It is now five years since IFRS 17 (the Standard) was introduced in May 2017. IFRS 17 applies to all insurance contracts. Thus, it is worthy of note that during the various pre-adoption consultation processes before the Standard was finalized, no takaful operator nor any IASB observant country’s Accounting Standards Board had approached the Board on the key question as to how the Standard should apply to takaful. Subsequent to the introduction of the Standard there was, however, that one formal International Accounting Standards Board (IASB) presentation in November 2021, made to the Islamic Finance Consultative Group (IFCG) entitled Takaful Contracts, IFRS 17 Insurance Contracts (the IASB Takaful presentation). The IFCG was formed by the IASB following the 2011 Agenda Consultation to assist in assessing whether the Board needed to take action to address the needs of Islamic finance. In this article I have decided to go back to basics and determine what the Standard has actually implied on how IFRS 17 should be applied to a reporting Entity practicing Shariah based takaful. What exactly is a Shariah based takaful operation? A Shariah based takaful operation is an insurance operation which practices the concept of risk sharing among the insureds as opposed to the concept of risk transfer from the insured to the insurer. Indeed, within that definition lies the key to determining how IFRS 17 should apply to takaful. Let me start from the beginning.
All Shariah based takaful operations in the world are based on one of two basic operating models. The basic difference between these two models (say Model A and Model B) is how management and other indirect expenses are allocated. In the examples for Models A and B given below, we only consider how Insurance Revenue (as defined under the Standard) is treated.
Model A has only one operating fund where the Insurance Revenue is deposited. Under Model A all expenses and claims are paid from the same operating fund. There is no constraint on what expenses are charged to the operating fund as long as these are valid expenses related to the running of the takaful operation.
Under Model B there are at a minimum two operating funds (the Operator Fund and at least one Risk Fund). All management and other indirect expenses are allocated to the Operator Fund while all claims and direct costs are allocated to the Risk Fund. Under Model B there is therefore a need to split the insurance revenue into two, one part going to the Operator Fund while the remaining going to the Risk Fund. The complication arises as, under Model B, the ownership (the equity underlying the Funds) of the two funds is different. The Risk Fund collectively belongs to the current AND future policyholders while the Operator Fund belongs to the takaful operator (usually a stock company). It is because of this difference in ownership that, unlike in Model A, there is a need to clearly define how the insurance revenue is spilt between the Operator Fund and the Risk Fund. How this split is done varies from one takaful operator to another. It can take the form of a fixed percentage of the Insurance Revenue and/or a fixed “dollar” amount. This is called an agency fee. The fee can be larger if most of the direct expenses are also allocated to the Operator Fund. This Model B is the dominant takaful model practiced globally as Regulators require that the takaful operator is sufficiently capitalized at day one. As such and in order to ensure a financially viable operation for itself, the takaful operator would also build into the business model a combination of types of agency fees. The primary fee would usually be determined as a percentage of the Insurance Revenue while any supplementary agency fees could take the form of a percentage of the Investment Return (as defined under the Standard) and, if and only if a profit were to arise, a share of the Insurance Service Result (as defined in the Standard) accruing in the year. The latter is somewhat controversial from a Shariah perspective and is practiced only in a limited number of jurisdictions (e.g., in Malaysia). Notwithstanding that, the largest portion of the fees collected is typically that of a percentage of the Insurance Revenue with any share of Insurance Service Result arising being the smallest. This is by no means an accident as this latter source of income is the most uncertain to the takaful operator and, unlike the other fees, has to be shared with the policyholders.
The difference between Model A and Model B therefore is only in how expenses are financed. Under Model B given the different ownership of the Operator and the Risk Fund(s) the agency fees charged (both in amount and type) have to be transparent and agreed in advance with the policyholders. These fees, given the nature of the arrangement, include a profit margin for the takaful operator. Under both models, however, the insurance risks are pooled among the takaful policyholders in the Risk Fund(s).
