IFRS 17 – on the home straight
Insurance companies around the world have less than six months before IFRS 17, the new standard for ‘insurance contracts’, becomes effective.
This reporting standard was issued in 2017 after more than a decade of development time and will become mandatory for annual reporting periods beginning on or after 1 January 2023. It applies to any organisation that issues insurance and/or reinsurance contracts – not just to licenced insurance and/or reinsurance companies.
It affects all listed insurers in Europe as well as all insurance companies in several jurisdictions with IFRS as a mandatory insurance accounting regime (e.g. Australia, Canada, South Korea, Spain, many countries in Central Eastern Europe, the Middle East, Africa, the Caribbean etc.).
For insurers, applying IFRS 17 will result in major changes to their financial statements and key performance indicators, such as replacing the familiar major income position ‘Gross Written Premiums’ with ‘Insurance Revenue’.
Presentation, however, is only a minor part of the changes which aim to make the financial statements more transparent and more comparable to other insurance companies and, wherever applicable, to other industries. For the latter, investment components represent an important part of the insurance premiums, particularly in life insurance products. The investment components of the premiums should no longer be part of the turnover, in line with bank revenues not containing any deposits.
Insurers will also have to get used to the familiar ‘Insurance Claims Payments’ now being represented as ‘Insurance Service Expenses‘. Claims payments are indeed the most important service an insurance company provides to its customers.
New measurement: Volatility
The more fundamental changes affect the measurement of future services (previously termed as ‘Reserves’. In most countries, insurance accounting regimes have tried to stabilise the financial statements over the years. Therefore, the companies calculated their reserves based on historic information: locked-in assumptions for insurance parameters as well as historic interest rates.
The latter, however, are not in line with the use of market values for the asset side of the balance sheet which is now perceived as the only fair-value representation for the different stakeholders. Therefore, the measurement of the liabilities in IFRS 17 will always be based on current assumptions.
Due to the compound effect over many projected years, the regular update of assumptions (particularly interest rate or discounting assumptions) can make long-term liabilities much more volatile. Fortunately, this affects other countries more than Australia where current rates have been already used for many years.
IFRS 17 is introducing two different buffers to dampen result volatility:
- the Risk Adjustment for non-financial risk (actual vs expected claims and expense fluctuations) which is put on top of the best estimate liability; and
- the Contractual Service Margin (CSM) for changes in actuarial assumptions. (However, the CSM is only introduced for the Liability for Remaining Coverage; for the Liability for Incurred Claims, any changes of assumptions flow directly through the Profit and Loss Statement.)
For direct participating life businesses (with-profit products and unit-linked businesses), the CSM is also supposed to absorb changes in the so-called ‘variable fee’, i.e. the shareholders’ part of the corresponding investment returns. Changes in discount rates, however, flow either through the Profit and Loss Statement or through ‘Other Comprehensive Income’ directly into the equity.
Choices for the companies
If, in a stable interest rate environment, everything runs as expected, the results for long-term business are entirely driven by the releases of Risk Adjustment and CSM; therefore, these two items will shape the profit pattern for any long-term insurance business. IFRS 17 does not provide an explicit definition for the two items (Risk Adjustment and CSM), but only some high-level principles; therefore, companies must make a choice that is hopefully based on a thorough quantitative analysis of the earnings patterns stemming from the different options.
Another important driver for the results is the grouping of the business.
IFRS 17 tries to avoid any cross-subsidy between different cohorts or businesses: losses in a particular business shall not be compensated by profits in other businesses but be recognised as a loss immediately (for the whole lifetime). The way you group the business is therefore important for the recognition of losses for ‘onerous groups’ and the companies have some freedom in how they group their business.
Other important choices refer to the starting balance sheet (‘Financial Position’) at the introduction of IFRS 17 – particularly CSM at the transition date (all other items are calculated according to the IFRS 17 principles, based on prospective cash flows). Ideally, IFRS 17 could be applied retroactively for a given group of contracts for all years from inception to the transition date.
However, in many cases, this is practicable only for cohorts starting in the most recent years when all requirements of the new standard have been known. Otherwise, companies can choose to apply some simplifications (‘Modified Retrospective Approach’) or derive the CSM from the fair value (‘Market Price’) for a given block of business. If a company chooses the Fair-Value Approach, they probably want to achieve a maximum CSM which will be released as profits over the remaining life of the portfolio.
Multi-currency groups of insurance contracts
The pace of critical questions from the insurance industry has not slowed down. Consequently, we may expect to see more amendments to IFRS 17 in the near future. The most recent issue that the IASB’s technical committee had to consider was how to account for insurance contracts that generate cash flows in more than one currency. Whether an entity considers currency exchange rate risks when applying IFRS 17 to identify portfolios of insurance contracts and how an entity applies IAS 21 in conjunction with IFRS 17 in measuring a group of insurance contracts that generate cash flows in more than one currency? IFRS 17 defines financial risk and insurance risk (a non-financial risk).
As per the definition in IFRS 17, the financial risk also includes currency exchange rate.
The requirements in both IFRS 17 and IAS 21 refer to transactions or items that are denominated or require settlement in a single currency. It would create a tricky issue for insurers measuring a group of insurance contracts that are in multi-currency.
Priorities in the last phase
For many companies, IFRS 17 has mainly been an ambitious IT project so far: data storage and maintenance are indeed playing a crucial role in the implementation of the new standard. However, given the principle-based nature, there are a lot of choices that have a major impact on the future results of the companies. These choices must be made based on a thorough quantitative analysis: if they have not been finalised yet, now is the very last chance to get it right!
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