Contract boundaries define when an insurer’s obligation under a contract ends. More than that, changes in contract boundaries have a dramatic impact on measurement of insurance liabilities, capital and solvency.
Determining contract boundaries is not always as simple or objective as you might expect.
The principles under IFRS 17, Solvency Assessment and Management (SAM), and Solvency II are broadly aligned – but not identical. IFRS 17 and SAM both link contract boundaries to:
- The insurer’s ability to terminate the contract or where the insurer no longer has a substantive obligation to provide coverage1
- The ability to reprice the premiums to fully reflect the risk of the particular policyholder2
- Whether there is pre-funding of future risks3 (e.g. where level premiums are charged despite increasing risk over time).
For details of regulatory definitions and guidance including key excerpts from IFRS 17 and SAM, see the Appendix.
While SAM has borrowed language from IFRS 17 drafts during its formulation, the application of these frameworks can diverge in practice. Who decides whether repricing ‘fully reflects’ risk? What constitutes enough pre-funding to extend the boundary? Can a contract that is profitable throughout its policy term be viewed as having pre-funding? And when does commercial substance override contractual form?
Contract boundaries can sometimes require expert judgement and interpretation. Similar products sold by different insurers may receive different treatment due to these judgements and interpretations.
Even where product features (like guaranteed insurability, pricing guarantees and waiting periods) are similar, interpretation of the boundary may differ between insurers, auditors and regulators. Different actuaries can – legitimately – reach different conclusions using the same facts.
Why might boundaries change?
Some life insurers adjusted SAM boundaries when implementing IFRS 17 to align the contract boundaries used.
Longer contract boundaries, while often justified, make best estimate liabilities (BELs) more sensitive to long-term assumptions – especially around policyholder behaviour like lapses, take-up of benefit increases and reactions to premium reviews.
While I’d argue a careful reading of the current FSI 2.2 and the current Guidance Note to FSI 2.2 supports longer boundaries for most profitable risk products, there may be commercial, regulatory or audit-driven pressures to shorten them. Long boundaries for profitable risk products result in the capitalisation of significant future profits into basic own funds (BOF), even while these future profits are a function of uncertain long-duration lapse assumptions, premium collection assumptions, mortality and morbidity rates, premium and benefit escalation rates, credit life utilisation and amortisation, and sometimes policy alteration experience.
One possible driver of change could be a change in guidance from the Prudential Authority (PA), which might include (amongst other changes) reducing or removing the role of pre-funding in determining contract boundaries or specifying additional rules that override the original principles and guidance.
Implications of shorter contract boundaries
Whatever prompts the potential change, if you are re-evaluating your SAM contract boundaries, the points in the section below are key considerations to think through carefully before proceeding.
The implications are far-reaching and go beyond technical provisions.
1. Basic own funds shrink
Where future profits were previously capitalised under SAM (as a negative BEL), these will no longer be recognised beyond the new shorter contract boundary. This directly reduces BOF.
For mature books, if shorter contract boundaries exclude losses on unprofitable contracts, there could be an offset where positive liabilities also disappear. It is possible, but practically unlikely, that liabilities could decrease if most policies affected are old and now have lower premiums than claims and expenses due to prior pre-funding.
2. Solvency Capital Requirement (SCR) reduces
The shortened contract boundary will likely result in a significant drop in mass lapse and lapse SCR – often the dominant components for life insurers with large portfolios of profitable risk business and long contract boundaries.
Mortality, morbidity and retrenchment SCR also drop due to shorter risk horizons. Operational risk and catastrophe risks may be mostly unchanged.
Market risk on the asset side won’t directly change, but liability side interest rate stresses will definitely change.
3. Tiering adjustments may be necessary
Tiering limits may change in unexpected ways as the liability and SCR figures change. Tier 2 and Tier 3 sources of own funds may appear proportionately larger with decreased Tier 1 own funds and SCR.
4. Risk margin drops
The risk margin for the affected business will fall, driven by a lower non-hedgeable SCR and shorter projection horizon. For long-duration business, it can result in a sharp drop in risk margin.
5. Deferred tax impacts
A decrease in the SAM contract boundary will likely increase SAM liabilities. The impact on IFRS 17 liabilities will likely be different, for one or both of the following reasons:
- The IFRS 17 contract boundary might not be changed, in which case the IFRS 17 liability won’t change at all.
- The IFRS 17 BEL might increase, but for profitable contracts, the contractual service margin (CSM) will at least partially offset this impact, meaning the total IFRS 17 liability will change by less than the SAM BEL.
