IFRS 17: A Challenge ahead for Insurers
The International Accounting Standard Board (IASB) issued IFRS17 in May 2017, with an original effective date for the annual period beginning on or after 1 January 2021. However, the effectivity date has since been shifted to reporting dates beginning on or after 1 January 2023.
IFRS 17 has been in development for more than 20 years and will result in a complete overhaul of accounting for insurance contracts and the way the insurance industry reports its financials. This standard supersedes IFRS 4, which is the current accounting standard applicable for insurance contracts accounting.
Why there is a need to transition to IFRS 17?
Current insurance accounting practices are quite diverse because they have been more driven by the regulatory requirement as allowed by IFRS 4. IFRS 4 served as an interim standard that allowed entities to use a wide variety of accounting practices for insurance contracts across jurisdictions, making it difficult for investors to evaluate and compare results between insurance companies and even to other industries (i.e. different revenue recognition principle).
The issuance of IFRS 17 is a breakthrough event for the insurance industry. This is because, for the very first time, there is a common global accounting guideline for insurance contracts. IFRS 17 will provide increased transparency and greater comparability about the insurance companies’ financial stewardship and performance. This is due to the consistent accounting framework concerning recognition, measurement, presentation, and reporting of insurance contracts that will be introduced by this new accounting standard. Early application of IFRS 17 (Insurance Contracts) is permitted, provided that IFRS 9 (Financial instruments) and IFRS 15 (Revenue from contracts with customers) are also applied.
IFRS 17 will be applied to insurance contracts, including reinsurance contracts, issued by the insurance companies; reinsurance contracts held; and investment contracts with discretionary participation features, provided that the company also issues an insurance contract.
With the forthcoming effective implementation of IFRS 17, there will be a gradual change in terms of accounting of insurance contracts. With this new requirement, insurance companies need to revisit various processes that are involved for insurance contracts accounting and reporting, as the new standard will have a significant impact. Adjustments will not just be required in the accounting process, but also in the preparation of data sets (actuarial expectation), IT systems and employee skillset. Some of the new requirements of IFRS 17 are the following:
a. Unit of account – IFRS 17 requires a level of aggregation, which determines the measurement and presentation. As a starting point, IFRS 17 suggested to group those insurance contracts that are managed together and are subject to similar risk. Identifying insurance contracts that are subject to similar risk will require a matter of judgment for insurance companies. These will then be group according to profitability buckets: (a) onerous at initial recognition, (b) no significant risk of becoming onerous and (c) all remaining contracts. The grouping of insurance contracts based on profitability was established to avoid the offsetting of profitable and unprofitable contracts, as this will provide more useful information to the management for making pricing decisions. Furthermore, the grouping of insurance contracts issued more than one year apart is prohibited by the standard. No subsequent reassessment for the group composition will be allowed once the grouping is established on initial recognition.
b. Measurement models – IFRS 17 introduced three measurement models: First is the general measurement model, a default approach for measuring the groups of insurance contracts. This model is composed of the following building blocks: (a) future cash flow estimates within contract boundary; (b) adjustment for the time value of money; (c) risk adjustment related to non-financial risks; and (d) contractual service margin. Second is the premium allocation approach, the most simplified among the measurement models available and mostly applicable to the short-term group of an insurance contract. This measurement model does not require separate identification of the components of the general model until the incurrence of the claim. The adaption of this measurement model is optional for each group of insurance contracts that meet the eligibility criteria. Lastly is the variable fee approach, which applies to a group of insurance contracts with direct participation features. This approach is a modification of the general measurement model, as the contracts qualifying for this approach lack insurance risk.
c. Revenue recognition principle – Insurance revenue should be recognized as services are provided/performed by the insurance companies to policyholders. That will mean that as a basic revenue recognition concept of IFRS 17, no profit should be recognized to profit or loss during the initial recognition. However, the loss must be recognized immediately if the group of an insurance contract is onerous.
d. Contractual service margin –The fourth element of the building block in the general measurement model. This represents the unearned profit for a group of insurance contracts that will be recognized by the insurance company as it provides services in the future within the coverage period. Estimates for fulfillment cash flows are re-measured every accounting period, certain changes to fulfillment cash flows related to the future services will likewise adjust the contractual service margin and to be recognized in profit or loss over the remaining coverage period.
e. Coverage Units – Coverage units determine how the contractual service margin (CSM) is recognized as profit or loss for each reporting period. The coverage units reflect the quantity of coverage provided by the contracts determined by the number of benefits provided during the expected coverage duration.
f. Deferred acquisition cost – No separate asset should be recognized for deferred acquisition cost, it is subsumed into the insurance liability for remaining coverage balance instead. For a group of insurance contracts applying premium allocation approach, an accounting policy option is available: (a) to recognize insurance acquisition cash flows as an outright expense to profit or loss; or (b) to be included within the liability for remaining coverage and subsequently amortized to profit and loss over the coverage period.
g. Separation of distinct components – Insurance contracts that may contain one or more components such as embedded derivatives, distinct investment components or promise to provide distinct goods and non-insurance services are required to be separated from host insurance contracts and should be accounted by other applicable IFRS (i.e. IFRS 19; IFRS 15).
