My first article of this series on applying IFRS 17 to takaful was posted on November 13 2019. Exactly one year on, and after ten such postings, I can report that Malaysia is moving somewhat in the right direction as to satisfying the two guiding principles of accounting for takaful:
- That the presentation of the accounts should reflect the risk-sharing nature of takaful in order to be Sharia compliant, and
- That the accounting reflects the economics of the takaful contract. IFRS 17 provides guidance on the basis and timing of how profits to the shareholders from the takaful contract should be recognized; it should not change the economic value the shareholders are expected to receive from writing the contract.
That first article raised concerns that the intention under IFRS 17 was to do away with the multi columnar approach currently adopted for takaful under IFRS 4 in favour of a single column representing the financial performance of the Takaful Entity (TE). At the time, it was implied that as the lowest unit of account is the contract, the contract should be accounted for as insurance. This is notwithstanding that the business of takaful is clearly defined differently by law in Malaysia.
Subsequent to that first article, the Malaysian Accounting Standards Board (MASB) came out with a revised recommendation that a multi column approach to reporting on takaful would instead be applicable. The MASB provided three options for how the accounts can be presented (see LinkedIn article of May 4 2020). The details of how the Takaful Fund (TF) and the TE accounts should be prepared were left to the implementers to determine. Should the takaful operator also decide to present the Takaful Operator’s accounts, these should instead be prepared under IFRS 15. The MASB’s preferred recommendation, however, was to go with the two column (TF and TE) approach and this would be the sticking point that the remainder of this article addresses.
The devil, as they say, is in the details. IFRS 17 is principles-based and designed with insurance in mind, both the proprietary type where investors provide capital, and the mutual type where a fund owned collectively by the policyholders underwrites the policies. Takaful in Malaysia is a hybrid, neither fully proprietary nor fully mutual, something the authors of the Standard did not consider. Thus, takaful operators in Malaysia would need to put careful thought into how exactly IFRS 17 would be implemented for their company.
The challenges facing implementers include:
- While the TE level requires that the policies need to be segregated by annual cohorts and then according to (from the Entity’s perspective) contracts which are onerous, non-onerous and others, at the TF level that condition can be dispensed with if it can be demonstrated that no residuals are expected from managing the TF. This difference in treatment raises challenges when applying mutualisation to the future cash flows in the TF.
- Mutualisation is covered under B67 to B70 of the Standard. Under the wakala operating model applied in Malaysia, this mutualisation only happens in the TF and is triggered when the contribution (premium), after deducting the wakala fee, is insufficient to meet the expected policy benefits for the contract. These policy benefits can be limited to the contractual claims payable to the policyholder from the TF but can also include a share of the surplus distributable from the TF in the year. The complications arise as the allocation of liabilities, from those policies which are in need of support to those policies where surplus is expected, can change from one year to the next. Each time the allocation of liabilities for the policy at the TF level changes, the Contractual Service Margin (CSM) for the same policy at the TE level would also change as would the CSM of the “donor” policy.
- Under IFRS 17 there is a need to establish a Risk Adjustment (RA) to reflect the compensation that the entity requires for bearing the uncertainty about the amount and timing of the cash flows that arises from non-financial risk. Under the TF, the non-financial risk is the insured benefit and the entity which undertakes the risk is the Participants Risk Fund (PRF). Under the TE, the non-financial risks are the expenses incurred by the TE and the RA is the compensation to the TE for underwriting that risk. This differentiation of the entity involved needs to be clearly accounted for.
- The choice of the Profit Carrier is not as straight forward as in insurance. Should it be based on the sum covered (which is accounted in the TF and may not be separately identified on a cohort basis) or one of the other expected cash flows in the TE?
- The treatment of qard (a subordinated loan from the TE to the TF) can be problematic. This is because the qard is triggered under the regulatory solvency valuation methodology and basis and solvency balance sheet which can be different from the IFRS 17 Best Estimate Liability and IFRS 17 balance sheet.
It is also important to realize that there is currently no IFRS 17 engine that we know of that can address the system challenges posed by takaful. Compounding this obstacle is a resource challenge; there are not many people who understand how to apply the Standard to the specific Takaful model adopted. Yes, there are multiple takaful operating models globally, each with its own particular nuances.
Many decisions are required from management at transition. Before making these decisions management should ideally be informed of the expected consequences of these decisions on the company’s financials. Examples include decisions which determine how much of the Operator’s retained profits are recycled or increased. Whether there is a need for management to review existing retakaful contracts to improve the recognition of earnings under IFRS 17. Whether there is a need to change the design/pricing of existing takaful products. One very important decision to be made is likely to be whether there is a need to reevaluate how wakala fees are structured. As their future KPIs would be based on these outcomes it would be natural for management to seek professional advice before committing their company to a particular financial outcome.
The role of auditors has also expanded under IFRS 17. New skill sets are required of them such as a deeper understanding of actuarial concepts as are applied under the Standard and of their clients’ book of business. Only then can they be comfortable signing off on the TE’s CSM, effectively the locked-in profits of the written book of business. This is one figure investors would be keenly following year in and year out.