October 22, 2019 | GC Capital Ideas
International Financial Reporting Standard (IFRS) 17, issued by the International Accounting Standards Board, is the new financial reporting standard for insurance contracts that will replace the current rules of IFRS 4 and will become effective on January 1, 2022. IFRS 17 will impact the insurance value chain far beyond the areas of actuarial modeling and financial reporting. Key aspects of strategic and operational management may be affected. The new rules for reinsurance may have numerous unintended consequences and some traditional reinsurance products may require modification in order to remain highly effective as capital and volatility management tools, according to Vasilka Bangeova, Managing Director, Strategic Advisory, EMEA, Guy Carpenter.
“IFRS 17 will not change the total profitability derived from insurance contracts. However, profit will likely emerge more slowly than under IFRS 4. As a result, when companies recalculate the value of in-force insurance contracts at January 1, 2021, their retained profits will likely be lower than currently reported,” Bangeova explains. This is often referred to as the “cliff effect” on transition.
“Traditional reinsurance products will remain effective but may benefit from some adjustments to better align the accounting outcomes under IFRS 17 with the economics of a contract. The management of the balance sheet and profit and loss volatility could also be very sensitive to seemingly small modifications to contract wordings, which are not specifically considered under the current reporting rules of IFRS 4,” says Bangeova. She provides examples: “Early termination clauses could change the accounting boundary of a reinsurance contract. The latter will determine which future cash flows are included in the value of reinsurance contracts for each reporting period. As a result, the volatility of net results of the underlying ceded business may be affected.”
Additionally,
• Commutation options under IFRS 17 have to be reflected in the value of a reinsurance contract at its inception (unlike current IFRS 4 practice where commutation is accounted for only in the year of execution). This could facilitate management strategies for improving sustainability of future reserves releases.
• Indexation clauses could redirect the effect of changes to inflation assumptions from the underwriting result (“insurance services result”) into the “insurance finance income and expenses” line. The latter will likely affect loss ratios and may require redesign of inflation hedging strategies.
In order to understand and manage the “cliff effect” on transition and subsequent results volatility, cedents may need to carefully consider the terms and conditions of multi-year placements prior to January 1, 2021.
Bangeova continues: “IFRS 17 will fundamentally reshape the financial accounts of insurers while the underlying business remains unchanged. Measures of volume such as gross written premium and ceded premiums, gross paid and ceded claims or net operating expenses will no longer be reported on the face of the income statement. For example, under IFRS 17 principles of accounting for ceding commissions, the total result of a reinsurance contract will not be affected but key ratios will differ from those that were reported under IFRS 4. The new rules will likely improve net loss ratios but may deteriorate net combined ratios. (Re) insurers will face challenges in explaining the performance of their businesses using the new metrics.”
The choice of accounting options among those allowed under IFRS 17 may have significant consequences for future operational costs such as data and information technology; profit and loss volatility; and key performance indicators. “In certain cases,” says Bangeova, “choosing the operationally simpler option may not be as beneficial as expected (at least for interim reporting periods).”
A cost-efficient IFRS implementation will demand a much wider range of skills and a multi-disciplinary approach, broader than those required for previous accounting changes. “Guy Carpenter has identified cost-efficient solutions to help cedents benefit from the IFRS 17 reporting change. They include: wording diagnostics, indicative modeling and analysis, training, new product development and subsequent placement. These solutions can be tailored to the unique circumstances and priorities of each client,” says Bangeova.
Bangeova concludes by noting that the transition to IFRS 17 is likely to affect business as usual processes in an environment of competing priorities. However, if well planned and informed, it can create opportunities to ensure reinsurance continues to help companies achieve their profitability and capital management goals. “Guy Carpenter is committed to ensuring its clients benefit from these opportunities and generate profitable growth. Our solutions will help build credibility and trust with key stakeholders and improve policy decisions and performance monitoring.”