The combined impact of SAM and IFRS 17 liability changes will therefore likely increase the differences between them, which would affect (likely decreasing) deferred tax liabilities (DTL) on the SAM balance sheet. In extreme scenarios, this could entirely remove the SAM DTL.
Further, changes in the SCR itself and to expected future profits emerging from beyond the contract boundary can have further impacts on the loss-absorbing capacity of deferred taxes (LAC DT).
6. Iterative versus non-iterative risk margins diverge
Iteratively derived risk margins (IRMs) typically respond differently to stresses than non-iterative risk margins (NIRMs). Given the rationale for an IRM is commonly derived from significant lapse risk, a change in lapse components may have a dramatic effect on the risk margin. In extreme cases, it may remove the rationale for the iterative approach entirely.
Iterative models may also need recalibration of proxies and re-running of all the checks on convergence and accuracy of proxies – and complex explanations to board members of both the NIRM and IRM changes.
7. Lapse and mass-lapse reinsurance strategy
The shift in capital drivers – particularly the reduction in mass-lapse SCR – may affect the need for mass-lapse reinsurance. Some insurers valued the dual capital and risk benefits of this type of reinsurance, whereas for others it was historically something of an expensive grudge purchase against what they viewed as an onerously calibrated lapse module.
Insurers should re-evaluate the cost-benefit trade-off of current mass-lapse structures or look to adjust the current structures at renewal.
8. SCR composition shifts
The composition of the SCR will change – less lapse risk, and relatively more catastrophe risk and operational risk. The capital profile shifts toward shorter-duration risks. Economic capital and regulatory capital may diverge more materially. This divergence complicates financial reporting and makes hedging targets harder to align between IFRS 17, SAM and internal economic views.
9. ORSA may require an out-of-cycle update
The change in balance sheet mix, SCR, SCR composition and sensitivity of SCR cover to shocks could invalidate existing Own Risk and Solvency Assessment (ORSA) assumptions and projections. With such fundamental changes, an out-of-cycle ORSA may be necessary.
For those currently contemplating the possible future effect of a change in contract boundary, your stress and scenario testing processes flowing into your current ORSAs are a natural home for these.
10. Target SCR cover ratio likely needs revision
If you previously had high mass-lapse exposure, your SCR cover may have been resilient to certain shocks, especially those that mirrored the major components of the SCR (like lapses). Those dynamics will likely change.
If you use a robust method to set SCR cover targets based on risks of dipping below minimum SCR cover, you’ll need to re-run those models. Your risk of falling below SCR coverage of 1 may have changed – and without updating your model parameters you won’t know by how much.
If your current targets are set more ‘intuitively’ or by peer comparison, you have a different sort of challenge. The change in contract boundary may change reported SCR cover but not necessarily (or at least to the same extent) the actual risk exposure. If your SCR cover target is based on peer comparisons, it won’t change. If you maintain the same SCR cover target with a different measure, you have unintentionally changed a key outcome of capital management. This shows the significant limitation of SCR cover targets based on peer comparisons in the first place.
11. Asset-liability management (ALM) and changes to interest rate matching targets
Shorter contract boundaries, especially for those life insurers with net negative BEL, will likely reduce interest rate sensitivity in the SCR. Many insurers in this position choose not to hedge the interest rate exposure on these negative liabilities since it typically requires swap or derivative structures, which add operational risk, default risk, liquidity risk and an overall increase in complexity.
Where the contract boundaries are different between SAM and IFRS 17, matching both the BEL on a SAM basis (to decrease capital requirements and stabilise solvency) and on an IFRS basis (to manage earnings volatility in the absence of use of other comprehensive income (OCI)) becomes more difficult.
Large changes in matching strategies could result in sale of assets intended to be held to maturity, with implications for those now needing to wash any capital gains or losses previously shown in OCI back through profit & loss prematurely.
12. Growth and run-off dynamics
For growing insurers, shorter boundaries limit the ability to self-fund new business strain (solvency or capital) by the BOF generated from long contracts. Solvency, rather than liquidity, may become the constraining factor.
If a rule to enforce short contract boundaries applies without consideration to whether contracts are loss-making or not, for shrinking or closed books, shorter boundaries may understate future losses where past pre-funding existed, painting an overly optimistic solvency picture.
13. Financial reporting complexity
Insurers using SAM-based balance sheets as a proxy for embedded value (EV) or shareholder value will find that shortened boundaries further understate the present value of future shareholder profits. This increases the extent of large reconciliations between SAM, IFRS 17 and EV.
14. Risks of rules-based regulations
If any regulatory change to contract boundaries was introduced as more rules-based, rather than principle-based, there is a risk of inconsistent treatment of otherwise similar products. This could arise if classification or regulatory triggers produce materially different results for similar products, potentially distorting comparability and business planning.
