1. Contractual Service Margins
Simon Walpole
Insurance IFRS Seminar
December 1, 2016
Darryl Wagner
Session 20

2. Topics Contractual service margin concept Acquisition expenses
Contractual service margin amortization
Areas open for interpretation

3. Contractual Service Margin Concept
The purpose of the contractual service margin is to prevent a gain at issue.
CSM0 = - (Best estimate liability + Risk Adjustment)
Note : For profitable contracts, (BEL+RA) < 0 at inception, meaning that CSM0 > 0
The contractual service margin at issue is the amount available to provide for overhead expenses and profit.
The contractual service margin may not be negative, either at issue or subsequently.

4. Contractual Service Margin Concept
What does the contractual service margin represent?
A current estimate of the profitability that the entity expects the contract to generate over the coverage period
Coverage for overhead and other unallocated expenses
Compensation for originating contracts
Compensation for providing ancillary services
Compensation for product development
Additional returns if the insurer has significant pricing power, or discounts building market power

5. Building Block Approach: Day One Liability
Acquisition Costs
CSM RA RA
Balance Sheet Liability +
Premiums
Undiscounted Cash Flows +
CSM
Discounted Cash Flows RA
Nets to Zero
Cash Inflows
Cash Outflows
NET
Building Blocks 1 & 2 - -

6. Contractual Service Margin Amortization
The key questions the 2013 ED intends to address are:
Over what period should the CSM be amortized?
What is reasonable amortization basis?
Should interest be accreted?
Should the amortization be unlocked?
At what level should the amortization take place?

7. Contractual Service Margin Amortization (cont’d)
The CSM should be amortized over the coverage period.
The pattern for recognizing the contractual service margin over the coverage period shall be on a systematic basis that reflects the remaining transfer of services that are provided under the contract.
Interest should be accreted to reflect the time value of money using the discount rate specified when the contract was initially recognized.
The entity shall adjust the CSM to reflect favorable and unfavorable change in the future cash flows (i.e., unlocking).
The entity should aggregate insurance contracts into a portfolio of insurance contracts when determining the CSM.

8. Updates since the ED – March 18, 2014
Confirmation of ED proposals
Previously recognized losses can be reversed
Changes to risk adjustment affect the contractual service margin

9. Updates since the ED – March 18, 2014
At its meeting on 18 March 2014 the IASB tentatively decided: a. to confirm the proposals in the 2013 ED that after inception: i. differences between the current and previous estimates of the present value of cash flows related to future coverage and other future services should be added to, or deducted from, the contractual service margin, subject to the condition that the contractual service margin should not be negative; and ii. differences between the current and previous estimates of the present value of cash flows that do not relate to future coverage and other future services should be recognised immediately in profit or loss. b. that favourable changes in estimates that arise after losses were previously recognised in profit or loss should be recognised in profit or loss to the extent that they reverse losses that relate to coverage and other services in the future. Ie, previously recognised losses can be reversed. c. that differences between the current and previous estimates of the risk adjustment that relate to future coverage and other services should be added to, or deducted from, the contractual service margin, subject to the condition that the contractual service margin should not be negative. Consequently, changes in the risk adjustment that relate to the coverage and other services provided in the current and past periods should be recognised immediately in profit or loss. i.e., changes to the risk adjustment affect the CSM.

10. Updates since the ED – April 25, 2014
Further considerations is required around “unit of account” and “portfolio” definition, allocation pattern, and symmetric reinsurance
At its meeting on 25 April 2014 the IASB tentatively decided to consider in future meetings the non-targeted issues in that the staff identified as requiring further analysis and that may possibly need addressing.
One of these issues is references to “unit of account” and “portfolio” and whether it will be possible to clarify the IASB’s intentions to provide more consistency.
Another issue is whether to provide more guidance on an appropriate allocation pattern for the contractual service margin.
One of these issues is whether in some circumstances of asymmetrical treatment of reinsurance contracts there is an accounting, rather than an economic mismatch, and if so, whether such a mismatch could be mitigated.

11. Updates since the ED – May 21, 2014
Confirmation of service margin principle and suggestion to use policy count where appropriate
At its meeting on 21 May 2014 the IASB tentatively decided:
a. to confirm the principle in the 2013 ED that an entity should recognise the remaining contractual service margin in profit or loss over the coverage period in the systematic way that best reflects the remaining transfer of the services that are provided under an insurance contract; and
b. clarify that, for contracts with no participating features, the service represented by the contractual service margin is insurance coverage that:
i. is provided on the basis of the passage of time; and
ii. reflects the expected number of contracts in force.

