Garry Smith and Richard Purcell investigate what the new accounting standard, IFRS 17, means for the insurance industry
In just over three years' time on 1 January 2021, IFRS 17 will come into effect as the new accounting standard for the insurance industry. To demystify what the new standard means and understand the implications for the industry, The Actuary has spoken with leading experts in the life insurance sector.
Those who have followed the development of the new accounting standard will know that the insurance industry is the only industry where there is no current International Accounting Standard Board (IASB) global standard for accounting. Kamran Foroughi, director at Willis Towers Watson, explains: "The existing standard, IFRS 4 Insurance Contracts, permits legacy country practices. IFRS 4 came into effect on 1 January 2005 and was designed as an interim standard, but the IASB has, in the past, made clear that it was not a long-term solution."
The new accounting standard will apply to both life and general insurance contracts as well as reinsurance and with-profits contracts, but, as Dominic Veney, partner at PwC, explains: "IFRS 17 only applies to insurance contracts. There are lots of 'life' contracts that are pure investment business - for example, some unit linked business. These changes do not impact this business. So the extent of change will also be impacted by the mix of insurance and investment business on the balance sheet."
The new standard
Under IFRS 17, the total liability for an insurance contract is the sum of a best-estimate liability, a risk adjustment, and a contractual service margin (CSM). Actuaries will already be familiar with the idea of projecting best estimate cashflows, and, in calculating a present value, the discount rate can also make an allowance for an illiquidity premium. For contracts where the value of the liabilities depends on the value of the assets, the liability discount rate should reflect the expected return on the assets.
An additional liability, the risk adjustment, needs to be held to reflect the fact that the projected cashflows are not certain. The third element of the liability is the CSM. This is calculated at inception, so as to ensure that the insurer makes no profit at the point the contract is written. It is calculated as a balancing item: equal to the difference between the initial premium received and the sum of any day-one cashflows paid out (for example, acquisition costs), the best-estimate liability and the risk adjustment.
The CSM is gradually amortised over the lifetime of the business. As it reduces from one year to the next, these reductions come through as profit. The aim is that profit is earned smoothly over the lifetime of the business, rather than on day one. However, any losses must be recognised completely on day one.
Dominic Veney puts this into context: "In the UK, we currently have a lot of capitalising of profit for long-term business on day one (that is, when the contract is sold), with future profits arising due to the release of prudent margins over time, as well as any economic and demographic variances. IFRS 17 does not allow day-one profits, rather these will be spread over the expected life of the contract via the CSM, so you will potentially see insurers having to put some profits on the balance sheet in terms of CSM that had already been reported."
Differences with Solvency II
The question many will have, particularly after just completing their Solvency II (SII) projects, is: 'How similar is the IFRS 17 balance sheet to SII?' Richard Olswang, head of finance actuarial at Prudential, says: "There is a perception among many stakeholders that, to implement IFRS 17, companies can simply take their SII systems and processes and add on a CSM and therefore the requirements are not that complex - but actually this is far from correct. Yes, both SII and IFRS 17 include a best-estimate liability (BEL), but there are a number of potential differences. For example, under IFRS 17, detailed and granular output will be required from the actuarial models to support the calculation of the CSM and the production of disclosures, and multiple model runs will be required to perform calculations using locked-in (issue date) discount rates. Also, there will be differences in economic assumptions and possibly in expense assumptions and contract boundaries. In addition, the IFRS 17 results will need to be completed in shorter timeframes than under SII. This all leads to a requirement to re-engineer the actuarial models."
Olswang explains that CSM is a completely new concept, and, for the first time, firms will have to carry out retrospective calculations. He adds: "They will need to calculate the CSM at a granular level, store the results and reference them in future periods. There are not many precedents for this and firms will need new data storage capabilities. The calculations could be carried out in the general ledger, in the actuarial models or in some form of data warehouse. Whatever form this calculation engine takes, there will need to be controlled data flows between the CSM engine and the actuarial models, finance systems and admin systems."
Stephen Makin, partner at Hymans Robertson, suggests that it may also not be just a matter of setting the risk adjustment equal to the SII risk margin. "The risk margin has been widely criticised by the industry, particularly with regards to both how large it is and how sensitive it is to interest rate movements. It seems unlikely that firms will want this level of volatility feeding into their IFRS results, albeit that the very real prospect of post-Brexit rule changes - emboldened by the recent Treasury Select Committee report on SII - may very well help here in the UK."
