ACT-UNITY : Should we apply IFRS 17 to unit-linked products?

Article written by Act-Unity as part of the sponsorship of ACA Insurance Days 2023, whose content is the sole responsibility of its author.

Introduction and context

IFRS and IAS are accounting standards issued by the IFRS Foundation and the International Accounting Standards Board (IASB).

The purpose of this paper is to analyse the interactions between IFRS 17 and unit-linked products. Although unit-linked products are directly affected by IFRS 9, they must nevertheless be measured under IFRS 17 in certain specific cases. The specific case of a unit-linked product with additional death cover is considered for illustrative purposes in this paper.

Analysis of a specific case

Description of the product

Consider a unit-linked insurance contract (UL) with the following additional death benefit (DB) : if the policyholder dies before the contract matures or lapses, the beneficiaries will receive :

• The contractual death benefit, if this amount is higher than the market value of the unit-linked part (net asset value);
• The market value of the unit-linked part otherwise (also in the event of lapse or maturity).

The contract terminates at the earliest on the death or lapse of the policyholder, or on the contractual maturity date.

We assume that the insurer charges a fee each year on the market value of the unit-linked product and that the contract maturity date is several years away. We also assume that the UL product meets the definition of an investment contract with direct participation features (as it is often the case), i.e. :

1. The contractual terms specify that the policyholder participates in a share of a clearly identified pool of underlying items;
2. The entity expects to pay to the policyholder an amount equal to a substantial share of the fair value returns on the underlying items; and
3. The entity expects a substantial proportion of any change in the amounts to be paid to the policyholder to vary with the change in fair value of the underlying items.

Application of the Standard

Most of UL products should be measured by default under IFRS 9 as these contracts are (pure) investment contracts: they do not comply with IFRS17.3. However, when a UL contract also provides death cover (DB) and using the terminology used in IFRS 17, we conclude that UL and DB are two non-distinct components of an insurance contract (IFRS17.10). Indeed:

• The DB component must be measured under IFRS 17: by the nature of such death cover, it is an insurance component (there is at least a scenario in which the insurer suffers a loss; see e.g. IFRS17.3, B2-B30);
• The UL component must also be measured under IFRS17 because the DB part and the UL part are not distinct (IFRS17.13): if one component lapses, so does the other. In addition, if the policyholder dies, both components are terminated.

As a consequence, both UL and DB components must be measured under IFRS 17. Nevertheless, in case of low materiality, one could also discuss the application of IFRS9 e.g., if the profitability of the additional death benefit is negligible compared to the profitability of the UL part.

Measurement approach and specificities

Under IFRS 17, as the UL product meets the definition of an investment contract with direct participation features (see the section 2.1), the VFA (Variable Fee Approach) must be applied to measure those contracts (IFRS17.45).

The question arises as to how to project the UL and the associated DB guarantee. One way of modelling the Best Estimate is to use the classic tools of modern financial theory. Indeed, the complementary guarantee DB can be reproduced through call options flows. This methodology can be easily applied and has the advantage of not relying on (heavy) stochastic simulations (the projection can be carried out in a deterministic world). However, as death and lapse probabilities and market prices are mixed, risk-neutral framework should be applied with caution, as both the real world and the risk-neutral world need to be applied in this setting. We also note that this methodology allows the financial impact on future cash flows to be separated from other (non-financial) assumptions. This feature is important in the context of IFRS 17 (e.g. OCI, insurance finance income or expenses…).

Conclusions

The example given in this analysis shows that:

• Unit-linked products are not necessarily modelled under IFRS 9, they must be modelled under IFRS 17 in some cases. Materiality considerations could be taken into account when assessing this point.
• In such cases, a simple deterministic model could be used to meet the requirements of IFRS 17.

The Act-unity team remain at your disposal for any questions or requests on the subject.