In life insurance under IFRS 17, there are two main valuation approaches: the General Measurement Model (GMM) and the Variable Fee Approach (VFA). This post focuses on the Variable Fee Approach - what it is and when it applies.
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The VFA is a modification of the GMM, specifically for direct participating contracts. These contracts must meet certain conditions at inception.
Direct participating contracts
Only direct participating contracts fall under the VFA in IFRS 17.
These contracts involve a significant level of investment-related services. The policyholder receives an investment return based on underlying items, and the insurer charges a variable fee for these services - hence the name Variable Fee Approach.
Key characteristics of direct participating contracts:
- offer investment-related services,
- share returns on underlying items with policyholders,
- provide the insurer with a variable fee.
VFA assessment criteria
For a contract to qualify for the VFA, it must meet all three conditions outlined in IFRS 17.B101:
A. Link to a clearly identified pool of underlying items
[IFRS 17.B101(a)] The contractual terms specify that the policyholder participates in a share of a clearly identified pool of underlying items.
There must be an enforceable link between the amounts paid to the policyholder and the underlying items.
B. Substantial share of fair value returns
[IFRS 17.B101(b)] The entity expects to pay the policyholder an amount equal to a substantial share of the fair value returns on the underlying items.
The insurer must assess the product's fee structure. The smaller the portion of investment returns passed on to the policyholder, the less likely the investment-related services are substantial. This requires judgment based on specific circumstances.
C. Policyholder benefits vary with underlying items
[IFRS 17.B101(c)] The entity expects a substantial proportion of any change in the amounts to be paid to the policyholder to vary with the change in fair value of the underlying items.
This requires evaluating the potential variability of policyholder benefits and their relation to investment returns over the contract's duration. The assessment considers present-value, probability-weighted averages.
If the policyholder has a guaranteed minimum return, the more valuable this guarantee is, the less likely the contract qualifies for the VFA.
Pool of underlying items
Understanding underlying items
VFA contracts are based on underlying items. Let's explain this with an example:
- Contract A: The policyholder's account balance grows at a fixed 2% annual rate.
- Contract B: The policyholder's account balance grows based on actual returns from an investment portfolio.
Contract A does not qualify as a VFA contract because there is no link to underlying items. The investment returns are fixed, not tied to actual performance.
Contract B qualifies as a VFA contract because the returns are linked to an underlying investment portfolio.
What are underlying items?
Underlying items are mostly assets (sometimes liabilities) in which the policyholder participates. For example, in unit-linked contracts, policyholders choose from different funds where their premiums are invested. These funds form the pool of underlying items. The underlying items must be clearly identified in the contract, though the insurer is not required to hold them.