Tuesday, December 17th, 2024
The insurance contracts standard requires important choices to be made that can have significant impact on company financial statements creating volatility in results, and need to reflect commercial practices, argue Shasat’s Michael Winkler and Sunil Kansal FCA.
IFRS 17 Insurance Contracts requires a much higher level of detailed information than any existing accounting standard and any regulatory framework including Solvency II. Portfolios must be split depending on their type of business, their expected profitability, and their respective underwriting year. This split has to be maintained for many years.
The priority for many companies is, therefore, to enable their IT systems to provide and ‘maintain’ the required granular data. This is a very challenging task on its own but there are other implementation challenges.
IFRS 17 is a principle-based standard. Therefore, many parts are not prescriptive, and companies can make various choices on the detailed implementation. However, the final outcome – the future annual results – will heavily depend on these choices.
Most companies try to mitigate result volatility as much as possible. There are several sources for result volatility in IFRS 17, starting with the grouping of contracts. The standard requires entities to keep onerous contracts separately and to recognise losses immediately so that there is no room for cross-subsidy.
Furthermore, discounting with current rates can be a source of significant volatility. For participating businesses, the so-called ‘variable fee approach’ can mitigate this volatility up to a certain degree with the contractual service margin (CSM) serving as a buffer for interest rate movements.
The authors of IFRS 17 would argue that the CSM is, in general, supposed to reduce profit volatility. However, compared to a standard with locked-in assumptions, IFRS 17 is expected to produce more volatile results, despite the CSM.
An important objective of IFRS 17 is to make the insurance business comparable to other businesses, treating components that are the same as in other businesses consistently and separate from the insurance contract.
This concept applies to services that are not an integral part of the insurance cover provided. It applies also to investment components.
Splitting out investment components that are also available without insurance (e.g. fund investments) is straightforward. However, there are other investment components which can only be identified as amounts are paid independent of any insured event.
The basis for the insurance contract liabilities are the discounted expected future cash flows. Expected cash flows are equal to best estimate cash flows only in the case of symmetric distributions. For other distributions, stochastic simulations (projections based on a set of random values) would be an adequate way to determine them.
This is a major challenge in practice. Accounting statements must be consistent over time as any variation flows through the results. However, stochastic simulations depend on random generators and tend to deliver inconsistent results over time.
Furthermore, they are difficult to audit. A better approach may be to capture the most relevant dependencies in tables (produced based on stochastic calculations) and use those for the periodic statements.
The yield curve for discounting is another challenging item. Companies normally aim for minimising the gap between the impact of market movements on the liabilities and the corresponding impact on the value of the corresponding assets, as this would be another source of volatility. However, asset liability management (ALM) is never perfect and many asset classes cannot be properly reflected in a yield curve.
The CSM at the inception is determined in a way that there is no initial gain. The amortisation runs in line with the so-called ‘coverage units’ reflecting the extent of services provided.
There is not much guidance for the calculation of these; however, the intention seems to be that they are based on pure volume measures (e.g. total sum insured, premiums, etc). They can also include investment services, allowing earlier profits for deferred annuities without risk cover in the deferment period.
In the variable fee approach, the investment yield is flowing into the CSM, leading to a potential deferment of profits. The coverage units should reflect that, leading to higher CSM releases in early years.
If all future cash flows are in line with the initial expectations, the annual insurance results are entirely driven by the CSM and risk adjustment releases. Therefore, a careful check of alternative concepts should be done before taking decisions.
IFRS 17 requires an explicit margin for insurance risk, the so-called risk adjustment (RA), reflecting the risk appetite of the company.
There is little guidance on how the RA should be calculated; the standard only contains qualitative statements. On the other hand, the corresponding quantile has to be disclosed. This seems to require stochastic simulations which, however, should rather be replaced by tables (see above).
Reinsurance assumed is treated exactly like primary insurance. However, ‘reinsurance held’ is causing additional challenges. Reinsurance held is booked separately from the underlying business, because primary insurance payments are never reduced due to any failure of a reinsurer to pay their part of the claims.
The actual challenges arise from a series of significant mismatches between the underlying business and the corresponding reinsurance held.
One of the biggest challenges is the transition to IFRS 17. This process determines equity and CSM at transition and therefore future results.
The most appropriate approach for the transition is the retrospective application of IFRS 17. However, this is very challenging in practice and may simply not be possible for certain portfolios.
Therefore, some simplifications may be used (modified retrospective approach) or the fair value approach. The expectation of the International Accounting Standards Board seems to be that the most recent business is fully retrospective (as the standard is known for a couple of years) and the fair value approach is used for very old business only.
Given its impact, managing the transition well should have high priority.
IFRS 17 requires a lot of decisions on items having a major impact on future results. Companies should check alternative concepts before coming to any conclusions.
The transition has to be handled carefully as it determines IFRS equity and CSM at the start date, with a big impact on future results and an even bigger impact on future return on equity.
Michael Winkler is an actuary (SAA/DAV) at Shasat Consulting and previously in leading actuarial positions at Swiss Re, Munich Re/New Re and Winterthur Group. Sunil Kansal, head of consulting at Shasat, is an FCA chartered accountant
Read More: IFRS 17: what are the actuarial challenges of insurance standard?
