We are at the fourth, final, and most important building block of IFRS 17. The contractual service margin (CSM) is in fact the entire reason the insurance company is in business in the first place: the profit.
After calculating the present value of incoming money (premiums), subtract the present value of outgoing money (claims and expenses). After subtracting your safety cushion (risk adjustment), whatever money is leftover is your anticipated profit.
Under the stringent rules of IFRS 17, this not-yet-earned, expected profit is formally referred to as Contractual Service Margin (CSM).
Let's look at a highly simplified formula to find the CSM on the very first day a contract is signed:
Here is the most important concept that you must have about CSM. Insurance companies used to take profit of 20,000 and show it in their income statement on Day 1 when the customer signed the contract in accordance with the old IFRS 4 rules. The profit was claimed before the service was actually provided!
IFRS 17 makes this "Day 1 Profit" illusion entirely illegal. When a contract is signed, the expected 20,000 profit (the CSM) has to be recorded as a liability in the Balance Sheet. It shows profit which the company has not earned yet.
How does the company actually get to claim that profit? They must earn it over time. As the months and years go by, and the company actually stands ready to pay claims and provides the insurance coverage, they are allowed to slowly "amortize" (or move) pieces of the CSM off the Balance Sheet and onto the Income Statement as realized, official profit. If the policy lasts for four years, they will steadily release that profit over the four-year coverage period.
What if the calculus does not back up your cause? If the expected claims and risk adjustment exceed the premiums you receive from the customer, your CSM could be a negative number. You have zero expected profit. You are likely to lose. A contract that results in losses is called an Onerous Contract we saw in Chapter 2.
If CSM calculation provides a negative number, the “Day 1” rule changes. It is not permitted for you to gradually acknowledge a loss. Companies will have to recognize the entire expected loss on the Income Statement on Day 1 which is a mandatory requirement of IFRS 17. It stops companies from hiding bad financial decisions from investors.
You've successfully tackled the engine! To properly value any insurance contract, The Future Cash Flows are estimated, mathematically discounted for Time Value, a Risk Adjustment for uncertainty added, and finally, the CSM (unearned profit) is calculated. The General Measurement Model is formed by these four blocks.