The Variable Fee Approach under IFRS 17 is a specialized measurement model for insurance contracts in which the insurer effectively manages a pool of assets on the policyholder’s behalf and takes a share of the returns as its fee. A contract qualifies only if it meets a three-part eligibility test at inception, and once it qualifies, the insurer’s profit margin is treated as a floating fee that rises and falls with the fair value of the underlying items. That mechanism is what sets the model apart from the General Measurement Model used for conventional insurance products.
The Three-Part Eligibility Test in Paragraph B101
A contract qualifies for VFA treatment only if it satisfies all three conditions in paragraph B101 of the standard at inception.1IFRS Foundation. IFRS 17 Insurance Contracts The contractual terms must specify that the policyholder participates in a share of a clearly identified pool of underlying items. These underlying items are typically investment portfolios, specific funds, or defined pools of net assets. The contract itself must spell out which assets belong to the pool. If the link between the policyholder and specific assets is vague or left to management discretion, the contract fails this first condition.
The insurer must also expect to pay the policyholder an amount equal to a substantial share of the fair value returns on those identified items. The standard deliberately avoids pinning “substantial” to a fixed percentage, which has led to variation in practice. Some reporting entities have treated participation of 80 percent or more as meeting the threshold, while at least one has drawn the line at 70 percent. The assessment is ultimately a judgment call that depends on the contract’s economics, projected payout patterns, and how tightly the policyholder’s returns track the underlying asset performance.
Finally, the insurer must expect a substantial proportion of any change in the amounts it pays the policyholder to vary with changes in the fair value of the underlying items. Where the second condition looks at the level of returns shared, this one focuses on variability. When asset values swing, the policyholder’s payout must move in a corresponding direction and by a meaningful amount. Insurers typically support this with sensitivity analyses and stress tests showing the degree of correlation between asset fluctuations and policyholder cash flows.2IFRS Foundation. IFRS 17 Insurance Contracts
A contract that fails any one of these three conditions is measured under the General Measurement Model instead. This gate-keeping function prevents insurers from applying the VFA to traditional insurance products that don’t genuinely share investment risk with policyholders. The eligibility assessment is made at inception, and reclassification between measurement models after initial recognition is not permitted.
Contracts That Typically Qualify
The B101 criteria map most naturally to products where the policyholder holds an identifiable economic stake in a managed asset pool. Unit-linked contracts are the clearest example: the policyholder’s benefits are explicitly tied to the value of specific investment units, and the insurer earns fees deducted from those unit values. With-profits contracts, both unitised and conventional varieties, also commonly meet the test, since policyholders participate in the returns of a defined fund and the insurer retains a share of the surplus as its variable fee. Participating contracts widely used across continental Europe and Asia fall into the same category.
Variable annuity products with account values linked to segregated funds often qualify as well, though the presence of guaranteed minimum benefits can complicate the analysis. Contracts with heavy guarantees may still pass all three B101 conditions at inception, but the guarantees themselves become part of the fulfillment cash flow measurement and can significantly affect how the Contractual Service Margin behaves over time.
How VFA Contracts Are Measured
Measurement under the VFA starts with the same building blocks used across all IFRS 17 models, collectively called fulfillment cash flows. These represent the insurer’s current, unbiased estimate of every future amount it expects to collect and pay out over the contract group’s lifetime. Two adjustments then bring those estimates onto a comparable basis: discounting for the time value of money, and a separate charge for the uncertainty in non-financial risks.
Discounting Future Cash Flows
IFRS 17 permits two approaches for setting discount rates. The bottom-up method starts with a liquid risk-free yield curve and adds a premium to reflect the liquidity characteristics of the insurance liabilities. The top-down method works in reverse. It starts with the observed market return on a reference portfolio of assets and strips out factors irrelevant to the insurance contracts, such as credit risk.3IFRS Foundation. TRG for IFRS 17 Insurance Contracts – Determining Discount Rates Using a Top-Down Approach
The two methods can produce different yield curves even in the same currency, and an insurer is not required to reconcile the results of its chosen approach against what the alternative would have produced. In practice, the top-down approach tends to yield rates closer to those embedded in the insurance liabilities, because the reference portfolio typically has liquidity characteristics that more closely resemble insurance contracts than the highly liquid government bonds used as a starting point in the bottom-up method.
Risk Adjustment for Non-Financial Risk
On top of the discounted cash flow estimates, insurers add a risk adjustment that compensates for the uncertainty in the timing and amount of future cash flows arising from non-financial risks. This covers things like unexpected claim patterns, mortality deviations, or expense overruns that have nothing to do with financial market movements.4IFRS Foundation. Determining the Risk Adjustment for Non-Financial Risk in a Group of Entities The standard does not mandate a specific technique for calculating this adjustment. Actuaries commonly use either a confidence level approach, expressing the adjustment as a percentile of the cash flow distribution, or a cost-of-capital method that applies a charge to the capital required to support the risk. The risk adjustment is updated every reporting period to reflect the most current information.
The Contractual Service Margin as a Variable Fee
The Contractual Service Margin represents the unearned profit the insurer expects to collect over the life of the contract group. Under the VFA, it has a specific economic meaning: the CSM equals the insurer’s share of the fair value of the underlying items, minus the fulfillment cash flows that don’t depend on the underlying items. Think of it as the management fee the insurer earns for running the investment pool on the policyholder’s behalf. At initial recognition, the CSM is calculated as the residual that prevents any day-one profit from being booked, closing the gap between expected inflows and outflows after accounting for risk.
This framing is what distinguishes the VFA from the General Measurement Model. Under the general model, the CSM is simply the deferred profit on providing insurance coverage. Under the VFA, the CSM is explicitly linked to asset performance. When the underlying pool gains value, the insurer’s share of that gain increases the margin. When assets decline, the insurer’s share of the loss shrinks it. The margin isn’t a fixed number locked in at inception. It’s a moving figure that reflects the insurer’s evolving economic interest in the underlying items.
