IFRS 17: where are we now?
Howden Tiger’s Charlie Beeching on the implications of the IFRS 17 regime.
The implementation of IFRS 17 on 1 January this year has caused significant upheaval for the insurance industry. Its purpose was to bring carrier financial reporting under an internationally unified framework, replacing the diverse applications pursued under the previous IFRS 4 regime.
A key issue faced by IFRS 4 which IFRS 17 was intended to tackle was a lack of a reserve discounting framework. This drove a significant dispersion of reserving methodologies, including a prudency buffer under IFRS 4. Additionally, (re)insurers were prone to large swings in IFRS equity under the previous standard, rendering comparability of price-to-book valuations challenging.
The IFRS 17 standard aims to bring assets and liabilities closer to a market-consistent basis, making the accounting standard more closely aligned with the Solvency II framework. Insurance liabilities under IFRS 17 are on a best-estimate basis, discounted using a similar methodology to that under Solvency II, namely at risk-free, plus a spread to account for an assumed illiquidity premium on backing assets. Prudency margins under IFRS 4 are replaced with a risk adjustment to allow for non-hedgeable risks, again similar to the concept of the risk margin under Solvency II.
The distinguishing new feature introduced under IFRS 17 is the concept of the contractual service margin (CSM). This represents the stock of future profits under insurance contracts which are released over the coverage period. These are calculated under the general measurement model and variable fee approach, applicable to life insurance policies and others with coverage periods of over one year.
This is a step-change for insurance accounting, as it mitigates the ability to recognise profits before the insurance service is delivered, bringing the insurance sector in line with other industry standards. This is particularly relevant for life insurers, where the release of CSM is now ~80-90 percent of life operating profits.
For non-life, including reinsurance, earnings look more similar to IFRS 4, where underwriting profit is now the ‘insurance service result’ – including the impact of discounted claims reserves, while the ‘insurance finance income and expenses’ line item now includes investment income, net the unwinding of the liability discounting benefit. For most non-life policies, providing coverage for a one-year period or less, the premium allocation approach (PAA) may be implemented, which does not require the calculation of a CSM.
Complications arise for reinsurance contracts, where the previous practice of ‘netting down’ has become impermissible under the new methodology as contracts must be valued and accounted for separately, rather than grouped together. Additionally, cedants may be unable to treat risk-attaching reinsurance under the PAA, if the coverage period is over one year.
Another specific area of issue is in the treatment of adverse development cover (ADC), where the cost of purchasing reinsurance relating to past events must be recognised immediately by the cedant, while the reinsurer must recognise profits as claims develop. The potential mismatch of cost and profit recognition, for cedant and reinsurer respectively, may alter the value of existing ADCs under IFRS 17, and may increase pricing over time.
It is important to note that cash flows are unaffected by IFRS 17; with product economics remaining the same regardless of accounting regime. The binding constraint for insurers’ capital allocation and dividend decisions should remain the Solvency II regime, or equivalent. Where complexities arise for (re)insurers under the new standard, Howden Tiger’s international strategic advisory team can help assess impacts and propose a range of solutions with comparative analyses of their effects on earnings, capital, rating and valuation.
Charlie Beeching is divisional director, Howden Tiger Strategic Advisory