Profitability Groups and Annual Cohorts (The Final Buckets)

Previously under IFRS 4, a company was able to hide a terrible, value-destroying contract by blending it into a group of highly profitable contracts. This is made illegal by IFRS 17. Now we will examine the last two steps of grouping: Profitability and Time.

Step 1 - Profitability Groups:

Once you have your Portfolio (e.g. Car Insurance), IFRS 17 compels you to split those contracts into three strict buckets, depending on how profitable you expect them to be at the very beginning:

• Onerous Contracts: These contracts incur losses. You expect the payouts to be greater than your collected premiums. (IFRS 17 requires you to immediately report these losses on your Income Statement!).
• Profitable Contracts: Contracts that have no significant risk of becoming loss-making.
• The Remaining Contracts: Contracts that are likely to yield a minor profit but will easily turn a loss if anything slightly goes wrong.

Companies will not be able to hide poor decisions behind good ones anymore, by segregating the “Onerous” (loss-making) contracts in their own bucket.

Step 2 - Annual Cohorts (The Time Limit):

Time is of the essence. If two contracts are both Car Insurance, and both are very profitable, you cannot group them together on the grounds that they were sold far apart in time.

As per IFRS 17, contracts which are included in the same group cannot be issued more than a year apart. A yearly segment is called an Annual Cohort. It guarantees that a firm cannot rely on profits from newer customers to mask the declining profitability of customers from five years ago.

You have now successfully found the “Level of Aggregation” (final bucket)! You take a single contract, put it in a Portfolio based on risk, divide it by Profitability, and slice it by the Year was sold. In this ultimate bucket, the complex math and accounting calculations take place exactly here.