Updating the CSM Each Reporting Period
At every reporting date, several adjustments flow through the CSM to keep it aligned with current conditions. The most significant is the insurer’s share of changes in the fair value of the underlying items. If equity markets rally and the pool’s value rises, the insurer’s cut of that gain gets added to the margin. If markets fall, the insurer’s share of the loss comes out. This is the core mechanism that makes the VFA behave differently from the general model.
Changes in fulfillment cash flows that relate to future service also adjust the CSM. If updated actuarial assumptions show that fewer claims are expected than originally projected, the resulting decrease in estimated outflows adds to the margin rather than flowing straight to the income statement. The reverse applies when projections worsen. The VFA also absorbs changes arising from financial risks, such as shifts in interest rates or other market variables, into the CSM rather than recognizing them immediately in profit or loss.1IFRS Foundation. IFRS 17 Insurance Contracts Under the general model, changes in financial assumptions bypass the CSM entirely. This difference matters because it means the VFA margin acts as a buffer against financial market volatility, producing a smoother profit pattern that better reflects the long-term nature of the insurer’s management fee.
A portion of the CSM is then released to profit or loss each period to reflect the services actually delivered.
When Contracts Become Onerous
If losses from falling asset values or worsening assumptions exceed the remaining CSM, the margin drops to zero and cannot go negative. Any excess loss beyond that point must be recognized immediately in the income statement, and the insurer establishes a loss component within the Liability for Remaining Coverage. Once a loss component exists, the insurer allocates a portion of subsequent claims, risk adjustment changes, and finance income or expenses to it, based on the ratio of the loss component to total expected future outflows.
The contract group doesn’t stay permanently onerous if conditions improve. If future cash flow estimates later decrease enough, say markets recover or claim projections improve, the loss component is reduced toward zero. Once the loss component is eliminated, the CSM can be reinstated, and the contract group returns to normal profit recognition. This two-way mechanism prevents both premature profit recognition and permanent loss overstating.
Releasing Profit Through Coverage Units
The CSM is not released to profit or loss in a lump sum. Instead, the insurer allocates it over the period during which it provides services, using coverage units. At each reporting date, the insurer divides the current CSM by the total coverage units expected to be provided in both the current and future periods, then recognizes the portion attributable to the current period’s units.2IFRS Foundation. IFRS 17 Insurance Contracts
For VFA contracts, the services provided include both insurance coverage and investment-related services. The IFRS 17 Transition Resource Group confirmed that the references to “services” and “quantity of benefits” in the standard’s coverage unit guidance encompass both types of service for VFA contracts.5IFRS Foundation. Determining the Quantity of Benefits for Identifying Coverage Units In practice, this means insurers need to define coverage units that reflect the quantity of both insurance and investment management benefits being delivered in each period, a judgment that significantly affects how quickly profit flows to the income statement.
The Risk Mitigation Option
The VFA’s default treatment absorbs changes in financial risk into the CSM, deferring their profit-or-loss impact. When an insurer uses derivatives or reinsurance to hedge that financial risk, an accounting mismatch appears: the hedging instrument’s fair value changes hit profit or loss immediately, while the corresponding insurance liability changes sit quietly in the CSM. The financial statements would show volatility from the hedge without showing the offsetting movement in the insurance liability.
The risk mitigation option addresses this by letting the insurer switch off the VFA treatment for the portion of financial risk being hedged. Instead of adjusting the CSM, the insurer recognizes the relevant changes in insurance finance income or expenses in profit or loss, where they can offset against the hedging instrument’s gains and losses.6IFRS Foundation. Applicability of the Risk Mitigation Option – Non-Derivative Financial Instruments at Fair Value Through Profit or Loss
Applying the option isn’t automatic. The insurer must have a documented risk management objective and strategy that specifies the nature of the risk being mitigated, the management objective, and the hedging strategy. An economic offset must exist between the insurance contracts and the hedging instrument, meaning their values must generally move in opposite directions in response to the risk being hedged, and credit risk must not dominate that offset. The insurer must designate the relevant contracts at or before the inception of the hedging relationship, and must discontinue the option if the conditions are no longer met.
Reinsurance Held Is Never Measured Under the VFA
When an insurer buys reinsurance to cover risks on contracts measured under the VFA, the reinsurance contract itself is never measured using the VFA, even though the underlying direct contracts qualify. The insurer and reinsurer do not share in the returns on the underlying items in the way B101 requires. The reinsurance contract’s CSM instead represents the net cost or net gain of purchasing the reinsurance protection, and the insurer does not receive investment-related services from the reinsurer.7IFRS Foundation. IFRS 17 Pocket Guide on Reinsurance Contracts Held Reinsurance held is always measured under the general model, with modifications specific to reinsurance.
Annual Cohorts and the Mutualisation Exemption
IFRS 17 generally requires insurers to divide contracts into groups that contain only contracts issued within the same annual period, known as the annual cohort requirement. For most VFA contracts, this means a 2024 vintage with-profits policy cannot be grouped with an otherwise identical 2025 vintage policy. Each annual cohort tracks its own CSM, coverage units, and profit emergence separately.
This requirement has been particularly contentious for with-profits and other intergenerationally mutualised contracts, where the entire economic model relies on pooling risks across generations of policyholders. Recognizing this tension, the IASB introduced a narrow exemption: contracts with direct participation features where the entity is required to hold the underlying items and pay the policyholder an amount equal to their fair value may be grouped across annual boundaries. The exemption allows certain mutualised VFA contracts to avoid the annual cohort split, preserving the economic substance of the pooling arrangement in the accounting.