The First Two Blocks (Cash Flows & Time Value)

You are at the heart of IFRS 17! The default methodology for measuring an insurance contract is the General Measurement Model (GMM). It is built by systematically stacking four different "blocks" on top of each other. We can begin with the first two building blocks: predicting the future and adjustment for time.

Building Block 1 - Estimates of Future Cash Flows

An insurance company, first of all, when it issues a contract, must look forward and estimate all the cash, the actual physical cash, that's going to come in, and all the actual physical cash that's going to go out, over the life of the policy.

• Cash Inflows: This represents the premiums the customer will pay to the company.
• Cash Outflows: These are the claims that the company thinks it will payout to the customer. Nonetheless, it also covers the direct costs associated with managing the policy on a day-to-day basis, like dealing with claims, legal defense costs, and administration of the claims.

Crucial Note: IFRS 17 has a very narrow interpretation of the term outflow. Costs that are directly attributable to the issuing of an insurance contract can only be included. Overhead costs, such as the CEO's salary or a corporate-wide marketing campaign, cannot be included in those cash flows. They do not relate directly to the carrying out of the specific policy.

If you expect to collect $100,000 in premiums (inflows) and pay out $80,000 in claims and direct expenses (outflows), your raw net cash flow is $20,000. But in accounting, we cannot simply stop there.

Building Block 2 - The Time Value of Money (Discounting)

The long life of insurance policies makes them unique in nature. One of the key concepts in finance is the time value of money. A dollar that you have in your hand today is worth more than a dollar ten years later. What is the reason? If you indeed possess a dollar today, you can deposit it in a bank and accrue interest on it. In addition, inflation will gradually erode the purchasing power of that future dollar.

If a life insurance company expects to pay $100,000 claim 10 years in the future, it does not actually cost the company $100,000 in today's money. IFRS 17 requires the accountant to "discount" those future cash flows to reflect their Present Value. This ensures the company's financial statements show the true economic reality of the contract today, rather than inflated future numbers.

The Present Value Formula

To find out what a future claim is worth today, finance professionals use a specific discounting formula:

\[ PV = FV x (1 + r)^-n \]

Where:

• PV = Present Value (What the cash flow is worth today)
• FV = Future Value (The estimated claim or premium amount in the future)
• r = The discount rate (The expected interest rate, expressed as a decimal)
• n = The number of periods (How many years into the future the cash flow will occur)

A Real-World Example: Imagine an insurance company knows they will have to pay a $10,000 claim exactly 3 years from today. The current interest rate is 10% (which is written as 0.05). Let's plug those numbers into our formula to find the Present Value: \[ PV = \$10,000 \times (1.10)^{-3} \] \[ PV = \$10,000 \times 0.751 \] \[ PV = \$7,510 \]

At this point we have our estimated raw cash flows (Block 1) and we have mathematically adjusted them to their present value (Block 2). Insurance, after all, is the business of unknowns. What occurs in case our initial assessments are entirely incorrect, being if the claims are worse than worse? We tackle that uncertainty in our next building block.