IFRS 4 is an accounting standard issued by the International Accounting Standards Board (IASB) that provides guidance on the accounting treatment for insurance contracts. It sets out the rules and requirements for measuring and recognizing insurance contracts, and aims to improve the transparency and comparability of financial statements for insurance companies.
Rules and Descriptions:
IFRS 4 allows insurance companies to use either the ‘incurred claims’ or ‘paid claims’ methods to calculate the liability for outstanding claims. The incurred claims method estimates the total cost of claims based on the current status of claims, while the paid claims method is based on the actual payments made to settle claims. Insurance companies must choose the method that best reflects the nature of their business and the information available to them.
IFRS 4 also requires insurance companies to assess the likelihood of claims being made and the timing and amount of future claim payments. This assessment is based on actuarial techniques and statistical data. Insurance companies must regularly review and update their assumptions, taking into account changes in the economic environment and any other relevant factors.
Under IFRS 4, insurance companies must classify their insurance contracts into two categories:
Insurance contracts with significant insurance risk
Insurance contracts with no significant insurance risk
Contracts with significant insurance risk are those that transfer significant insurance risk from the policyholder to the insurer, and may include life insurance, health insurance, and property and casualty insurance. Contracts with no significant insurance risk include warranties, service contracts, and investment contracts.
For contracts with significant insurance risk, insurance companies must calculate the liability for future claims and expenses, and recognize this liability on their balance sheet. The liability is calculated by estimating the present value of expected future cash flows, using appropriate discount rates and assumptions about the expected timing and amounts of claims. Any changes in the liability must be reflected in the income statement.
For contracts with no significant insurance risk, insurance companies must recognize revenue over the period of the contract, based on the progress of the service being provided.
An insurance company issues a life insurance policy with a death benefit of $1 million. The policyholder pays an annual premium of $10,000, and the policy is in force for 20 years. The insurance company estimates that the probability of the policyholder dying within the next year is 1%, and that the discount rate is 5%.
Under IFRS 4, the insurance company would calculate the liability for the policy as follows:
Present value of expected future claims = ($1 million x 1% x 20) / (1 + 5%)^1 + ($1 million x 1% x 19) / (1 + 5%)^2 + … + ($1 million x 1% x 1) / (1 + 5%)^20 = $158,305
The insurance company would recognize this liability on its balance sheet and adjust it as necessary for any changes in the expected future claims.
IFRS 4 has been implemented by many insurance companies around the world. One example is the American insurance company, MetLife, which reported its financial results for the first quarter of 2021 using IFRS 4. MetLife reported a net loss of $397 million for the quarter, which included a charge of $699 million related to changes in assumptions for its retirement and group benefits business.
The IASB is currently working on a new accounting standard for insurance contracts, known as IFRS 17. This standard aims to address some of the limitations of IFRS 4 and provide more consistent and transparent accounting for insurance contracts. IFRS 17 is expected to be effective from January 1, 2023, and will replace IFRS 4