Implementing IFRS 17 for Model A
Model A is very much akin to the traditional Mutual Insurer practiced for the life insurance business in many countries. Given the need to clarify how the Standard should apply to mutual entities, the IASB issued in July 2018 a presentation entitled Insurance contracts issued by mutual entities, IFRS 17 Insurance Contracts (the presentation). The presentation was clear in that IFRS 17 applies to insurance contracts within its scope, regardless of the legal form of the issuing entity. This presentation started off by defining exactly what a mutual entity is:
- A mutual entity accepts risks from each policyholder and pools that risk
- Policyholders hold the residual interest in a mutual entity (in comparison to insurers which are owned by shareholders who then hold the residual interest in the entity, notwithstanding that the residuals may be held in the insurance fund)
- The policyholders with a residual interest in the mutual entity bear the pooled risk collectively in their capacity as owners
It went on to describe the nature of the contracts issued by a mutual entity, as contracts that affect or are affected by the cash flows to policyholders of other insurance contracts. This is the case for insurance contracts that provide the policyholder with a residual interest in a mutual entity. The fulfilment cash flows of a group of contracts within a mutual entity reflect the extent to which the contracts in the group cause the entity to be affected by expected cash flows, whether to policyholders in that group or policyholders in another group (including both current and future policyholders). The presentation went on to define that the cash flows to policyholders with a residual interest in a mutual entity would vary depending on the returns on underlying items – the net assets of the mutual entity.
The fulfilment cash flows under an insurance contract would therefore consist of:
- Premiums (including premiums due but still outstanding)
- Payments to policyholder together with the associated Risk Adjustment
- Payments to policyholder that vary depending on returns on underlying items (for a mutual entity this can be positive or negative)
- Policy administration and maintenance costs 5. An allocation of fixed and variable expense
What is important to realize is that the net cash flows of the mutual entity are eventually returned to policyholders with a residual interest (either current or future policyholders). Indeed, a TRG Paper dated September 2018 concluded that contracts with policyholders that share in 100% of the returns on a pool of underlying items that include the insurance contracts issued to those policyholders, i.e., they fully share all risks, do not cause the entity to be ultimately affected by the expected cash flows of each individual contract issued. For those contracts, applying paragraph B68 of IFRS 17, the contractual service margin will be nil. Therefore, for those contracts, an entity measuring the contractual service margin at a higher level than the annual cohort level, such as at a portfolio level, would achieve the same accounting outcome as measuring the contractual service margin at an annual cohort level applying paragraph 22 of IFRS 17. Thus, effectively what the paper concluded is that for such a mutual entity there is therefore no need to apply the requirement to group policies by annual cohorts.
One very important feature outlined in the presentation is the role of the Risk Adjustment in a mutual entity. To recap, the Risk Adjustment for non-financial risk in IFRS 17 is “the compensation an entity requires for bearing the uncertainty about the amount and timing of the cash flows that arises from non-financial risk”. The presentation was clear in that although the policyholders with a residual interest as a whole bear the pooled risk collectively, the mutual, as a separate entity, has accepted risk from each individual policyholder. The Risk Adjustment for contracts with policyholders who have a residual interest in a mutual entity therefore reflects the compensation the mutual entity requires for bearing the uncertainty from the non-financial risk in those contracts. The presentation is thus clear that all of the Risk Adjustment in a mutual entity accrues to the mutual pool. Importantly the Risk Adjustment together with the Contractual Service Margin i.e., the CSM (in a non-mutual entity) comprise the planned release of surplus when determining the Insurance Service Result arising in the year.
What are the tweaks required when applying the accounting for mutual entities to a takaful operation under Model A? One major difference between a mutual entity and takaful as practiced in Model A is that the Insurance Revenue under takaful is, for Shariah reasons, treated as a donation to any takaful policyholders who would ultimately claim from the operating fund. Effectively the takaful policyholders would not have any expectation to be paid other than for a valid claim arising from the contract.
