IFRS 17 transition approach and grouping
A life insurer is adopting IFRS 17 for a closed portfolio of 100,000 25-year level term assurance policies. At the transition date, the portfolio has 18 years remaining. Historical data before the current administration system is incomplete, and the firm cannot reliably reconstruct the assumptions used at inception for the earliest cohorts. The portfolio currently produces a small profit on a Solvency II basis. Expected annual premium is £600 per policy; expected claims are 45% of premium, maintenance expenses 20%, lapses 6% a year and the risk-adjusted discount rate is 4%. Some cohorts are expected to be onerous because of high initial expenses; others are profitable. The finance team proposes using the fair value approach for all cohorts because it is simpler. The auditor has asked for the grouping rationale and the risk adjustment methodology.
1. Advise whether the fair value approach is appropriate for all cohorts, and explain how the firm should determine the transition approach and level of aggregation.
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The fair value approach is not a free choice. IFRS 17 requires full retrospective application unless it is impracticable. If full retrospective is impracticable, the firm must use the modified retrospective approach; fair value is permitted only if both are impracticable. The data gap may support impracticability for the earliest cohorts, but the firm must test each cohort and document why. Using fair value for all cohorts because it is simpler would not satisfy the standard.
Grouping should be by annual cohort, by portfolio of contracts with similar risks, and into at least three profitability groups: onerous at initial recognition, no significant possibility of becoming onerous, and other. Onerous groups cannot be offset against profitable groups. The firm should use the evidence available, such as current premium, claims, lapse and expense data, to allocate contracts. If the earliest cohorts cannot be reconstructed, a modified retrospective approach using reasonable and supportable information available at transition, without hindsight, is likely to be more defensible than fair value.
2. Explain how the CSM and risk adjustment should be determined at transition, and how the firm should avoid recognising a large one-off loss if some cohorts are onerous.
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For non-onerous groups, the CSM at transition is the present value of expected future cash flows plus the risk adjustment, measured at the transition date. Future cash flows include premiums, claims, expenses and lapses over the remaining 18 years. A simple check: annual margin before risk adjustment is £600 x (1 - 45% - 20%) = £210 per policy; discounted at 4% over 18 years, allowing for lapses, this is a positive amount before the risk adjustment. The risk adjustment should reflect the compensation required for non-financial risk, with a disclosed methodology and confidence level.
For onerous groups, the fulfilment cash flows are negative and the loss is recognised in equity at transition; a CSM cannot be created to hide it. The firm should not try to avoid a loss by manipulating grouping. It can ensure the grouping reflects the economics, use the modified retrospective approach where it better reflects historical margins, and document the judgements. The auditor will challenge any approach that appears chosen to avoid recognising onerous contracts.