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Facing IFRS Challenges, by Snejina Malinova


...IFRS 17 brings a lot of changes and challenges for the insurance industry.



In the world of financial reporting the insurance sector has been considered a distinct case. The long-term nature and inherent complexity of insurance, as well as the intrinsic difficulty in recognizing 'revenue' as in any other business, has set it apart. Furthermore, as the current standard, IFRS 4, allows a wide variety of accounting policies, comparisons across insurance companies and products from different jurisdictions are difficult.

That is intended to change in 2021 with the implementation of the Board's new global Standard, IFRS 17 Insurance Contracts.
 
IFRS 17 is quite a complex standard that tries to achieve a consistent insurance accounting framework, as well as to increase the transparency around the drivers of performance and source of earnings. It also is hoped that this new Standard will help to make sure that insurers are not taking excessive risks. Last but not least, one of the benefits expected is to contribute in making the insurance sector a more attractive prospect for investors.

All this inevitably means that IFRS 17 brings a lot of changes and challenges for the insurance industry.
 
IFRS 17 applies to all (re)insurance contracts an entity issues, reinsurance contracts and investment contracts with a discretionary participation feature it holds, provided the entity also issues insurance contracts. Some application choice, based on predefined conditions, is given with respect to Fixed fee service contract and Financial guarantees.
 
Put aside two very specific exceptions, the new standard will need to be applied retrospectively for all contracts that are in-force at the date of transition, as if the standard has always applied, unless the entity demonstrates retrospection is impracticable, based on the availability and quality of its historic data. In such case, the entity can exercise one of the available alternative options (a modified retrospective approach and the fair value approach).

In practice, for ‘in-force’ books on transition, using different transitional approaches could result in considerably different results that will drive profit recognition in upcoming periods and undermine future reporting policy choices.
 
IFRS 17 alters the rulebook for insurance accounting and reporting in the most significant way over the last 20 years. It brings fundamental changes to how profits are recognized and presented, as well as some innovative concepts related to the liabilities valuations.

Indeed, with the IFRS 17, a new concept, a contractual service margin (‘CSM’)   is added to a more familiar actuarial calculation of the present value of future cash flows. The CSM is designed to reflect the remaining unearned profit on a group of contracts and potentially absorb the gain at initial contract recognition. This represents a substantial change in how insurers need to manage their profit.

Furthermore, entities may adjust for the financial risk inherent in the future cash flows and reflect the time value of money through market consistent discount rates that reflect the characteristics of the contracts’cash flows. Note that with IFRS, unlike like with Solvency II, entities are given the possibility to decide how to estimate appropriate discount rates. 
 
A final component, a Risk Adjustment “RA”, is added to the discounted best estimate cash flows, intended to represent the compensation of the entity for taking on the non-financial risk inherent in these cash flows.
 
Some modifications to this measurement model are allowed for qualifying short-term contracts and participating contracts and a separate measurement model applies to reinsurance contracts held.
 
Under the new standard, there are requirements on the level of granularity at which the measurement principles and recognition should be applied. The ‘portfolio’ level, where portfolio is defined as a group of contracts with similar risks which are managed together is the first level of the hierarchy of grouping. Because the implication of recognizing losses immediately means that loss-making contracts should not be allowed to offset profitable ones (unless some regulatory pricing constraints exist), insurers will need to split portfolios further according to profitability “buckets”, into at least three groups of contracts: onerous; no significant risk of becoming onerous; and remaining contracts, depending on the expected profitability at inception.

The portfolio is broken down even further, in cohorts, according to the contract inception date, as the new standards prohibits the grouping of contracts issued more than one year apart.

Further desegregation is also allowed if the entity has enough data to support such sub-divisions.

As we can see, improved comparability and transparency targeted by the IFRS 17 come at a price of increased complexity.
 
The measurement model defined, together with the unprecedented level of granularity required by the new standard, will likely result not only in a review of the entity’s data management strategy, including data quality and storage but also in choices around the design of systems and processes to comply. Making the right choices in this respect appears as one of the major challenges.  Specific financial and operational implications will vary by entity, however, IFRS 17 is expected to impact various departments and functions, including product strategy, pricing, valuation, finance, actuarial models and IT architecture.

IFRS 17 was designed to be principles-based and to apply to all types of insurance. This inevitably leads to some challenges in the interpretation of the text and in translating it into practical terms, without introducing artificial noise or volatility into the reporting.
Because of the high demand of the new standard in terms of performance, reporting timetable and increased data volumes, we expect new technologies can be of a great support to its implementation.
 
Inevitably some parallels could be done with the recent implementation of the Solvency II capital model that required significant investment in systems and processes, as well as in the transformation of key functions like actuarial, risk management, audit and compliance.

A survey of senior insurance professionals in UK by analytics firm SAS has found that 90% are preparing for costs greater than those incurred by the implementation of Solvency II, with 93% predicting that the reporting standard will completely change their business model.

That being said, existing Solvency II infrastructure can be used as a starting point for IFRS 17.

In terms of project implementation, re-using the three pillar approach from Solvency II for instance could be more familiar and easier to follow and give an opportunity to leverage on the experience and structure of implementing such a massive project as Solvency II.
 
Though the requirements of Solvency II second and third pillar are not directly applicable for IFRS17, further capitalizing on the so cherished concepts of governance and discipline by public disclosure can only facilitate the implementation of the new standard, enhance the quality of the reporting and the processes that support it.

Entities may also be able to use, at least partially, some of the actuarial solutions they set up for Solvency II to calculate some of the IFRS 17 building blocks.

However, while the nature of information and core valuation principles for measuring liabilities may sound familiar from Solvency II, the two standards have been designed to achieve different goals and therefore rely on different processes, data and data granularity.

In the end, a considerable number of judgments need to be made by companies in translating between the two bases and many new processes need to developed and implemented for IFRS 17.
 
The IFRS implementation seems challenging and there are some important steps on this journey:

1)            IFRS 17 education and awareness training
2)            Program setup and objectives, governance, resourcing and budget
3)            Decisions design according to the technical, financial and operational impact assessment
4)            Detailed scoping and roadmap of activities for implementation
5)            Implementation, systems and processes deployment
6)            Dry run, comparatives and refinement
7)            Moving to Business as usual (BAU)
 
Ensuring that the IFRS 17 implementation project has the right level of attention, resources and a robust, yet flexible plan is key to its success. You have probably started with this but if you haven’t we definitely invite you to get going soon.
 
In conclusion, the new standard will facilitate cross industry comparability and enable a wider range of users to understand and compare insurers’ financial statements with those of companies outside the insurance industry. For insurers, this comes at a cost of more complex actuarial modelling and a more rigorous and granular reporting. Preparing for IFRS 17 compliance should be in the insurance focus for the next two years.

Snejina Malinova

Operational Partner in the Global Insurance Services department at FTI Consulting. She has over 15 years of experience in the Insurance Industry. She has been responsible for various actuarial and risk management areas, namely Chief Actuary, Risk Officer and Solvency II Responsible Actuary of International Insurance Companies. She was Managing Partner of Optimind Winter Portugal, were led several projects, namely validation of the Prudential Balance Sheet, advisory on Solvency II matters, ORSA, advisory on the application of transitional measures / adjustments under SII.




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