Wednesday, November 9th, 2022
Michael Winkler, actuary and Sunil Kansal FCA, head of consulting at Shasat Consulting highlight some of the key financial reporting changes as a result of the transition to IFRS 17 Insurance Contracts
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 licensed 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 (eg.,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 more 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’. Many insurance accounting regimes have tried to stabilise their financial statements over the years; therefore, they calculated their reserves based on historic information: locked-in assumptions for insurance parameters as well as historic interest rates.
The latter, however, is 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.
IFRS 17 is introducing two different buffers to dampen result volatility:
• the risk adjustment for actual versus expected claims and expense fluctuations; 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 businesses (with-profit products and unit-linked businesses), the contractual service margin is also supposed to absorb changes in the so-called ‘variable fee’, ie, 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 (OCI) directly into the equity.
Choices for the companies
If in a stable interest rate environment, everything runs as expected, the results are entirely driven by the releases of risk adjustment and contractual service margin; 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 ‘contractual service margin’), but only some high-level principles; therefore, companies must make a choice which hopefully is based on a thorough quantitative analysis of the earnings patterns stemming from the different options.
Other important choices refer to the starting balance sheet (‘financial position’) at the introduction of IFRS 17 – particularly the contractual service margin 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 contractual service margin 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 contractual service margin, which will be released as profits over the remaining life of the portfolio.
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 latest issue that the International Accounting Standards Board’s (IASB) technical committee had to consider was how to account for insurance contracts that generate cash flows in more than one currency.
The question was 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 Effects of Changes in Foreign Exchange Rates to 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 which 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 which 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!
About the authors
Michael Winkler, actuary and Sunil Kansal FCA, head of consulting at Shasat Consulting