Cell Captives: IFRS 17

Transcript

Shreeya

Hello, and welcome back to our podcast series “On the top shelf”, which deals with topical issues in IFRS that impact clients operating in the retail and consumer industry. 

My name is Shreeya and I am a Senior Manager in PwC’s Accounting Consulting Services.

Today we’re going to be focusing on the hot new standard that is soon coming our way… IFRS 17, Insurance Contracts. With IFRS 17’s implementation date fast approaching, it is important for corporates to understand that IFRS 17 will not only impact insurers but may impact other entities as well. Hopefully, after this podcast, one will be unable to “claim” ignorance about IFRS 17. 

I’m joined, today, by Dewald van den Berg, a partner in the PwC Financial Services practice. Welcome to our podcast!

Dewald

Thank you Shreeya. Great to be here. This is definitely a hot topic at the moment. 

I’m sure the listeners are wondering why there’s an insurance expert on a RETAIL podcast … but the reality is that there are a number of arrangements which could trigger IFRS 17 effects for entities that don’t perceive themselves to be “Insurers”. 

The issue is that corporates often do not identify these structures and arrangements and therefore may not account for them appropriately. 

The current standard on Insurance contracts - IFRS 4 - is not prescriptive with regards to measurement and therefore corporates could continue to apply their existing accounting practices - whatever that might have been… but - IFRS 17 changes all that.

Shreeya

You make a very valid point Dewald - and I think the clock is ticking down until IFRS 17 becomes mandatory, right?

Dewald

Yes. IFRS 17 is effective for annual reporting periods beginning on or after 1 January 2023.

Shreeya

That’s practically right around the corner!

I want to unpack that point you raised just now about not identifying insurance structures in the corporate space … I agree, it can easily be missed and that’s why we thought that we should deep dive into this issue.

In today’s session, we’d like to focus on cell captive arrangements specifically - as we feel that these structures are commonly overlooked by corporates.

I understand that there are two types of arrangements housed in a cell captive structure, which are: a first party and a third party arrangement. Can you walk us through the key differences and how we can identify those?

Dewald

Sure. Let’s tackle first party cell captive arrangements first.

In a first-party cell captive arrangement…  I am basically insuring myself and other members within my group.

Let’s say a retailer has a large fleet of trucks. Traditional insurance for risks such as damage or theft of the fleet might be too expensive. This is because in a large fleet of trucks, you almost have a fixed minimum amount of losses that are incurred every year. The retailer may then, instead, choose to insure the vehicle fleet through its own first-party cell captive structure. This also serves as an incentive to better manage the fleet risk.

Practically, a cell owner will subscribe for a special class of shares in an insurance company. In terms of the cell shareholders agreement, the cell owner is responsible to ensure that the cell always has sufficient capital to cover any claims under the insurance policy. 

The cell owner will then enter into an insurance policy with the cell captive insurer to insure the cell owner’s own risks or the risk of its subsidiaries/related parties through the cell.

Claims will be paid to the insured out of any funds within the cell.

Therefore, the cell will not go into a deficit scenario or incur an overall loss where the insurer incurs insurance losses as a result of claims. 

This practically means that the cell shareholder, being the retailer, accepts all insurance risk back from the cell due to the circular flow of insurance risk.

Shreeya 

That makes sense. It sounds like a type of ‘self-insurance’. 

Another example could be that a retailer uses first-party insurance to insure its own distribution centres and stores. 

So what happens in a situation where the cell does not hold sufficient funds to pay out claims? 

Dewald

What we typically see is that the corporate entity must at all times, in terms of the shareholding agreement, ensure that the cell remains financially sound. If the cell is not financially sound, the corporate would need to inject more money into the cell.

This is often coupled with claims limitation clauses - i.e. that claims will only be paid when the cell is in a financially solvent position - that is properly capitalised - before and after the claim payment.

Shreeya

I see. Could you maybe unpack at a high level what the typical accounting outcome of a cell like that would be?

Dewald

The burning question that we always need to ask ourselves is whether that arrangement results in the transfer of significant insurance risk and it is important to do this assessment both at a group level and a stand-alone financial statement level.

