“Business combinations are transactions in which an entity acquires control of another entity or business, and they can have significant accounting implications for the entities involved. In this article, we will focus on two types of business combinations that are relevant for the insurance industry: (i) The merger and acquisition (M&A) of insurers; and (ii) The acquisition of a legacy portfolio. We will explain how these transactions are accounted for under IFRS 17, the new international accounting standard for insurance contracts, and what are the key concepts and challenges involved.
(i) M&A of insurers
One of the key concepts in accounting for insurance contracts under IFRS 17 is the value of business acquired (VoBA), which is an intangible asset that represents the difference between the fair value of the consideration paid for an acquired insurance business or portfolio and the fair value of the identifiable net assets of that business or portfolio. VoBA is recognised only in a business combination involving insurance entities or businesses under common control, such as a merger or a consolidation of subsidiaries within a group. VoBA is not recognised in other types of business combinations, such as acquisitions of insurance entities or businesses that are not under common control.
The initial measurement of VoBA is based on the fair value of the consideration paid for the acquired insurance business or portfolio, which may include cash, equity instruments, contingent consideration, or other forms of payment. The fair value of the consideration paid is determined at the acquisition date, which is the date when the acquirer obtains control of the acquired insurance business or portfolio. The fair value of the identifiable net assets of the acquired insurance business or portfolio is also determined at the acquisition date, based on the acquisition method prescribed by IFRS 3. The difference between the fair value of the consideration paid and the fair value of the identifiable net assets is the amount of VoBA recognised as an intangible asset.
The subsequent measurement of VoBA depends on the nature and characteristics of the acquired insurance business or portfolio. VoBA may be amortised over its useful life, if it is possible to reliably estimate the pattern of consumption of the expected future economic benefits embodied in the asset. Alternatively, VoBA may be tested for impairment annually, or more frequently if there is an indication of impairment, if it is not possible to reliably estimate the useful life or the pattern of consumption of the expected future economic benefits. The impairment test compares the carrying amount of VoBA with its recoverable amount, which is the higher of its fair value less costs of disposal and its value in use. If the carrying amount exceeds the recoverable amount, an impairment loss is recognised in profit or loss.
The assessment of impairment losses for VoBA is similar to the assessment of impairment losses for goodwill, which is another intangible asset that arises from some business combinations. However, unlike goodwill, VoBA is not allocated to cash-generating units for the purpose of impairment testing. Instead, VoBA is tested for impairment at the level of the acquired insurance business or portfolio or the group of acquired insurance businesses or portfolios that generate the expected future economic benefits from VoBA.
(ii) Acquisition of a legacy portfolio
In the insurance industry, the acquisition of a legacy portfolio, also known as a portfolio transfer, is a transaction in which an insurer transfers a group of insurance contracts that are no longer being issued to another insurer. The acquirer of the legacy portfolio assumes the rights and obligations of the contracts, and the cedant of the legacy portfolio is released from its liabilities. A legacy portfolio usually consists of contracts that are in run-off, meaning that they are not expected to generate any new premiums, but only incur claims and expenses.
The acquisition of a legacy portfolio is the only situation in which the CSM can be set up under the liability for remaining coverage under IFRS 17. This is because the CSM is normally recognised when an insurer issues an insurance contract, not when it acquires an existing contract. However, IFRS 17 provides an exception for the acquisition of a legacy portfolio, because the acquirer effectively pays for the future profit embedded in the contracts, and therefore should recognise the CSM as it provides the services that generate that profit.
The gain on initial recognition of the acquired contracts is recognised as a contractual service margin (CSM) for the liability for remaining coverage, unless the contracts are onerous. The CSM represents the unearned profit that the acquirer expects to recognise as it provides services under the contracts. The CSM is allocated to profit or loss over the remaining coverage period of the contracts, in a systematic way that reflects the transfer of services. The CSM is adjusted for changes in estimates of future cash flows that relate to future services.
The acquisition of a legacy portfolio is a complex and significant transaction for both the acquirer and the cedant of the portfolio. It involves the recognition and measurement of VoBA and CSM. The accounting for the acquisition of a legacy portfolio under IFRS 17 differs from the accounting for other types of business combinations, and requires the application of professional judgment and the consideration of the context and purpose of the transaction.
In conclusion, this article has explained how the M&A of insurers and the acquisition of a legacy portfolio are accounted for under IFRS 17, and what are the key concepts and challenges involved. The article has discussed the role and the methods of the value of business acquired (VoBA) and the contractual service margin (CSM) in these transactions, and how they differ between themselves. The article has also highlighted the importance of using professional judgment and considering the context and purpose of the transaction when applying the accounting standards.”