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	🤔 '''Think about it.''' If the [[Definition:General model\|general model]] creates misleading [[Definition:Volatility\|volatility]] for these contracts, how might IFRS 17 redesign the mechanics to better reflect the insurer's true economics?		🤔 '''Think about it.''' If the [[Definition:General model\|general model]] creates misleading [[Definition:Volatility\|volatility]] for these contracts, how might IFRS 17 redesign the mechanics to better reflect the insurer's true economics?

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Wikilah admin: Created page with "{{Internal:Training/IFRS17/nav-dropdown}} 🔗 '''Recall.''' In the previous page, you learned how the premium allocation approach simplifies measurement for short-duration contracts. Now we turn to the other end of the spectrum: long-duration contracts where the policyholder's returns are tied to underlying items, and where a different modification of the Definition..."

2026-03-31T16:36:40Z

Created page with "{{Internal:Training/IFRS17/nav-dropdown}} 🔗 '''Recall.''' In the previous page, you learned how the premium allocation approach simplifies measurement for short-duration contracts. Now we turn to the other end of the spectrum: long-duration contracts where the policyholder's returns are tied to underlying items, and where a different modification of the Definition..."

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{{Internal:Training/IFRS17/nav-dropdown}}

🔗 '''Recall.''' In the previous page, you learned how the [[Definition:Premium allocation approach|premium allocation approach]] simplifies measurement for short-duration contracts. Now we turn to the other end of the spectrum: long-duration contracts where the [[Definition:Policyholder|policyholder's]] returns are tied to [[Definition:Underlying items|underlying items]], and where a different modification of the [[Definition:General model|general model]] is needed to reflect their unique economics.

🎯 '''Objective.''' In this page, you will learn:
* What [[Definition:Direct participating contracts|direct participating contracts]] are and why they behave differently from traditional [[Definition:Insurance contract|insurance contracts]].
* How the variable fee concept modifies the [[Definition:General model|general model]] by treating changes in the insurer's share of [[Definition:Underlying items|underlying items]] as an adjustment to the [[Definition:Contractual service margin|CSM]] rather than sending them to [[Definition:Profit and loss|profit or loss]].
* What the three eligibility criteria are that a contract must satisfy before the [[Definition:Variable fee approach|variable fee approach]] can be applied.

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== What are direct participating contracts ==

🤝 '''A different kind of promise.''' Not all [[Definition:Insurance contract|insurance contracts]] work like the traditional policies we have studied so far. In a traditional contract, the insurer promises a fixed or formulaic benefit: if your house burns down, you receive the repair cost; if you die during the [[Definition:Coverage period|coverage period]], your family receives a set sum. But some contracts make a fundamentally different promise. They tell the [[Definition:Policyholder|policyholder]]: "We will invest a pool of [[Definition:Underlying items|underlying items]] on your behalf, you will receive a substantial share of the returns from those items, and we will also provide you with [[Definition:Insurance coverage|insurance coverage]]." These are [[Definition:Direct participating contracts|direct participating contracts]], and they sit at the heart of many [[Definition:Life insurance|life insurance]] and [[Definition:Savings contract|savings]] products sold across Europe.

💼 '''A familiar product.''' If you have encountered [[Definition:Unit-linked contract|unit-linked]] life insurance or [[Definition:With-profits contract|with-profits]] endowment policies, you have already met direct participating contracts in practice. Consider a with-profits savings product sold in France: the [[Definition:Policyholder|policyholder]] pays [[Definition:Premium|premiums]] that are invested in a pool of [[Definition:Bonds|bonds]], [[Definition:Equities|equities]], and [[Definition:Real estate|real estate]]. Each year, the policyholder receives a share of the [[Definition:Investment return|investment returns]] generated by that pool, plus a guaranteed minimum. AXA, as the insurer, retains a fee for managing the assets and bearing the [[Definition:Insurance risk|insurance risk]]. The policyholder's benefit is not fixed in advance; it depends directly on how the [[Definition:Underlying items|underlying items]] perform.

⚠️ '''Common misconception.''' Learners sometimes assume that any contract with an [[Definition:Investment component|investment component]] qualifies as a [[Definition:Direct participating contracts|direct participating contract]]. That is not the case. The defining feature is not merely the presence of an investment element, but the fact that the [[Definition:Policyholder|policyholder]] is promised a substantial share of the returns on a clearly identified pool of [[Definition:Underlying items|underlying items]]. A [[Definition:Term life insurance|term life]] contract with a small cash-value rider, for example, would not typically qualify.

🔗 '''Why traditional accounting falls short.''' Under the [[Definition:General model|general model]], changes in [[Definition:Financial risk|financial assumptions]], such as shifts in [[Definition:Interest rates|interest rates]] or [[Definition:Equity|equity]] prices, flow through to the [[Definition:Income statement|income statement]] or [[Definition:Other comprehensive income|OCI]]. For a traditional contract, that treatment makes sense: the insurer bears the financial risk. But for a [[Definition:Direct participating contracts|direct participating contract]], the insurer is essentially acting as an asset manager who also provides [[Definition:Insurance coverage|insurance coverage]]. When the value of [[Definition:Underlying items|underlying items]] rises, the policyholder's benefit rises too, and the insurer's share, its fee, adjusts accordingly. Forcing these financial movements into the [[Definition:Income statement|income statement]] would create artificial [[Definition:Volatility|volatility]] that does not reflect the real economics of the relationship.