Implications for running the business
The new accounting standard will probably change the way insurers manage their balance sheet, and one area could be hedging. Foroughi explains: "When matching assets and liabilities, companies must first choose the key matching metric used; it is not possible to simultaneously match to more than one metric. SII and IFRS 17 both create greater differences between profit, cash and solvency metrics, creating a dilemma for insurers - which metric to manage to? This is already a challenge today - for those insurers that today decided to match to current IFRS profits (typically on a Solvency 1 basis), they may wish to revisit. Those insurers today matching to other metrics are unlikely to match to IFRS 17 when it comes in."
Pricing and product development is another area where the new accounting standard could bring about change. Makin explains: "We would expect most firms to be thinking about how their pricing structures will look from an IFRS 17 perspective. The new standard is likely to result in more questions being asked of pricing teams particularly for model points that result in onerous or potentially onerous contracts. The change in the profit signature could also result in a greater preference among insurers to write shorter-term business that does not defer profits over such a long period of time."
Overall though, Veney believes the changes will not result in a significant change in business models: "We expect there may be some who look at the changes in reported profitability and seek to tweak products, but we aren't aware of anyone looking at fundamental changes to date. Really, the standard will change the timing of recognition of profits - not the underlying profits themselves."
When it comes to the challenge of implementation, Olswang says that, as IFRS 17 is principles-based, it includes a number of accounting policy choices. He adds: "Firms will need to decide how they interpret the principles and exercise the options, taking account of both operational and financial implications. It will be essential that the various options are thoroughly tested before the approach is finalised." Olswang also believes this is an opportunity for firms to perform a fuller review of their finance and actuarial systems strategy: "Firms will need to ask themselves whether they should aim for minimum compliance or consider a more fundamental review of systems and processes. Management will be seeking a tangible benefit that justifies the very significant implementation costs."
When asked if there are any lessons that can be learned from the recent SII implementation, Veney agrees, adding: "Companies I talk to are really trying to plan more effectively, identify working assumptions early and understand where plans need to flex as these develop, and to secure resources now for the project to avoid the squeeze at the end that we saw on SII."
Foroughi also agrees and explains that: "The key lessons are to start early, but do not do too much too early, and keep options open as long as possible. Do not become over-reliant on particular individuals - there will be a squeeze on experts!"
However, there remain some different implementation challenges compared with SII that firms will need to factor in, as Makin points out: "While SII challenged insurers to 'look through' to the individual securities held in collective investment schemes on the asset side of the balance sheet, a key practical challenge of IFRS 17 is the grouping of contracts for the purpose of calculating liabilities. Many insurers will still battle with having numerous systems, and be challenged in integrating them." Overall, the relative size of the IFRS 17 implementation challenge is large. Foroughi explains: "It will vary by company, country, product, and be systems dependent. The cost range could be anywhere between 20% and 150% of Solvency II."
IFRS 17 has been developed with the intention of making insurance easier to understand for investors, and therefore increase the capital flows into the industry. But will the new standard achieve what it set out to do? Foroughi believes that: "Equity analysts currently following insurance have not got their head round IFRS 17 or thought of the implications - which is not surprising given the industry hasn't either. For current sell-side and buy-side analysts, this will create issues and a lack of understanding in the short term post-2021, like we had with Solvency II in 2016/2017 and existing IFRS in 2004." However, in the long term, Foroughi is more optimistic: "Having one global approach (US GAAP excepting) may help attract a new generalist buy-side investor pool, many of whom do not invest in the insurance industry currently." But he warns: "They are likely to be far more interested in insurer strategies and growth prospects more generally, with the accounting approach being of secondary importance, particularly given that the IFRS 17 approach is complex."
Makin adds: "As with any new metric, companies will be very keen to explain to the analysts how IFRS 17 results should be interpreted. Insurers will have an internal view of the economic attractiveness of the business ,but the IFRS dynamic could have an effect on where they choose to deploy their capital. Companies should do what they see as economically important and work with the analysts to explain this against the backdrop of the IFRS 17 numbers."
Olswang explains: "Proponents of IFRS 17 assert that there is currently little consistency or comparability under IFRS 4, between or even within companies. So, IFRS 17 could be perceived as a step forward, and it might appear difficult to argue with that conclusion. However, the standard (for example, the granularity in the way the CSM is determined) is not consistent with existing insurance business models and is overly complex.
"IFRS 17 will also result in a number of accounting mismatches (for example, in relation to hedging and reinsurance). So companies may still need to use non-GAAP measures to explain performance to users."
He sums it all up nicely with an analogy: "No one has pulled it all together and tested what it means in aggregate. It is like building a plane. The parts have been assessed individually, but the plane has not been test flown."
Olswang concludes: "After 20 years in the making, the jury is still out. Will the benefits exceed the very significant costs of implementation, and will IFRS 17 help explain performance to users?"