The complexity of the insurance business is both highlighted and exacerbated due to the presence of multiple reporting standards across the globe—statutory accounting for US mutual companies, US GAAP accounting for publicly traded US companies, C-GAAP for Canadian
insurers, and disclosure requirements with respect to Solvency II for EU insurers. Each standard serves a different purpose but leads to difficulties in analyzing an insurer’s financial position by various stakeholders. The International Financial Reporting Standards (IFRS) are
issued by the International Accounting Standards Board (IASB) to e hance comparability of accounting statements across international boundaries.
The current IFRS 4 allows insurers to use their jurisdictional accounting rules to report the value of the insurance contracts. IFRS 17, published in May 2017, represents efforts by the IASB to increase insurance accounting consistency and transparency globally. Although the US is not expected to adopt IFRS, the impact is still likely to be significant, particularly for investors, as they may be forced to compare varying accounting results. The effective date of IFRS is currently January 1, 2021; however, companies will have to restate 2020 results under the new standard for comparability.
Separation of Underwriting and Financial Performance
The IFRS 17 proposal attempts to separate an insurer’s underwriting results from the financial (non-underwriting, investment-related) results that comprise investment income and other financial expenses not related to insurance operations. These calculations could provide for better insights into the underwriting performance and comparisons between insurers for stakeholders.
Insurers’ results have the potential to become more volatile, as IFRS 17 requires the use of current market discount rates. At present, many insurers discount future cash flows from long-term insurance contracts with discount rates adopted at inception. These discount rate assumptions are often not unlocked. Under IFRS 17, however, the periodic reassessment of the liabilities using up-to-date discount rates may result in greater volatility of financial results. Insurers with well-established ALM strategies may be less affected than those who take on greater ALM risk.
IFRS 17 Introduces Several New Concepts to the Balance Sheet
Under IFRS 17, an insurer’s balance sheet will reflect the insurance liability as the sum of three components: expected Present Value (PV) of cash flows, Risk Adjustment (RA), and Contractual Service Margin (CSM).
The PV of cash flows will reflect future inflows and outflows on a best estimate basis at a particular point in time. Insurers may need to re-think the cash flows that can be allocated to the contract. Determining the expected value of cash flows on a probability-weighted basis may lead to the use of stochastics, especially to capture values of policyholder options and guarantees. US GAAP practices have involved primarily deterministic scenarios. Under IFRS 17, the liability must be established to fulfill the contracts, requiring demonstration of cash flow asymmetry when embedded options are present.
The RA is similar to a risk margin or compensation to capture the potential for adverse deviation.
Typically, the RA would be stochastic, but IFRS 17 is not prescriptive as to the methodology. It does, however, mandate that whatever methodology is used, a confidence level relating to the reported RA should be disclosed, to enable comparisons between insurers. Insurers using Solvency II approaches may be able to leverage some of the paradigms into IFRS 17.
The CSM is established if the PV of cash flows and the RA result in profits and is released over time, reflecting the temporal pattern of insurance cover provided. Similarly to the periodic changes in discounting rates, IFRS 17 requires insurers to unlock the CSM for changes in assumptions at each reporting period.
Earnings Patterns Significantly Altered Under IFRS 17
In IFRS 17, assumption changes affecting the CSM emerge into profit over the remaining contract term, whereas US GAAP produces an element of immediate earnings impact through retrospective unlocking (normally identified separately in the narrative), and consequently a lesser impact on future earnings. The CSM under IFRS 17 will serve as a buffer to offset favorable or unfavorable changes in future profit patterns. Under IFRS 17, profits/losses are recognized up front (if related to past cover) and spread over the remaining contractual service period (if related to future cover) through the CSM. US GAAP adjusts back-loaded statutory reporting surplus emergence (or ‘profit’) to target a more level profit profile.
Significant Rating Changes Not Expected
- M. Best’s rating process looks at various accounting regimes to capture an economic view of insurers. We recognize the volatility that could be caused by accounting mismatching and incorporate these into our assessments. In addition, as insurers enhance their reporting metrics and calculations, we incorporate some of these enhancements as added bases for our assessments, to the extent these provide us with an additional or improved lens to look at insurer performance.
Implementation is Complex and Will Carry Operational Risk
The complexity of the systems requirements to adapt to IFRS 17 may result in significant effort to build links across actuarial, finance, and accounting systems. This cannot be understated, as some of the insurers affected by this rule operate globally under varying economic conditions and are already strained by compliance with a number of other regulatory and accounting regimes.
We do expect insurers to prepare for the 2021 deadline well in advance and will monitor the operational risk accompanying such large implementations.