🤔 '''Think about it.''' If the [[Definition:General model|general model]] creates misleading [[Definition:Volatility|volatility]] for these contracts, how might IFRS 17 redesign the mechanics to better reflect the insurer's true economics?

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== The variable fee concept: how VFA modifies the general model ==

💡 '''Reframing the insurer's role.''' The key insight behind the [[Definition:Variable fee approach|variable fee approach]] is that, for [[Definition:Direct participating contracts|direct participating contracts]], the insurer's profit is best understood as a variable fee charged for services rendered. That fee has two parts: a share of the returns on [[Definition:Underlying items|underlying items]], and compensation for providing [[Definition:Insurance coverage|insurance coverage]] and [[Definition:Investment management services|investment management services]]. Instead of treating changes in [[Definition:Underlying items|underlying items]] as [[Definition:Insurance finance income or expense|financial income or expense]] that hits the [[Definition:Income statement|income statement]], the [[Definition:Variable fee approach|VFA]] routes the insurer's share of those changes through the [[Definition:Contractual service margin|CSM]]. The result is a smoother, more representative [[Definition:Profit|profit]] pattern.

📊 '''How the mechanics differ.''' Recall that under the [[Definition:General model|general model]], changes in [[Definition:Financial risk|financial assumptions]] (such as [[Definition:Discount rate|discount rates]] or [[Definition:Market returns|market returns]]) do not adjust the [[Definition:Contractual service margin|CSM]]; they flow to the [[Definition:Income statement|income statement]] or [[Definition:Other comprehensive income|OCI]]. The [[Definition:Variable fee approach|VFA]] changes this rule for [[Definition:Direct participating contracts|direct participating contracts]]. Suppose AXA manages a with-profits portfolio in Belgium backed by a pool of [[Definition:Underlying items|underlying items]] worth €500 million. If [[Definition:Equity|equity]] markets rise and the pool's value increases by €25 million, the [[Definition:Policyholder|policyholders]] are entitled to, say, 90% of that gain (€22.5 million), and the insurer's share is 10% (€2.5 million). Under the [[Definition:Variable fee approach|VFA]], that €2.5 million increase in the insurer's share adjusts the [[Definition:Contractual service margin|CSM]] upward. It will be released as [[Definition:Insurance revenue|insurance revenue]] over future periods as the insurer continues to provide service.

⚠️ '''Common misconception.''' A common error is believing that the [[Definition:Variable fee approach|VFA]] eliminates all [[Definition:Volatility|volatility]] from the [[Definition:Income statement|income statement]]. It does not. Changes in [[Definition:Non-financial risk|non-financial assumptions]], such as revised [[Definition:Mortality|mortality]] or [[Definition:Lapse rate|lapse]] expectations, are treated the same way as under the [[Definition:General model|general model]]: changes relating to future service still adjust the [[Definition:Contractual service margin|CSM]], but changes relating to current or past service still go to [[Definition:Profit and loss|profit or loss]]. What the [[Definition:Variable fee approach|VFA]] specifically adds is the routing of [[Definition:Financial risk|financial]] changes through the [[Definition:Contractual service margin|CSM]], something the general model does not permit.

🔎 '''Seeing it in context.''' To appreciate why this matters, imagine the Belgian portfolio at year-end after a sharp stock market decline. The pool's value drops by €30 million. Policyholders absorb €27 million (90%), and the insurer's share falls by €3 million. Under the [[Definition:General model|general model]], that €3 million would hit the [[Definition:Income statement|income statement]] immediately, creating a visible loss even though the insurer's long-term fee structure is unchanged. Under the [[Definition:Variable fee approach|VFA]], the €3 million reduces the [[Definition:Contractual service margin|CSM]] instead. As long as the [[Definition:Contractual service margin|CSM]] remains positive, the insurer simply recognises less [[Definition:Profit|profit]] in future periods, matching the economics of a fee that fluctuates with the assets it manages.

🤔 '''Think about it.''' The [[Definition:Variable fee approach|VFA]] clearly suits contracts where [[Definition:Policyholder|policyholders]] share in [[Definition:Investment return|investment returns]]. But not every contract with some participation feature qualifies. How does IFRS 17 draw the line between contracts that may use the [[Definition:Variable fee approach|VFA]] and those that must stay under the [[Definition:General model|general model]]?

