Captives will need to prepare for “drastic changes” in their reporting to ensure compliance with the upcoming requirements of International Financial Reporting Standard (IFRS) 17, according to Marsh.
From 1 January 2023, IFRS 17 will enforce material changes to the way in which insurance companies, including captives, value and report on insurance contracts.
Issued by the International Accounting Standards Board, the new standard is designed to harmonise the reporting approach of insurers to promote greater transparency.
Marsh notes that a captive may still be impacted by the requirements if the parent company reports under IFRS, which may require the captive to perform IFRS 17 valuations for consolidation purposes.
IFRS 17 establishes three measurement models to value insurance contracts, two of which will apply to captives.
The general measurement model (GMM), which acts as the default measurement model to define how insurance contract assets and liabilities are recognised and subsequently measured at reporting periods, while the premium allocation approach (PAA), which is a simplified approach to measure a group of insurance contracts that meet IFRS 17’s qualifying criteria.
With the PAA as the preferable model owing to its simplified calculations and reporting requirements, Marsh notes: “The clock is now ticking for insurers to prepare for implementation.”
A captive can qualify for the PAA if the insurance contract has a coverage period of one year or less (this is likely to be the case for most captives that issue annual policies with a 12-month boundary) and if it satisfies quantification analysis that the PAA output will not materially differ from that of GMM.
Marsh warns that captives should be aware of four distinct areas that will be affected by the implementation of IFRS 17, beginning with contract boundaries, which will impact the cash flows that are considered in the valuation and the PAA qualification.
Marsh advises captive managers to be mindful of underlying clauses within policy terms and conditions, such as a termination clause or re-underwriting clause which could potentially establish a boundary in the contract that is different to the policy expiration date.
Secondly, IFRS 17 requires insurance entities to estimate the probability-weighted future cash flows of an insurance contract and introduces the concept of discounting for cash flows that are settled more than 12 months after coverage is provided or claims and expenses are incurred.
Therefore, Marsh warns that captives should measure all cash flows that are attributable to insurance contracts, including claims, premiums, expenses, profit commissions and no claims discounts.
In addition, the new standard requires an entity-specific calculation to allow for the compensation required for bearing the uncertainty around the amount and timing of cash flows arising from non-financial risk.
In this instance, Marsh says that captive managers must ensure they align the risk appetite of the captive with the appropriate risk adjustment confidence level.
Finally, Marsh advises that captives be aware of the contractual service margin (CSM). Although only applicable to captives that are valuing under the GMM, CSM represents the expected profit of a contract at the date of inception that is recognised as the insurer provides services under the contract.
Marsh notes that captives should take into account the sensitivity of the modelling of the pattern of service to the underlying terms and conditions of the contract, describing this as “one of the most judgmental areas of IFRS 17”.