In the group scenario/example we’ve just chatted about:  the insurance risk remains with the cell owner or the retailer, as the arrangement is circular in terms of the flow of insurance risk. As you mentioned, it is a type of self-insurance. 

The arrangement is similar to the cell owner having placed funds in a deposit that is readily available to draw on for insurance losses.

It is however important to be on the lookout for scenarios where some of the catastrophe risk elements are reinsured to external reinsurers - say to a Swiss Re. In such a scenario, the group has transferred insurance risk.

From a stand-alone entity perspective, where the parent entity enters into the cell shareholders agreement and the operating subsidiaries enters into insurance policies, the parent entity in its stand-alone financial statements may need to apply IFRS 17 due to the acceptance of insurance risk from the cell insurer.

Shreeya

Well, when you put it that way… I think it would make sense for the entity to recognise an asset! This is because, from what you’ve just explained, the accumulated funds within the cell will be payable to the cell owner either through claims, dividends etc. 

Therefore a first party cell captive would likely be within the scope of IFRS 9. Am I on the right track with that thinking? 

Dewald

Exactly right for those scenarios where there isn’t any external reinsurance. Where there is external reinsurance in place -  corporates need to think whether their current accounting policy adequately accounts for the asset component in the insurance arrangement. This is often overlooked and very relevant given the guidance in IFRS 17 for dealing with investment components.

Shreeya

That’s interesting! 

So how do third party cell captive arrangements differ from this?

Dewald

The main difference between a first party and third party cell captive arrangement is whose risks are being insured. In first party arrangements, the corporate entity’s own risk is insured. In third party arrangements, it is the corporate entity’s customer’s risk being insured.

For example:

• If you take out a loan with a bank, the bank provides you, as their customer, with credit life insurance, or
• A retailer that sells furniture on credit could sell credit-life insurance to their customer via a third party cell 
• On purchase of a phone, the retailer or telecoms company could also sell insurance on that phone. 

These retailers may not have their own insurance licences and therefore they will team up with a cell insurer who will underwrite these products. 

Common cell insurers are Guardrisk, Hollard, Old Mutual and Centriq.

Shreeya

Okay, so the distinction would be to understand whose risk is being insured to determine if we are working with a first party or third party cell captive arrangement.

I would assume that the third party cell captive would still be set up in a similar way as a first party cell?

Dewald

Precisely so. A third party cell is also created through a shareholder agreement in which the cell owner subscribes for a special class of shares in the insurer. 

As with a first party arrangement, the corporate must ensure that at all times the cell remains financially sound.

The insurance contracts later issued are however not with the corporate entity but rather with third party customers.

Shreeya

So taking this into account, surely the accounting for third party cell captive arrangements would vastly differ from first party arrangements?

Dewald

Definitely- Like you mentioned earlier, first party cell captive arrangements are within the scope of the financial instruments standard, IFRS 9 or an entity applies their own accounting policy developed for insurance contracts - and don’t forget to cover the asset component in that policy.

A third party cell captive arrangement of a corporate entity would actually - in all likelihood - fall within scope of the new insurance standard, IFRS 17 as there is a scenario under which the cell owner (i.e. the corporate) could make a significant loss, and would need to recapitalise these funds in the cell structure, therefore accepting significant insurance risk from the cell insurer (the underlying risk from third party customers).

Shreeya

In that case, one could look at third party cell captive arrangements as a type of inward reinsurance for the corporate. The cell owner or corporate in a third party cell arrangement is the reinsurer in this contract as they are insuring the risk within the cell and will need to recapitalise the cell if any claims were to be paid out from the cell and result in a financially unsound position.

Dewald

Yes, precisely. 

The cell owner (i.e. the corporate) is a reinsurance contract issuer and therefore will apply the IFRS 17 insurance accounting  principles. 

The cell insurer, the registered insurance company, is therefore a reinsurance contract holder and will apply IFRS 17 reinsurance accounting.

Shreeya

This is very helpful! I can now see how easily one can get confused when dealing with these types of structures and therefore it is important to have a full understanding of them.

Now that we understand how cell captive arrangements can get scoped into IFRS 17, how would you briefly describe the accounting impacts as a result of this?