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== Scope and the three eligibility criteria ==

📏 '''A strict gateway.''' IFRS 17 does not allow insurers to choose the [[Definition:Variable fee approach|variable fee approach]] freely. A contract must satisfy three criteria at [[Definition:Inception|inception]], and all three must be met simultaneously. If even one fails, the contract must be measured under the [[Definition:General model|general model]] (or the [[Definition:Premium allocation approach|PAA]] if eligible). The three criteria are designed to ensure that the contract genuinely represents a fee-for-service arrangement tied to [[Definition:Underlying items|underlying items]], rather than a traditional contract with a thin investment wrapper.

1️⃣ '''Criterion one: a specified pool of underlying items.''' The contractual terms must specify that the [[Definition:Policyholder|policyholder]] participates in the returns of a clearly identified pool of [[Definition:Underlying items|underlying items]]. These items might be a portfolio of [[Definition:Bonds|bonds]], an [[Definition:Equity fund|equity fund]], a basket of [[Definition:Real estate|real estate]] holdings, or any other identifiable collection of [[Definition:Assets|assets]], [[Definition:Liabilities|liabilities]], or a combination. The pool must be identifiable; a vague reference to "the insurer's general investment portfolio" would not qualify. For example, a [[Definition:Unit-linked contract|unit-linked]] product in Italy where each policyholder's account is linked to a named fund of European [[Definition:Equities|equities]] clearly satisfies this criterion.

2️⃣ '''Criterion two: a substantial share of fair value returns.''' The insurer must expect to pay the [[Definition:Policyholder|policyholder]] a substantial share of the [[Definition:Fair value|fair value]] returns on those [[Definition:Underlying items|underlying items]]. "Substantial" is not defined as a specific percentage, but the standard requires that the policyholder's share be significant enough that the contract is genuinely participatory. A product that promises the policyholder 90% of the returns on an identified [[Definition:Bond fund|bond fund]] easily meets this test. A product that promises only 5% of returns, with 95% retained by the insurer, would not, because the policyholder's participation is not substantial.

⚠️ '''Common misconception.''' Some learners interpret "substantial share" as meaning the policyholder must receive the majority (over 50%) of the returns. The standard does not set a fixed threshold. What matters is the overall economic substance: the policyholder's share must be large enough that the contract's [[Definition:Cash flows|cash flows]] are expected to vary substantially with the performance of the [[Definition:Underlying items|underlying items]]. The assessment is made at [[Definition:Inception|inception]] and considers the full range of scenarios, not just the most likely outcome.

3️⃣ '''Criterion three: substantial variability with underlying items.''' The insurer must expect that a substantial proportion of any change in the amounts paid to the [[Definition:Policyholder|policyholder]] will vary with the change in [[Definition:Fair value|fair value]] of the [[Definition:Underlying items|underlying items]]. This criterion zooms in on the variability of the total benefit, not just the existence of participation. Consider a product that offers both a guaranteed floor and a participation feature. If the guarantee is so generous that the policyholder will almost always receive the guaranteed amount regardless of how the [[Definition:Underlying items|underlying items]] perform, then the benefit does not substantially vary with those items, and criterion three fails. The contract might look participatory, but the guarantee dominates the economics, making the [[Definition:General model|general model]] more appropriate.

🧩 '''Putting the pieces together.''' All three criteria work as a single gate. A [[Definition:With-profits contract|with-profits]] savings product at an insurer like AXA that names a specific asset pool, promises the policyholder 85% of the returns, and has only a modest minimum guarantee would typically pass all three tests and qualify for the [[Definition:Variable fee approach|VFA]]. Conversely, a [[Definition:Guaranteed annuity|guaranteed annuity]] product that happens to hold an identifiable asset pool but promises the policyholder a fixed benefit regardless of performance would fail criteria two and three, even though criterion one is met. The three criteria ensure that the [[Definition:Variable fee approach|VFA]] is reserved for contracts where the insurer truly acts as a fee-collecting service provider, not a traditional risk bearer.

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== Takeaways ==

📌 '''Key takeaways.'''
* [[Definition:Direct participating contracts|Direct participating contracts]] promise the [[Definition:Policyholder|policyholder]] a substantial share of the returns on a specified pool of [[Definition:Underlying items|underlying items]], making the insurer's profit function like a variable fee for service.
* The [[Definition:Variable fee approach|VFA]] modifies the [[Definition:General model|general model]] by routing the insurer's share of changes in [[Definition:Underlying items|underlying items]] through the [[Definition:Contractual service margin|CSM]], producing a profit pattern that reflects the economics of a fee-based relationship rather than creating artificial [[Definition:Volatility|volatility]].
* A contract qualifies for the [[Definition:Variable fee approach|VFA]] only if it meets all three eligibility criteria at [[Definition:Inception|inception]]: a specified pool of [[Definition:Underlying items|underlying items]], a substantial policyholder share of returns, and substantial variability of benefits with those items.

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== Quiz ==

{{Wix:Training/IFRS17/The variable fee approach/quiz}}

{{Internal:Training/IFRS17/nav-dropdown}}

Internal:Training/IFRS17/The variable fee approach - Revision history

Wikilah admin at 18:09, 6 April 2026