Contractual Service Margin

Study guide: Exam 6C

The Contractual Service Margin (CSM) is the IFRS 17 building block holding the unearned profit on a group of insurance contracts. At initial recognition it is set at exactly the amount that makes the total liability produce no gain on day one; it is then released to revenue as coverage is provided, measured in Coverage Units.

\text{CSM}_0 = -\bigl(\text{PV of future cash inflows} - \text{PV of outflows} - \text{RA}\bigr)

• No day-one gain, but a day-one loss is recognised immediately. If the fulfilment cash flows are negative in the insurer's favour there is profit, and it is deferred as CSM; if they are unfavourable the group is onerous and the loss goes straight to profit or loss with no CSM at all. The asymmetry is deliberate.
• Release over Coverage Units. Each period, the CSM is allocated to revenue in proportion to the coverage units provided that period out of the total expected — so a group covering more or larger risks in a period releases more profit then.
• The CSM absorbs changes in future service. Favourable or unfavourable revisions to estimates of future cash flows adjust the CSM rather than hitting profit immediately — a shock absorber that spreads the effect over the remaining coverage. Changes relating to past service (claims experience, revisions to the LIC) go straight to profit.
• The CSM cannot go negative. If an unfavourable revision exceeds the remaining CSM, the CSM is reduced to zero and the excess is recognised as a loss, creating a Loss Component.
• P&C insurers see relatively little of it. Most Canadian P&C business is measured under the PAA, which has no CSM for the LRC, and the LIC never has one. The CSM matters for multi-year contracts, some commercial business, and — importantly — reinsurance held, where the CSM can be an asset representing the net cost of reinsurance.
• Interest accretes on the CSM at the locked-in discount rate at initial recognition, not at current rates — one of the few places IFRS 17 retains a historical rate.

Setting and Releasing the CSM A three-year group of contracts is written for premium of \$60 million received at inception. The present value of expected claims and expenses is \$44 million and the risk adjustment is \$5 million. Coverage units are expected to be 40\%, 35\% and 25\% across the three years. Ignore interest accretion.

Compute the CSM at inception and the amount released in year 1. Then suppose that at the end of year 1, expected future claims for years 2 and 3 rise by \$4 million.

Answer At inception:

\begin{align*}
\text{CSM}_0 &= \$60\text{M} - \$44\text{M} - \$5\text{M} \\
&= \$11\text{M}
\end{align*}

No gain is recognised at inception; the whole \$11 million is deferred.

Year 1 release:

0.40 \times \$11\text{M} = \$4.4\text{M}

leaving a CSM of \$6.6 million.

The unfavourable revision. The \$4 million relates to future service (years 2 and 3), so it adjusts the CSM rather than hitting profit:

\$6.6\text{M} - \$4\text{M} = \$2.6\text{M}

Profit for year 1 is unaffected by the revision — the entire effect is absorbed and will emerge as reduced profit in years 2 and 3. This is the CSM's purpose: it smooths revisions to future expectations.

The contrast worth drawing. Had the \$4 million instead been adverse development on claims already incurred, it would relate to past service and would hit profit or loss immediately, with no CSM absorption. And had the revision been \$8 million rather than \$4 million, the CSM would fall to zero and the remaining \$1.4 million would be recognised as a loss, creating a Loss Component — the CSM has a floor at zero.