In my November 2019 posting I commented that accountants are approaching the question of accounting for takaful under IFRS 17 from the wrong perspective. I stressed that the right way to approach this is first to look at the economics of the contract. By economics I meant how the cash flows between the various parties to the contract. In my previous posting I also concluded that takaful is a multi-party contract where the parties involved are the Operator, the participants and the takaful fund.
So where are we now as to accounting for takaful? It is accepted in Malaysia that a multi columnar approach remains relevant under IFRS 17 and that, where the Operator chooses to adopt the three columns option, the Operator column should be accounted under IFRS 15. This is consistent with the economics of the role of the Operator in takaful; the Operator is effectively the administrator of the takaful fund and administers the takaful fund on behalf of the participants to the takaful fund in exchange for a fee. It is also accepted that the accounts must separately show the accounting of the takaful fund in its own column. The takaful fund is an entity separate from the participants and accepts the insurance risks from the participants in exchange for a contribution. The contentious issue, however, is the basis of accounting at the Takaful Entity (TE) level. As it is currently being proposed, the methodology implicitly assumes that there remains a risk transfer between the Operator and the participants. To the casual observer this approach must seem inconsistent with the prior conclusion that the column for the Operator should be prepared under IFRS 15.
To demonstrate how the cash flows between the Operator fund and the takaful fund in the event that a qard arises, I go back to the example in my previous posting with the comparison between a life insurance participating fund (i.e. with-profits fund) and a takaful fund. In this simple example let us assume zero expenses. Under the participating fund any surplus arising is shared 10:90, 10% going to the shareholders and 90% going to the policyholders. Under the takaful fund 100% of any surplus first goes to the participants after repaying qard, but should the takaful fund still show a surplus after the repayment of any outstanding qard, a 10% performance bonus is payable to the Operator. The example shows the cash flow over 8 years under a participating fund and alternatively under a takaful fund. Under both scenarios there is a yearly surplus of 100.
However, in the fourth year an unexpected loss of 130 is assumed. The table below shows the cash flows under the participating fund and alternatively under the takaful fund.
It is clear from the above example how differently a deficit is treated in a participating fund compared to under a takaful fund. The economics show clearly that after 8 years, under the participating fund model, the shareholders incur a cumulative net loss of 60 whilst, under the takaful model, the shareholders enjoy a cumulative profit of 57. The financial impact is different between the two and it is important that the accounting reflects this difference. The difference in cash flows arises because, in the participating fund model, there is a risk transfer between the policyholders and the shareholders whilst, under the takaful model, there is no such transfer between the participants and the Operator. What the Operator fund pays into the takaful fund is basically a loan which is subsequently recovered from the future surpluses of the takaful fund.
At this point I want to refer the reader to US GAAP accounting. Under Accounting Standards Codification 944-20 Insurance Activities, insurance risk is defined as “The risk arising from uncertainties about both underwriting risk and timing risk. Actual or imputed investment returns are not an element of insurance risk”. It goes on to explain:
- Underwriting risk is the risk arising from uncertainties about the ultimate amount of net cash flows from premiums, commissions, claims, and claim settlement expenses paid under a contract.
- Timing risk is the risk arising from uncertainties about the timing of the receipt and payments of the net cash flows from premiums, commissions, claims, and claim settlement expenses paid under a contract.
I would argue that the TE does not qualify as undertaking insurance risk; instead, what it is undertaking would qualify under US GAAP as Deposit Accounting (ASC 340-30 Other Assets and Deferred Costs – Insurance Contracts that Do Not Transfer Insurance Risk). To quote from www.irmi.com, “Deposit Accounting is the method of accounting for premium when the policy or reinsurance agreement does not qualify as insurance. The premium is not recognized as income but as a deposit or contribution to the insurer’s surplus. Losses paid are not an expense but rather return of capital. Since premium does not flow through the income statement, the insurer cannot reduce income by the increase in loss reserves.” So how would this work at the TE level under Deposit Accounting? Under Deposit Accounting, the participants’ contributions less wakala fee and any performance fees are treated as deposits or a liability in the TE balance sheet. This deposit would constitute the takaful fund. Any claims paid to participants are treated as a return of capital (i.e. a withdrawal of deposit). This deposit balance would increase as new contributions are deposited and investment income accrued. The deposit balance would correspondingly reduce as claims are paid. Once in a while the TE could extend a loan (an Overdraft?) to the takaful fund which would be repaid by the takaful fund from future contributions.
To reiterate, at the TE level there is no transfer of underwriting risk, only a transfer of timing risk as cash flows between the three parties to the contract. I would argue that accounting for the takaful fund at the TE level as deposit accounting is much simpler (and thus cheaper from a cost perspective) and should be considered by the account preparer. This approach solves the multitude of complications that preparers are probably currently facing when applying IFR17.B67 to IFRS17.B69 and its subsequent knock-on impact on the CSM. Although there is no explicit guidance on Deposit Accounting for insurers/reinsurers under IFRS, account preparers can fall back on IFRS Conceptual Framework for Financial Reporting 2010 which says that “In the absence of an IFRS Standard or an Interpretation that specifically applies to a transaction, management must use its judgement in developing and applying an accounting policy that results in information that is relevant and reliable. In making the judgement management is required to consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income, and expenses.” The beauty of Deposit Accounting, apart from its simplicity, is it is totally Sharia compliant!