The two main valuation approaches in life insurance for IFRS 17 are General Measurement Model (GMM) Variable Fee Approach (VFA).
In this post, let's that a look at what the Variable Fee Approach is and when it should be used.
The VFA is a modification to the General Measurement Model (GMM) for direct participating contracts. These contracts need to fulfil certain conditions at inception.
Direct participating contracts
Only direct participating contracts fall under the scope of the VFA under IFRS 17.
Direct participating contracts have a substantial portion of investment-related services. The policyholder is promised an investment return based on the underlying items. The insurance company charges a fee based on the services that are provided. This fee is variable, hence the term Variable Fee Approach.
Direct participating contracts:
- offer investment-related services,
- include features that share returns on underlying items with the policyholder(s),
- provide the insurer with a variable fee for the services rendered.
VFA assessment criteria
[IFRS 17.B101(a)] The contractual terms specify that the policyhoder participates in a share of a clearly identified pool of underlying items.
There must be an enforceable link between the amounts paid to the policyholder and the underlying items.
[IFRS 17.B101(b)] The entity expects to pay the policyholder an amount equal to a substantial share of the fair value returns on the underlying items.
This point requires consideration of the product's fee structure.
The smaller the part of the investment returns that are passed on to the policyholder, the less likely that the investment related-services are substantial. The is an area of judgement and requires consideration of specific facts and circumstances.
[IFRS 17.B101(c)] 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.
This requires consideration of the potential variability of policyholder benefits and the extent to which they relate to the variability in investment returns. The variability is assessed, based on the duration of the contract and a present-value, probability-weighted average basis.
Often the policyholder is also guaranteed a minimum return. The more valuable this guarantee is, the less likely that the investment-related services are substantial.
The assessment is only performed at inception.
Pool of underlying items
Underlying items
VFA contracts base on the underlying items. What does it mean? It’s the easiest to explain with an example.
Imagine two contracts: contract A and contract B. Each contract provides a death benefit for the whole life. The death benefit amounts to the higher: guaranteed amount and the account balance.
In contract A, account balance is credited with the fixed 2% annual rate.
In contract B, the account balance is credited with the actual return of the underlying portfolio.
Contract A does not qualify as a VFA contract because there is no link to the underlying items. The actual performance of the underlying portfolio is unknown. This contract does not meet a criterium of a direct participating contract and should not be measured with the VFA approach.
In contract B, there is a link to the underlying portfolio which meets the definition of a direct participating contract.
VFA contracts should have a clear link to the underlying items.
What are underlying items?
Underlying items are mostly assets, but sometimes also liabilities, in which the policyholder participates.
An example is unit-linked contracts – in these contracts, the policyholder is also offered investment return services.
The policyholder can choose out of the variety of funds in which their premiums can be invested.
These funds are reffered to as the pool of the underlying items.
The underlying items should be clearly identified in the contract. The insurer does not need to hold them.