Notwithstanding this there is no reason not to allocate any expected residuals to the B71 reserves to be used to finance any future deficits in the mutual pool. Alternatively, the expected residuals can instead be notionally allocated as surplus to be distributed to the policyholder in the future. What this means is that the policyholder can actually receive more than just what is stated in the contract but this is subject to the full discretion of management.
Implementing IFRS 17 for Model B
The basic difference between Model A and Model B is the presence of the Operator Fund under Model B and the subsequent need to allocate part of the Insurance Revenue as agency fees to the Operator Fund. Subsequent to this allocation the accounting treatment under IFRS 17 of the Risk Fund under Model B would be the same as the accounting treatment of the sole Operating Fund under Model A. The only difference is in the fulfilment cash flows of the takaful policy in Risk Fund under Model B, wherein the various expenses already captured by that portion of the Insurance Revenue now paid directly to the Operator Fund disappears from the policy’s fulfilment cash flows.
At this stage of the article, I want to bring up and discuss certain features of the takaful contract which have been the source of much discussion and some disagreement among practitioners. a) The accounting status of the Risk Fund under IFRS 17 As mentioned earlier, IFRS 17 applies to insurance contracts within its scope, regardless of the legal form of the issuing entity. This is an important point to reiterate. Obviously, under Model B, the Risk Fund is by itself not a legal entity and the takaful contract has been issued under the name of the takaful operator. However, this contractual feature alone cannot be used from the IFRS perspective to conclude that the takaful operator is underwriting the insurance risk. Consider first the Objective of the Standard. Under Paragraph 2 of the Standard, it states that “An entity shall consider its substantive rights and obligations, whether they arise from a contract, law or regulation, when applying IFRS 17:
”It goes on to define “Contracts can be written, oral or implied by an entity’s customary business practice. Contractual terms include all terms in a contract, explicit or implied,..”.
I would interpret this paragraph in the following manner:
i) There is no objection from an accounting perspective to account for the Risk Fund separately from the Operator Fund even though the Risk Fund is not independent of the Operator Fund. For all intents and purpose the Risk Fund can be treated as a reporting entity under IFRS. ii) Contracts need not only be written but can be oral in nature or indeed just implied by an entity’s customary business practice. Thus, from an accounting perspective the Risk Fund has to be treated as a separate party to the takaful contract (separate from the takaful operator and the individual policyholder). iii) Following from (i) and (ii) above the takaful contract, again from the accounting perspective, is a triparty contract, a contract between the takaful Operator, the takaful Risk Fund and the takaful policyholder.
We can conclude from the above that the Standard requires that the Risk Fund must account as a separate entity, detached from the Operator Fund. We note that this is currently being practiced in the MENA region under IFRS 4.
b) The nature of the takaful contract under IFRS 17 A persistent argument forwarded for the accounting of the takaful contract at the Takaful Entity level is the TRG discussion at its February 2018 meeting. In that meeting it was reported that the TRG considered that the lowest level of the unit of account used in IFRS 17 is a contract, and that contracts are normally designed in a way that reflects their substance. It has been argued from this TRG discussion that a contract as a whole should be accounted for using IFRS 17 – that is, it would be inconsistent with IFRS 17 to separately account for the disaggregated components of a contract. Effectively the TRG discussion in the February 2018 meeting concluded that an entity is not permitted to separate out insurance components in a single contract for measurement purposes.
This conclusion has been embraced by the Malaysian Accounting Standards Board (as explained in its Issues Bulletin 2 in September 2020) and has been the go-to statement when applying IFRS 17 to takaful contracts in Malaysia.
