Reinsurance: turning a problem into a solution

Reinsurance under IFRS17 typically has been perceived to be another question to be addressed. Wijdan Yousuf, Milena Lacheta and Colin Dutkiewicz suggest it can also be looked at as an answer

Today, across the globe, there is an army of actuarial, accounting and IT professionals dedicated to the transformation of insurance accounting. What is promised is greater consistency and comparability in insurance contract measurement across the globe. What is expected is significant impacts on shareholder equity and profit emergence profiles upon transition. What is inevitable is the anxiety and nervousness about how to contain the fallout. All this (and more) in the context of an environment where companies are weary: budgets are stretched (the costs of Solvency II implementation still engraved in some minds); there is a shortage of skilled resource to work through the intricate issues that need to be addressed, and finally there is the fatigue that follows the continued uncertainty about where and when the final IFRS 17 Standard will land (true at the time of writing).

Flipping the question around

Within all this noise, reinsurance under IFRS 17 typically has been perceived to be just another item in the unending list of problems that needs to be addressed. While it is correct that there are several aspects of reinsurance that remain to be worked through, it is also true that considerable progress has been made by implementation projects across the industry, with several insurers now clearer on the potential financial impacts. It is therefore possible now, at this stage of implementation, for one to flip the question around: It is no longer sufficient to ask "how is reinsurance a problem?"; instead, the question should now be "how is reinsurance a solution?" 

Impacts on the date of transition

Figure 1 gives a brief overview of the potential impacts on shareholder equity positions on the date of transition from IFRS 4 to IFRS 17. Two scenarios emerge: one resulting in an equity gain and the other in an equity hit. 

Similarly, Figures 2 and 3 illustrate two scenarios that may emerge in respect of the impact on the profit and loss statements.

Developing solutions

Once a company has a clearer picture of the financial impacts of IFRS 17, it will be able to make an informed decision as to which problems it would like to address. Here is a list of typical concerns that have emerged which can be addressed using reinsurance solutions:

• 'Lost profits' (see Figure 2) - some companies want these profits to be reinstated (particularly in countries where current reserving methodology has very high levels of prudence). In theory, the idea is simple: the insurer needs to enter into a reinsurance arrangement that is a net-gain contract (i.e. the reinsurance premiums payable are less than the reinsurance recoverables) hence increasing the (expected) level of profits recognised in the future. In practice, the arrangement would have to take account of commercial realities to reflect that the reinsurer would also want to make profits for the risk it agrees to take on. 
  
  
• 'Equity hit at transition' (see Figure 1) - typically (but not necessarily) driven by the opposite concern to lost profits, this is a worry more commonly expected in the UK and Irish markets. Here, the issue stems from unacceptably large equity impacts emerging. The reinsurance solution here would be effectively a mirror reverse of the 'lost profits' solution, and would begin by requiring the insurer to enter into an arrangement that is a net-cost contract. As above, the actual arrangement would then be made more sophisticated to reflect the fact that simply ceding away future profits is hardly an innovative solution.
  
  
• 'Accelerating profits' - companies are keen to accelerate profit recognition after the date of transition. While changing coverage unit definitions can address this, entering into a reinsurance arrangement can drastically increase the scope of what is possible as it enables companies to target the precise shape and level of the accelerated profits. This will particularly appeal to annuity writers, which will lose the ability to recognise large day 1 profits after the introduction of IFRS 17 (consider Figure 3 but from time 0), but will also be relevant to any company that wants to supplement methodology-based solutions with the 'fine-tuning' made possible by reinsurance. The solution here would begin from the premise that the reinsurance arrangement needs to cover different blocks of underlying business and then worked up into a robust mechanism that can be used to achieve the desired levels of profits. 
  
  
• 'VIF securitisation' - while less popular deals since the introduction of Solvency II, some companies are still interested in these transactions for various commercial and strategic reasons. The problem under IFRS 17 to date has been that the CSM already reflects all relevant cash inflows and outflows. Consequently, day 1 gains cannot be recognised in the P&L immediately and rather must be spread over the lifetime of the group of contracts. However, a close look at the Standard suggests that this may be too quick; IFRS 17 may not necessarily mean the death of VIF transactions.
  
  
• 'Calibrating fair value CSM' - the sheer amount of judgment required to apply the fair value approach and gain auditor approval is likely to be an onerous task to be faced by several companies that are unable to apply a full or modified retrospective approach. Reinsurance arrangements may help to support the determination of the fair value of liabilities.

We note that for these and other problems, some solutions are likely to take the form of derivatives rather than reinsurance contracts - the main attraction of derivatives being the ability to recognise changes in their fair value in the P&L immediately, rather than having to spread them through a CSM. 

We also note that while the examples and illustrations provided above are more relevant to life insurers, similar concerns emerge for non-life insurers, for which solutions are modified slightly to reflect the differences between life and non-life.

Uncharted territory

The need for specialised reinsurance solutions has never been greater - up until now, reinsurance has been a cornerstone of sensible risk and capital management. With the introduction of IFRS 17, reinsurance increasingly will begin to be used for opening-up superior P&L management possibilities.

However, with opportunities come risks. 

The solutions introduced briefly here are largely untested in the market - a lot of collaborative work is being undertaken to ensure the solutions deliver 'what they say on the tin', and that there are no nasty surprises from auditors and regulators. 

As the 'go-live' date inches closer, the window of opportunities for companies interested in many of these solutions will forever close - transition is a one-off exercise that proactive and well-prepared companies fully intend to capitalise on (pun intended); the next time this opportunity might arise is at least a decade or two from now.

Wijdan Yousuf is a capital solutions actuary at Aon, and chairs the IFoA IFRS 17 CSM Working Party. 

Milena Lacheta is Global IFRS 17 Lead at Aon.

 

Colin Dutkiewicz is Global Head of Life at Aon, and chair of the IFoA Life Practice Area Board