Contracts entered into by entities that are not insurers may fall within the scope of the new insurance standard.
AASB 17 Insurance Contracts is the most significant new accounting standard to become effective since the last major new standard, AASB 16 Leases. It supersedes AASB 4 Insurance Contracts and fundamentally changes the way insurance contracts are accounted for. The new standard applies to annual reporting periods beginning on or after 1 January 2023.
Understandably, non-insurers may have given the new insurance standard very little thought on the basis that it will not apply to them. While this may be true in many cases, AASB 17 should not be completely ignored as some contracts that non-insurers enter into on a regular basis may fall within the scope of this complex new standard. This is because AASB 17 applies to insurance contracts regardless of the entity that issues them.
In a series of articles, we will explore the scope of AASB 17 with non-insurers in mind. The focus will be on key definitions and concepts, transactions that are explicitly carved out of the scope of the standard, and optional exemptions that allow certain contracts that meet the definition of an insurance contract to be accounted for under another accounting standard.
Part 1: What is an insurance contract?
AASB 17 defines an insurance contract as a contract under which one party (the insurer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder.
Insurance risk is defined as being any risk other than financial risk transferred from the holder of a contract to the issuer.
Financial risk is explicitly defined in AASB 17 as the risk of a possible future change in one or more of a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract.
Existence of a contract
For an insurance contract to exist, there must be an enforceable contractual arrangement between two or more parties that creates substantive rights and obligations. Such contracts can be written, verbal or implied by an entity’s customary business practices. Implied terms include those imposed by law or regulation.
Compensation for a specified uncertain future event
An insurance contract requires there to be compensation for a specified uncertain future event (the insured event). Compensation can be in cash or in kind (i.e., repairing or replacing a damaged item).
Uncertainty is at the core of an insurance contract. At least one of the following must be uncertain at inception of the contract:
- Probability of the insured event occurring
- Timing of the insured event
- How much will need to be paid if the insured event occurs.
Adverse effect on policyholder
An adverse effect on a policyholder means that the policyholder suffers a loss as a result of the occurrence of the insured event. This is important because contracts which pay the counterparty when an event occurs, regardless of whether the counterparty is adversely affected or not, are not insurance contracts.
Non-financial risk is a risk that is specific to a party to the contract e.g., the occurrence or non-occurrence of a flood that damages a party’s asset. Consequently, insurance risk is the non-financial risk the issuer accepts from the policyholder.
The policyholder must be exposed to the risk before entering the insurance contract. Risk that is created by a contract is not a pre-existing risk and therefore is not insurance risk.
Significant insurance risk
For insurance risk to be significant, it must require the issuer to pay significant additional amounts beyond what it would pay if the insured event did not occur, and it could suffer a loss as a result.
Key concepts regarding the assessment of significance in the context of insurance risk:
- It is done from the issuer’s perspective at the individual contract level
- Time value of money is taken into account
- The likelihood of the insured event occurring is ignored
- Scenarios that have no commercial substance are excluded
Wish to learn more?
Download the four-part series or contact your HLB Mann Judd adviser.