IFRS 17 treatment of an onerous construction contract
A specialist engineering insurer writes a five-year construction all-risks policy with a single premium of £120m, paid upfront. At inception, expected claims are £70m, acquisition costs are £12m, and the risk adjustment for non-financial risk is £9m. The discount rate is 3%. The contract is expected to be profitable. At the end of year two, after two years of poor experience, the insurer revises expected ultimate claims to £95m because of defective workmanship and higher repair costs. Remaining coverage is 60% of the original. There is no reinsurance. The CFO asks how the change should be reflected under IFRS 17, including the contractual service margin (CSM), the loss component, and the impact on profit or loss. The auditor has queried whether the contract is onerous and how the CSM should be unlocked.
1. Calculate the CSM at inception and explain how it would be released over the coverage period.
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At inception, the expected profit is premium minus expected claims, acquisition costs and risk adjustment: £120m - £70m - £12m - £9m = £29m before discounting. Because the premium is received upfront and costs are incurred over time, discounting at 3% would slightly increase the CSM, but £29m is a reasonable approximation for the purpose of the board discussion. The contract is not onerous at inception, so the CSM is recognised as a liability and is not taken to profit or loss immediately. It is released over the coverage period as services are provided. A simple approach is to release the CSM in proportion to coverage units, which in this case could be the remaining construction period. At the end of year two, 40% of the coverage has expired, so around 40% of the CSM, or £11.6m, would have been released to profit or loss, leaving about £17.4m of CSM before any reassessment. The exact release depends on the coverage units chosen and on whether the insurer uses a straight-line or activity-based pattern. The key point is that the CSM is a deferral of profit, not a reserve for future claims.
2. Explain how the revised claims estimate at the end of year two should affect the CSM, the loss component and profit or loss.
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The revised ultimate claims estimate is £95m, an increase of £25m over the original £70m. Under IFRS 17, changes in estimates of future cash flows adjust the CSM, but only to the extent that the CSM is available. Before the revision, the remaining CSM is about £17.4m. The increase of £25m is larger than the remaining CSM, so the CSM is reduced to zero and the excess of £7.6m is recognised immediately in profit or loss as a loss component. The contract becomes onerous. The loss component is not a separate cash reserve; it is a component of the liability that will be reversed as the remaining coverage is provided. In later periods, the insurer will recognise the loss component in profit or loss in a way that reflects the pattern of coverage, and it will need to distinguish insurance service expense from insurance finance expense. If part of the £25m increase relates to past service rather than future service, that part should be recognised immediately in profit or loss rather than adjusted against the CSM. The split between past and future service is a key judgement and should be documented.
3. What should the CFO tell the auditor about the onerous contract and the CSM roll-forward?
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The CFO should explain that the contract was profitable at inception, with a CSM of approximately £29m, and that the CSM was released over coverage. At the end of year two, the remaining CSM was about £17.4m. The revision to expected claims increased future cash flows by £25m, which exceeded the remaining CSM. The CSM was therefore reduced to zero and a loss component of £7.6m was recognised. The auditor will want to see the split between past and future service, the coverage units used, the discount rate and risk adjustment assumptions, and the calculation of the loss component. The insurer should provide a roll-forward showing the opening CSM, the release to profit or loss, the adjustment for the change in estimates, the closing CSM and the loss component. It should also explain why the change was treated as a future-service adjustment rather than an immediate past-service loss. If the auditor challenges the £7.6m figure, the insurer should show sensitivity to the coverage pattern and to the split of the claims increase between years two and three to five.