it even useful to recognize and trace that group separately?

Great question.

The fact of the matter is, love never dies. It transforms into something more beautiful. More universal.

Considering this fact, IASB said that an entity is not required to continue to allocate such fulfillment cash flows to specific groups but can instead recognize and measure a liability for such fulfillment cash flows arising from all groups.

One combined liability for all the groups whose coverage has ended. Like a realm beyond space and time where the unfulfilled love finds its purpose.

The net cash flows of the mutual entity are eventually returned to policyholders with a residual interest (either current or future policyholders).

And therefore the CSM should be zero.

This is because the contract is already sharing in the profits of the pool, and there is no additional unearned profit for the insurer to recognize.

However note that in mutual entities, some of the return contractually passes from one group of policyholders to another.?

And because the CSM would be NIL for all groups, the accounting would not differ whether FCFs are computed at a group level or portfolio level.

According to the TRG for IC meeting summary September 2018, if a contract shares in 100% of the return on a pool of underlying items consisting of insurance contracts, then the CSM will be nil.

In this case, measuring the CSM at a higher level than the annual cohort level, such as a portfolio level, would achieve the same accounting outcome as measuring the CSM at an annual cohort level by applying IFRS 17.

In other words, for contracts that share in 100% of the return on a pool of underlying items consisting of insurance contracts, there is no need to measure the CSM at the annual cohort level. Measuring the CSM at a higher level would achieve the same accounting outcome, and this would simplify the accounting process for insurers.

The paper also suggested that in some cases measuring CSM at a higher level may produce the same results even if the contracts only share 90% in the pool of underlying items.

Risk Adjustment

Yes, in a mutual insurance entity, policyholders have a residual interest in the entity as a whole, which means they collectively bear the pooled risk. However, the mutual insurance entity is a "separate legal entity" that has accepted risk from each individual policyholder.

Therefore the risk adjustment for contracts with policyholders that have a residual interest in the mutual entity reflects the compensation that the mutual entity requires for bearing the uncertainty from the non-financial risk in those contracts.

In other words, policyholders with a residual interest in a mutual entity are exposed to non-financial risks, such as natural disasters or accidents, which can create uncertainty and increase the cost of providing insurance coverage.

The mutual entity needs to account for this risk and charge a risk adjustment to compensate for the uncertainty. This adjustment reflects the additional cost that the mutual entity requires to bear the risk associated with these types of contracts. The risk adjustment is calculated on an individual contract basis and is typically reflected in the premiums charged to the policyholders.

Equity

You might ask, "Can mutual entities have equity when there is no surplus that is not attributable to policyholders?"

The fulfillment cash flows are measured at current value whereas some other assets and liabilities are not required or permitted to be measured at fair value in accordance with IFRS Standards.

This accounting mismatch can result in a situation where a company's reported equity (which is the amount of money it has left over after paying all its liabilities) might be negative, even if it has no debts when it comes to regulatory purposes. This negative equity means that the company owes more than it owns.

Really! which items can create this accounting mismatch?

Here are some examples of items in which fair value is not required and/or permitted by IFRS Standards:

• Financial assets that are held to collect and meet the SPPI criteria are held at amortized cost
• Deferred tax balances
• Goodwill in subsidiaries in subsidiaries is not revalued but tested for impairment.

Presentation of Financial Statements

Because the policyholders are also owners, a mutual entity can present separate amounts due to policyholders on their balance sheet as follows:

• as liability arising from expected claims
• as surplus in their capacity as owners

Similarly, Income or expenses attributable to policyholders in their capacity as policyholders may be distinguished from the amounts attributable to policyholders with the most residual interest in the entity

The above approach may be adopted if it provides more useful information about its financial position and financial performance.