h. Risk mitigation option for direct participating contracts – This allows the insurance companies to recognize the effect of some changes in financial risk for direct participating contracts in profit or loss rather than as a contractual service margin adjustment, provided that all of the criteria are met. This approach will help to reduce accounting mismatch for insurance companies who are using derivatives for example to mitigate the financial risk arising from the direct participating contracts that it issues.
i. Other comprehensive income options – Insurance companies have an accounting policy choice between (a) including entire finance income and expenses in profit or loss; or (b) disaggregate the finance income and expenses between profit or loss and other comprehensive income. The policy choice election is per portfolio of insurance contracts (grouping).
j. Transition approach – Insurance companies are required to apply the new standard retrospectively. That will mean that the balances at the beginning of the period immediately preceding the date of initial application of IFRS 17 are required to be restarted to present an IFRS 17 comparative information using the full retrospective approach. However, applying the full retrospective approach will be a major challenge to insurance companies due to the availability and quality of historic data. To address this concern, two alternative transition approaches were provided by the standard should the full retrospective approach be impracticable to apply: (a) the modified retrospective approach that will achieve the closest outcome of a full retrospective application using reasonable and supportable information without undue cost or effort or (b) fair value approach.
Challenges to insurance companies
Moving forward, the worldwide implementation of IFRS 17 will likely result in massive changes in the insurance industry forever and it will vary from company to company and by region. Some of the challenges faced by insurance companies in the implementation of IFRS 17 are the following:
1. Data granularity - The challenges faced by insurance companies are not only confined to the accounting or reporting aspects, but are also related to actuarial data, which will require more granularity and strict control. Areas such as the grouping of insurance contracts for measurement purposes will require to be more defined on a specific granular level.
For a group of contracts that are onerous at initial recognition, it will require the insurers to identify and account for the onerous business. Overcoming this challenge will require the implementation of a solid insurance data foundation and sound data integration techniques.
2. Increased balance sheet volatility - Valuation of assets and liabilities in IFRS 17 will be based on market values rather than the book values, hence balance sheets could fluctuate more with market conditions. Companies will be required to upgrade their ALM capabilities to better manage the ALM mismatches.
3. Discount rate determination - Under IFRS 17, insurers are required to determine discount rates to reflect the time value of money and financial risks while calculating the insurance liabilities. As such, it can have an impact on the operational and financial aspects of the business. The financial impact can arise due to the magnitude of contractual service margin released in profit or loss due to the interest accretion on contractual service margin and adjustments to contractual service margin on account for changes in future estimates, which are measured at locked-in discount rates. At the same time, current discount rates will be used to measure the present value of cash flows that will be shown in the balance sheet. Hence, an appropriate selection of discount rates has to be done.
4. Pricing strategy - The portfolio construct in IFRS 17 will result in onerous contracts to be separated from profitable ones. For onerous contracts, a loss will be recognized and the same cannot be netted off against the profitable contracts. This will present as a challenge to the insurer’s pricing strategy of insurance contracts.
5. Tracking and amortization of contractual service margin (CSM) - The contractual service margin has to be amortized over the coverage period and on a systematic basis that reflects the transfer of services provided under the insurance contracts. Insurance companies may face challenges on amortization policy choice, as the same will impact the profit emergence together with the changes in the discount rates and insurance companies will be required to track these changes.
6. The granularity of data from the actuarial process - This will be a significant challenge for most insurance companies, as the actuarial system has to be capable of providing the level of granularity required by IFRS 17, with focus on cash flows. These expected cash flow calculations will eventually drive revenue and profitability through the release of risk adjustment and CSM.
7. Quality of historical data for transition - IFRS 17 requires insurance companies to place a greater focus on the quality of data when the same is being used for transition to the new standard. The transitional data may have a large impact on equity and reported profits for many years after the date of the initial application.
What is next for insurance companies?
Overcoming the above challenges will require insurance companies to have a connected reporting platform, as this standard will be a major change program extending beyond the finance and actuarial teams. There can be many approaches to overcome the challenges and to comply with IFRS 17 implementation. Some are:
1. Leverage the existing system - This approach is based on existing data, processes, and systems. The current actuarial system can be enhanced to produce the CSM calculations and related data and results. Existing finance systems and IT solutions can be further enhanced to cover specific accounting and reporting requirements as required by the new standard. This approach may be the easiest one, but may not meet the future IFRS 17 requirements.
2. Integrated IFRS 17 solution - This approach involves using an integrated sub-ledger solution that will connect the finance and actuarial systems. This will involve building an integrated insurance data model into a single platform and also a powerful data warehouse to provide multiple reporting requirements and analysis tools. The benefit of using this approach is it will provide the information at a more granular level and will meet the future IFRS 17 requirements.
Now is the best time for insurance companies to start their IFRS 17 implementation planning. A thorough fit-gap analysis will be extremely beneficial for insurance companies to assess the impact and extent of effort that will be required to implement the new IFRS requirement. With the change that IFRS 17 will bring, insurance companies should look at this new implementation not as a burden and additional cost but instead as a one-time opportunity for the insurance companies to align the actuarial, risk, accounting and reporting areas that will provide more transparent and meaningful financial information results to stakeholders. This will also allow insurance companies to streamline the accounting and reporting process and redesign their performance metrics to maximize the benefits of the new implementation and not just to comply with the new accounting requirement.