15. Governance and oversight will need recalibration
Boards and risk committees will need refreshed reporting. The link between risk profile, own funds volatility and capital target calibration must be re-established. Years of intuition and education may be at least partially reversed.
Final thoughts
Revising contract boundaries may seem like a technical update, but these impacts cascade through governance, reporting and capital management. It reshapes not just valuation, but risk exposure, capital requirements, ALM practices and strategic capital planning.
Appendix: regulatory definitions of contract boundaries
This appendix contains detailed references from IFRS 17 (paragraphs B61–B62, 34), South Africa’s Prudential Standard FSI 2.2, the associated Guidance Note and Solvency II. It highlights distinctions in treatment of termination rights, repricing at policy or portfolio level, and how pre-funding of premiums impacts contract boundary determination.
IFRS 17
IFRS 17 paragraph 34
Cash flows are within the boundary of an insurance contract if they arise from substantive rights and obligations that exist during the reporting period in which the entity can compel the policyholder to pay the premiums or in which the entity has a substantive obligation to provide the policyholder with insurance contract services (see paragraphs B61–B71). A substantive obligation to provide insurance contract services ends when:
(a) the entity has the practical ability to reassess the risks of the particular policyholder and, as a result, can set a price or level of benefits that fully reflects those risks; or
(b) both of the following criteria are satisfied:
(i) the entity has the practical ability to reassess the risks of the portfolio of insurance contracts that contains the contract and, as a result, can set a price or level of benefits that fully reflects the risk of that portfolio; and
(ii) the pricing of the premiums up to the date when the risks are reassessed does not take into account the risks that relate to periods after the reassessment date.
IFRS17 Basis for Conclusions B160
The essence of a contract is that it binds one or both of the parties. If both parties are bound equally, the boundary of the contract is generally clear. Similarly, if neither party is bound, it is clear that no genuine contract exists.
Thus:
(a) the outer limit of the existing contract is the point at which the entity is no longer required to provide coverage and the policyholder has no right of renewal. Beyond that outer limit, neither party is bound.
(b) the entity is no longer bound by the existing contract at the point at which the contract confers on the entity the practical ability to reassess the risk presented by a policyholder and, as a result, the right to set a price that fully reflects that risk. Thus, any cash flows arising beyond that point occur beyond the boundary of the existing contract and relate to a future contract, not to the existing contract.
SAM – Financial Soundness for Insurers (FSI) 2.2 and Guidance Note
FSI 2.2 Section 8: Contract Boundary
Only cash flows associated with existing insurance obligations at the valuation date should be included. The contract boundary for insurance obligations shall be determined based on the point at which the insurer either:
a) has the unilateral right to terminate the contract;
b) has the unilateral right to reject premiums payable under the contract; or
c) has the unilateral right to amend the premiums or the benefits payable under the contract, such that the premiums fully reflect the risks
GN to FSI 2.2 Chapter 2, Section B(e): Guidance for individual life risk policies
- The contract boundary should generally be the same as the contract term where the pricing of the premiums takes into account risks that relate to future periods. The insurer may have the ability to implement certain management actions, such as changing future premium rates after an initial guaranteed term. Allowance should be made for the management actions that the insurer could reasonably be expected to implement and allow appropriately for expected policyholder behaviour.
- If the insurer can only re-price on a portfolio level, the unilateral right to change policy conditions to fully reflect risk inherent in the specific policy is limited and therefore a longer contract boundary should apply. In order for a shorter boundary to apply, the insurer should have the right to set premium rates for existing policies that are the same as that for new policyholders with the same risk profile and should also have the right to re-underwrite the policies (on the same rules as applying for new policies).
- The contract boundary should not be longer than the contractual end of the policy.
1 IFRS 17 Basis for Conclusions 160(a) states, ‘The outer limit of the existing contract is the point at which the entity is no longer required to provide coverage and the policyholder has no right of renewal. Beyond that outer limit, neither party is bound.’ For SAM, FSI 2.2 8.2(a) includes termination as a key principle to establish the contract boundary, although later detail and the Guidance Note to FSI 2.2 provides more information on when other factors may take precedence.
2 IFRS 17 paragraph 34 states, ‘The entity has the practical ability to reassess the risks of the particular policyholder and, as a result, can set a price or level of benefits that fully reflects those risks.’ For SAM, FSI 2.2 8.2(c) covers how changing premiums or benefits such that ‘premiums fully reflect the risks’ will determine the contract boundary.
3 As outlined in IFRS 17 paragraph 34(b) for IFRS and the Guidance Note to FSI 2.2, Chapter 2(B, e, i) for risk policies under SAM.