This February 2018 TRG conclusion was subsequently deliberated at the November 2021 IASB Takaful presentation and a different conclusion ensued. The reader is encouraged to refer to that presentation for the details. In summary, the November 2021 IASB presentation had the following comments on the conclusion made at the February 2018 TRG meeting:
- IFRS 17 is silent and therefore does not prohibit separation
- TRG conclusion requires – an assumption that form of contract reflects substance – judgement be applied if indications are substance differs from form – lists non exhaustive facts and circumstances to consider
- TRG did not consider circumstance in which contract is triparty (i.e., gives rise to rights and obligations for three (or more) parties)
- In multi-party contracts, each party should consider its own rights and obligations (i.e., not a separation)
It has to be emphasized that the February 2018 TRG discussions did not have takaful contracts as part of its agenda whilst the November 2021 IASB presentation was exclusively focused on takaful contracts. It is therefore clear, from the presentation to the members of the Islamic Finance Consultative Group, that the conclusion arrived at in the February 2018 TRG meeting does not apply to takaful contracts.
After determining the accounting status of the Risk Fund (i.e., it should be accounted for separately under Model B) and the nature of the takaful contracts (in particular that they are triparty contracts), we now turn to the accounting relationship between the Operator Fund and the Risk Fund.
The Operator Fund’s primary role is to manage the Risk Fund in a fiduciary capacity. This can be likened to the role of the management of a company to its shareholders. What perhaps has muddied the water somewhat is that the Operator Fund is responsible to either source or provide a subordinated interest free loan to the Risk Fund should a deficit arise in that fund. There have been many debates whether this responsibility means that the Operator Fund is effectively providing reinsurance to the Risk Fund or, even more basic, that it is actually the Takaful Entity that is underwriting the takaful contracts. Let me address the second question first.
An insurance contract is defined under IFRS 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. However, even if this were to apply in the circumstance being considered this statement addresses only one half of the contract; in any contract there must also be a consideration for that service. In the case of insurance, it would be the insurance premium which is paid to the insurer to underwrite that risk. In takaful it is the Risk Fund that receives the risk premium, and not the Operator fund. The Risk Fund does not belong to the Operator; the Operator has no residual interest in the Risk Fund. It is therefore clear that no insurance contract exists between the Takaful Entity and the takaful policyholder.
We now turn to the first question, is the Operator Fund providing reinsurance cover to the Risk Fund? The Operator Fund is in receipt of a portion of the insurance revenue and could be entitled to other agency fees in accordance with the terms of the takaful contract. We therefore need to turn to Paragraph B27(b) of IFRS 17. Paragraph B27 has eight sub paragraphs, with each sub paragraph specifically providing examples of items that are NOT insurance contracts and thus are NOT covered by IFRS 17. Sub paragraph (b) is of interest. Specifically, it specifies these as:
“contracts that have the legal form of insurance, but return all significant insurance risk to the policyholder through non-cancellable and enforceable mechanisms that adjust future payments by the policyholder to the issuer as a direct result of insured losses. For example, some financial reinsurance contracts or some group contracts return all significant insurance risk to the policyholders; such contracts are normally financial instruments or service contracts (see paragraph B28)”
While B28 states that:
“An entity shall apply other applicable Standards, such as IFRS 9 and IFRS 15, to the contracts described in paragraph B27” The contract between the Operator Fund and the Risk Fund fits exactly the definition provided under Paragraph B27(b). This can be proven by examining what happens should a deficit arise in the Risk Fund and a loan is provided by the Operator Fund to the Risk Fund. In the simulation below the policyholder is the Risk Fund.
- A reinsurance contract is assumed to exist between the Operator Fund and the Risk Fund as the Operator Fund undertakes to provide a subordinated loan to the Risk Fund should a need arise. In return the Operator Fund receives fees from the Risk Fund.
- At some point of time the Risk Fund does indeed incur a deficit and the Operator Fund duly injects an amount equal to the deficit into the Risk Fund. It is important to realize here that when a Risk Fund is in deficit it does not automatically imply that the Risk Fund is unable to meet all of its obligations on an ongoing basis. There is an expectation that with the release of the Risk Adjustment under existing contracts and the entry of new profitable policies this position of deficit would be reversed in the future.
