Perspectives | 6 July 2018
After many years of development, in May 2017, the International Accounting Standards Board (IASB) published a new standard for insurance contracts. Coming into effect on January 1st 2021, the IFRS 17 standard introduces a new model for accounting and measuring insurance liabilities with a framework which is substantially different from current accounting practices.
While the current temporary IFRS 4 model is based on various underlying local accounting principles, the new IFRS 17 standard has introduced a more harmonized accounting approach for insurance contracts, with the objective to increase comparability and the transparency in measuring insurance companies’ performance and activities across jurisdictions.
The introduction of new concepts such as contractual service margin, risk adjustment and discounted best estimate will require significant changes to existing systems and processes resulting in increased complexity around building and communicating financial information. Although synergies with Solvency II are expected, the target operating environment will require insurance companies to make various organisational and business strategy changes.
In terms of scope, IFRS 17 applies to both insurance and reinsurance companies. Although reinsurance contracts assumed would follow the same accounting model as insurance contracts using the general model, the application of the standard to reinsurers is expected to result in specific challenges due to their activities. Also, the requirements of IFRS 17 regarding ceded reinsurance could influence the way reinsurance is managed within insurance companies leading some reinsurers to redesign products.
Main challenges the reinsurance industry is expected to face once IFRS 17 comes into effect would be those arising from requirements regarding the Variable Fee Approach (VFA) eligibility of life reinsurance products, from which reinsurance contracts are excluded. Also, reinsurance companies should be impacted by the standard provisions concerning the level of aggregation where the lower unit of account is set at contract level, thus impacting the granularity at which reinsurance contracts would be grouped.
A major difference for reinsurance compared to direct insurance is a VFA exclusion for reinsurance contracts, even if they fulfil the criteria set in the standard for using the model applied to contracts with direct participation features. For the insurer, this would lead to a mismatch in accounting between the reinsurance contract and the underlying insurance contracts (i.e. using VFA), possibly requiring the adaptation of the existing product structure. From a reinsurer’s perspective, the use of the general model to measure a reinsurance contract, where the liabilities are substantially linked to performance of the underlying financial assets, might not reflect the economic substance of the reinsurance contract. This could result in increased volatility of the P&L or OCI (depending on elected option).
Volatility would be increased, firstly because the discount rate set to determine the liability interest expense would not allow mirroring of the financial returns of underlying assets, as is the case when applying VFA. Secondly, the Contractual Service Margin (CSM) would not absorb the remeasurement of cash flows arising from financial assumptions changes, thus resulting in an accounting mismatch when remeasuring assets and liabilities.
Such a situation could penalize reinsurance company performance and financial communication when financial markets are volatile because the application of the general model would not allow the absorption of impacts arising from such market conditions. While the recent growth of reinsurance for life and saving products could be challenged due to IFRS 17 accounting model restrictions, the traditional reinsurance market which is mainly oriented toward risk reinsurance products should not be materially impacted.
Level of aggregation and IFRS 17 requirements in terms of unit of account also represent a matter of attention for reinsurance companies. The granularity of the information collected from ceding companies has always been a struggle for reinsurers looking to match their needs in terms of input for actuarial modelling. However, the challenges anticipated from IFRS 17 model application would rather relate to the unit of account definition and the requirement to aggregate underlying guarantees at reinsurance contract level when defining insurance groups and performing the onerous contracts testing. Indeed, such an approach would not allow for aggregating similar risks when these are included in contracts with several guarantees.
While insurance contracts with single guarantees could be grouped together for measuring and allocating the CSM, the aggregation could become more complex when dealing with reinsurance contracts. The grouping would need to be performed at contract level whereas reinsurers manage their business on a Line of Business basis and measure their solvency ratio accordingly. Rebuilding a new modelling framework to align actuarial tools with IFRS 17 unit of account definition would not only add complexity, but increase costs. One could expect, therefore, proxy solutions to emerge and allow for maintaining existing tools as much as possible while complying with the standard requirements, specifically those relating to onerous contracts testing and CSM allocation.
However, such relief would come at the cost of additional efforts to demonstrate the relevance of an alternative methodology and to followup at every closing on its effectiveness. What is more, anticipation would be needed with auditors’ prior approval to ensure that views are aligned from a conceptual perspective and thereby avoid late changes during the implementation phase.
Another consequence of IFRS 17 requirements regarding the level of aggregation could be the adaptation of reinsurance product structure in order to align the unit of account level with individual guarantees: reinsurance treaties with various guarantee coverages could be split over various sub-contracts per guarantee, with the objective of a more harmonized approach for grouping contracts in both accounting and risk management frameworks.
Variable fee approach restriction and level of aggregation are the main areas where assumed reinsurance specific issues will arise. However, one should not underestimate the impact of other IFRS 17 provisions for ceded reinsurance on the industry and on the reinsurance market. The industry stakeholders have already identified various areas of discussions where accounting mismatches and operational complexity could prove to be a serious burden for insurers and lead to changing their reinsurance program to avoid unnecessary complexity and any increased volatility arising from the IFRS 17 model for ceded reinsurance.
Implementation projects are ongoing for all major reinsurance market players and could result in a refinement of identified implementation issues, along with the definition of best approaches or alternatives to address them. The first effects of IFRS 17 on reinsurance business structures should be observed in advance of 2021 to relieve preparers from dealing with implementation and transition complexity on the most sensitive areas of the standard.
