What is an Insurance Contract?

It may sound obvious, but not every contract that gets signed by an insurance company is an “insurance contract”. Under IFRS 17, there is a very detailed, multi-stage test to categorize contracts.

According to IFRS 17, a contract is an insurance contract if one party (the insurer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate them if a specified uncertain future event adversely affects them.

Let's break down the most critical parts of this rule:

• Transfer of Risk & The Adverse Event: The customer has to be transferring a risk to the company and event has to cause an actual negative impact on the customer (like visit to the hospital, car crash). One cannot insure against something that does not affect them adversely.
• Insurance Risk vs. Financial Risk: IFRS 17 only deals with insurance risk. Financial risk, which refers to fluctuations in interest rates, exchange rates or stock prices, is not covered. If it narrows down the protection only to stock market crashes, it is a financial instrument, not an insurance contract.
• The Risk Must Be "Significant": This test is the most important test. If the insurance policy is triggered by an adverse event that happens, the insurance company must be required to pay out significantly more money compared to if that event did not happen. The payout which is significantly similar is not permissible under IFRS 17.
• The Uncertainty of Timing (Timing Risk): How about life insurance? Death is an event whose certainty we know. Nonetheless, life insurance qualifies under IFRS 17 due to the uncertainty in timing of the event. This uncertainty whether and when they'll have to pay creates a huge risk for the insurance company.
• The Reinsurance Rule (Insurance for Insurers): What will happen when an insurance company realizes that it has accepted excessive risk? To safeguard themselves, they purchase their own policy from another insurer, for example, to cover their losses in the event of a hurricane. That is what we call reinsurance. Reinsurance contracts are considered legitimate insurance contracts under IFRS 17, as substantial insurance risk continues to be transferred from one contracting party to another.

The golden rule is this: Look at the substance of the contract. Is the company taking on a significant risk of having to pay out extra money because something bad happened to the customer (or another insurer)? If yes, you are almost certainly looking at an IFRS 17 contract.