- As the Operator Fund effectively also manages the Risk Fund, there already exists a non-cancellable and enforceable mechanisms that would adjust future payments by the Risk Fund to the Operator Fund as a direct result of the insured losses.
- Thus subsequently, when the Risk Fund generates a surplus, the loan is repaid to the Operator Fund from the Risk Fund. Once we have established that the accounting relationship between the Operator Fund and the Risk Fund is not covered by IFRS 17, Paragraph B27 says that the entity shall apply other accounting Standards to such contracts. An appropriate Standard in such an arrangement is IFRS 15 as this neatly ties in with the Agency fees payable to the Operator Fund.
The application of IFRS 17 to takaful is not complicated. Indeed, there is no need to make a mountain out of a molehill. The authors of the Standard had 20 years to put the standard together and it shows the breadth with which the Standard covers the various types of insurance contracts out there.
- Where the takaful setup includes an Operator, the takaful contract is triparty in nature.
- The first contract is between the Risk Fund and the takaful policyholders. IFRS 17 applies here and its application can be likened to the manner in which IFRS 17 applies to a mutual entity. Thus, for example, as there is no CSM there is no need to do cohorting.
The second contract is between the Operator Fund and the Risk Fund. The takaful operator does everything that an insurance entity would do except one: underwrite the risk (remember takaful is risk sharing and not risk transfer). It is interesting to note that there are such (non-takaful) reinsurance arrangements which also fit this description. Paragraph B27(b) of the Standard says that insurance arrangements where the insurers return all significant insurance risk to the policyholder should not apply IFRS 17. In such a circumstance it is proposed to apply IFRS 15 to the Operator Fund.
To my understanding IFRS 15 does not require cohorting. Instead, it is recommended that any premium related agency fee is recognized as revenue under IFRS 15 in the Operator Fund proportionately to the insurance revenue recognized in the Risk Fund under IFRS 17. There is then the question of whether there is a need to consolidate the Operator Fund accounts with the Risk Fund accounts. Reference has been made that this is required under IFRS 10 as the Takaful Entity controls the Risk Fund. I believe IFRS 10 associates control with the consolidating entity having some equity in the entity to be consolidated with, as otherwise one plus one will always equal two and there is no added value in consolidating the two accounts. The Takaful Entity has no equity in the Risk Fund; this is apparent as the CSM in the Risk Fund is nil. Furthermore the control established by the Takaful Entity is only fiduciary in nature.
The title of this article is Back to Basics and I started the article by explaining the basic structure of the takaful operating models. I explained that the major differentiator of takaful is that the insurance risk is pooled among its policyholders rather than transferred to the takaful operator. Indeed, the takaful operator’s Shariah Advisory Body would testify every year in the Takaful Entity’s financial statements that the takaful contracts are in compliance with this basic Shariah principle. It would be odd if this feature of the takaful contracts is not reflected when presenting the Takaful Entity’s accounts for the takaful business.
Going back again to basics, the International Financial Reporting Standards have been carefully formulated to reflect the economics of the business and to ensure transparency and comparability between reporting entities’ accounts. IFRS 17 is the soon to be effective IFRS for the purpose of accounting for insurance contracts. IFRS 17 is clear as to how mutual entities should account for insurance contracts. The Risk Fund satisfies the requirements to be accounted as a mutual entity under IFRS 17. IFRS 17 is also clear in paragraph 27 as to what should NOT be accounted for under the Standard. The accounting relationship between the Takaful Entity and the takaful Risk Fund is not insurance and should not be accounted for under IFRS 17. This relationship is described specifically as not being insurance under paragraph 27 (b). Instead, accounting for this relationship under IFRS 15 would be appropriate. Doing otherwise would not be in compliance with the International Financial Reporting Standards.
Zainal Abidin Mohd. Kassim