Dewald

Hmm.. if I can sum up some high level considerations:

IFRS 4, our current insurance accounting standard, does not prescribe specific presentation requirements for the income statement. This is different from IFRS 17 consequential amendments to IAS 1 which contains specific income statement presentation requirements. Therefore, what is currently being done by entities in IFRS 4 most likely will be different to what is required once entities move to IFRS 17.

For example- The income statement in terms of IFRS 17 must include the Insurance revenue line item as well as the insurance service expenses line item. 

The IFRS 17 standard defines what would be seen as revenue and what would be seen as a service expense thus impacting what is presented on the face of the income statement.

The other area is that the measurement requirements of the new standard are different to what entities do today.

Shreeya

So let’s take a step back and make this practical. Let’s say I’m a corporate and I’m in the data gathering process - looking to assess the impact of IFRS 17 on my cell arrangements. What kind of information should I ask my cell captive insurer for?

Dewald

Well Shreeya - the data requirements actually depend on what model you’re going to be applying to account for the underlying insurance contract.

The data requirements can actually become quite extensive, particularly if you’re doing the general model - I don’t think we can get into that level of detail in one podcast!

Shreeya

Thanks for that Dewald - it sounds like we should already be gearing up for another episode with you - one seems like it’s not enough!

Since you’ve brought up the point around measurement models … - can you help me understand what the typical measurement model considerations are for cells that are in the scope of IFRS 17?

Dewald

IFRS 17 has three measurement models But of these three -  two stand out that would apply most commonly to cell captives:

1. General Model
2. Premium Allocation Approach

The general model is the default model that is applied to insurance contracts. IFRS 17 requires a company that issues insurance contracts to report them on the balance sheet as the total of: 

• the fulfilment cash flows—the current estimates of amounts that the insurer expects to collect from premiums and pay out for claims, benefits and expenses, including an adjustment for the timing and risk of those cash flows; and 
• the contractual service margin—the expected profit for providing future insurance coverage (ie unearned profit)

The premium allocation approach or PAA is a simplified measurement model for short-term contracts - the period for which the entity provides insurance coverage is one year or less.  Under this approach, a liability will be built up on the balance sheet that  represents the future services to be provided by the insurer in terms of the contract. It’s unlikely you’d be using this approach for cells with longer-term policies - such as credit life insurance on a long term instalment sales agreement that exceeds one year, but for short-term insurance, take my cell phone insurance example from earlier, there you might be able to apply the PAA..

Shreeya

Thanks for the inputs, Dewald. 

It’s clear that  IFRS 17 contains more requirements compared to IFRS 4 that have material impacts on the accounting for these structures and presentation on our primary statements. 

We’ve covered quite a bit in this session! We discussed how to identify a first party and a third party cell captive arrangement respectively and also touched on the scoping of each of these arrangements to understand the accounting impacts. 

From your last point, Dewald, it is also evident that IFRS 17 is expected to also have a significant impact on a corporate’s financial statements, specifically the income statement and balance sheet presentation.

Is there anything additional that you would like to add, Dewald?

Dewald

IFRS 17 can be quite complex, so I would say that a key takeaway from this session is to note that IFRS 17 will not only have an impact on insurance entities. Corporate entities need to keep a lookout in their existing and new contracts for terms which may fall under the IFRS 17 scoping requirements. The key is to identify whether the entity has accepted significant insurance risk.

If I can make it specific to our session today- Corporate entities with a third party cell captive arrangement need to be aware of the new accounting requirements of IFRS 17 and start working on any information which may be required to implement the new standard. The data requirements of the new standard are granular and extensive. This should not be underestimated. Corporates should also not forget about the potential impact in stand alone financial statements for certain first party arrangements.

Shreeya

I agree. The accounting impact, if deemed to be material, should then already start to make its way into a corporate’s disclosures as part of the impact of new standards and interpretations.

Thanks for joining us today in the studio, Dewald! Thank you for sharing great insight on cell captive arrangements and what corporates need to think about in anticipation of IFRS 17. We hope to have you back soon to discuss policyholder accounting in a bit more detail for corporates. You are such an insurance expert - I’d say your views should come at a “premium”.

Dewald

Thanks for having me. It was great joining in on the podcast and I hope to be back in the aisle soon - looking up at the Top Shelf!

Shreeya 

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