12. Updates since the ED – June 17, 2014
Clarification of the standard’s purpose
Amendment to portfolio definition
Disaggregation of onerous contracts at initial recognition
At its meeting on 17 June 2014 the IASB tentatively decided to:
(a) clarify that the objective of the proposed insurance contracts standard is to provide principles for the measurement of an individual insurance contract, but that in applying the standard an entity could aggregate insurance contracts provided that it meets that objective.
(b) amend the definition of a portfolio of insurance contracts to be: “insurance contracts that provide coverage for similar risks and are managed together as a single pool”; and
(c) add guidance to explain that in determining the contractual service margin or loss at initial recognition, an entity should not aggregate onerous contracts with profit-making contracts. An entity should consider the facts and circumstances to determine whether a contract is onerous at initial recognition.
The IASB also tentatively decided to provide examples on how an entity could aggregate contracts but nonetheless satisfy the objective in (a) above when determining the contractual service margin at subsequent measurement.

13. Updates since the ED – November 2015; January/June 2016
Discount Rates
Level of measurement
At its meeting on 18 November, 2015, IASB tentatively decided not to require or permit in the general model the re-measurement of the CSM using current discount rates.
At its meetings in January 2016,as well as in June 2016, the IASB tentatively decided to:
(a) The objective for the adjustment and allocation of the CSM should be that the CSM at the end of a reporting period represents the profit for the future services to be provided for a group of contracts.
(b) An entity can group contracts for measuring and allocating the CSM provided that the grouping of insurance contracts meets the objective in (a). An entity that groups contracts is deemed to meet the objective in (a) provided that the contracts in the group:
have cash flows that the entity expects will respond in similar ways to key drivers of risk in terms of amount and timing; and
on inception had similar expected profitability; and
the entity adjusts the allocation of the CSM for the group in the period to reflect the expected duration and size of the contracts remaining after the end of the period
(c) There should be no exception to the level of aggregation for determining onerous contracts or the allocation of the CSM when regulation affects the pricing of contracts.

14. Updates since the ED – November 2016
The definition of portfolio should be retained, with further guidance that contracts within each product line would be expected to have similar risks, and hence contracts from different product lines would not be expected in the same portfolio
Onerous contracts should be identified based on available information at inception and grouped separately from contracts that are not onerous at inception
Insurance contracts that are not onerous at inception should be measured by dividing portfolios, at a minimum, into a group of contracts that have no significant risk of becoming onerous and a group of other profitable contracts. Further guidance to be provided on how to assess the risk of contracts becoming onerous
Only contracts issued within the same year should be included within the same group
The CSM for a group of contracts would be allocated over the current period and expected remaining coverage on the basis of coverage units, reflecting the expected duration and size of the contracts in the group
A weighted-average discount rate permitted for the accretion of interest on the CSM, with an averaging period of up to one year.

15. What this means (1) At issue: Choose portfolios of similar contracts
For each contract in each portfolio, calculate:
CSM0 = - (BEL0 + RA0); if < 0 then set to 0
k0 = ∑ CSM0 / ∑ PV0(carrier)
Carrier is the passage of time over the coverage period by contract i.e. claims/lapse adjusted expected coverage. CSM $ size matters (coverage unit = k-factor)
Divide the contracts sold for that portfolio and for that year in two groups, as a minimum: one with high CSM over expected revenue and another with the other profitable contracts
If there are loss making contracts (CSM0 < 0) they must be grouped on their own (third group)
In future periods, if all assumptions remain unchanged:
CSMt = k0 * ∑ PVt(carrier); if < 0 then set to 0

16. What this means (2) In future periods, if assumptions change:
First calculate the BEL+RA+CSM using the old assumptions, ie:
BBMoldt = BELoldt + RAoldt + CSMoldt
Then update the BEL, RA and PV(carrier) to the new assumptions and calculate a new “k factor” such that BBM is unchanged, ie:
BBMoldt = BBMnewt
= BELnewt + RAnewt + CSMnewt
= BELnewt + RAnewt + knew0 * ∑ PVnewt(carrier)
If in any future periods CSM <0, then:
Zeroise the CSM for balance sheet reporting
But, keep track of the negative CSM and carry out the above unlocking of the CSM using the negative CSM; when the unlocked CSM turns positive, hold the positive CSM in the balance sheet

17. What this means (3)
General calculation approach is similar to Australian MoS
At the transition date, historical CSM’s need to be calculated
However, after that all calculations are prospective only (unlike US GAAP FAS97 UL)
Main challenges:
Definition and tracking of portfolios and groups
Definition of onerous contracts
Tracking of negative CSMs (if any?!?)
Transition

18. Thank You