To prepare for the implementation of IFRS 17, RGA has met with life and health insurers around the globe over the past several years. RGA's Paul Sauvé shares common themes and insights RGA has discovered in this process.
Insurers buy reinsurance for a variety of reasons, but an insurer’s accounting rules and solvency regulations are inevitably at the heart of the decision.
Whether they are primary drivers or simply help insurers judge acceptable pricing for a risk- or service-motivated transaction, these rules and regulations are a key part of the equation.
IFRS 17 is the imminent new global accounting standard for insurance (outside the U.S.), and a few countries also link solvency regulations directly to IFRS. It is therefore natural to think IFRS 17 might be a major factor in insurers’ reinsurance buying decisions. To prepare for this, RGA has met with life and health insurers around the globe over the past several years to better understand and predict how those decisions might eventually change.
The transition experience from IFRS 4 to IFRS 17 could be different in every country and for every insurer, but there are clear, recurring themes. This article will explore those themes and share some of the related insights RGA has gained in the process leading up to IFRS 17, as well as the challenges insurers are experiencing as they adjust to the new standard.
The transition experience from IFRS 4 to IFRS 17 could be different in every country and for every insurer, but there are clear, recurring themes.
IFRS 17 requires the adoption of a prospective economic valuation method for insurance liabilities with an updating of the assumptions in the valuation at each future reporting date.
The feedback gained from clients globally when discussing IFRS 17 revealed three major areas of concern about the new standard:
IFRS 17’s prospective economic valuation has entailed costly and challenging implementation efforts for insurers, especially life insurers. Paradoxically, IFRS 17 first required insurers to focus on the past to collect large amounts of data and to recreate history to project the future based on IASB beliefs. Needing to then perform individual policy-level projections repeatedly is the next-level challenge.
IFRS 17 also requires companies to track, recalculate, and amortize assorted values (e.g., “Loss Component” and “Contract Service Margin”), which have complex links to other values at different points in time. The final challenges will be understanding, explaining, and ultimately using these outputs.
These combined challenges have proven formidable and caused the cost of implementation projects to grow beyond original budgets. Bemoaning this ever-expanding cost and complexity has become a constant refrain from insurers in the global IFRS 17 environment.
Only after companies make significant progress in implementing IFRS 17 systems are they typically ready to start meaningful discussions on the IFRS 17 accounting values. At this stage, volatility in earnings is a consistent complaint. This volatility boils down to two distinguishable items:
Once companies understand the sources of this volatility and try to minimize it, they typically express dissatisfaction with the inherent pattern of IFRS 17 earnings emergence. Though this overlaps somewhat with the problem of volatility, there is indeed a distinct issue and underlying cause here. The core issue is that IFRS 17’s foundational beliefs and chosen methods lead to slow earnings emergence.
After receiving feedback from many clients over the years about their challenges and frustrations with IFRS 17, RGA has explored a range of potential solutions. In the process, we have deepened our own understanding of IFRS 17, investigating the foundations of the standard to consider its implications. Based on that journey, we believe the recurring insurer themes noted above derive from an incompatibility between IFRS 17 design elements and the insurance environment.
A broader, clearer understanding of these underlying issues will allow companies to determine which problems to tackle and how to solve them. While reinsurance solutions will help address new IFRS 17 issues, much of the transition will require familiarizing internal and external stakeholders with earnings patterns that simply look different but are fundamentally neither better nor worse than those seen before IFRS 17.
Considering these three elements in relation to the client themes discussed earlier, one can construct the following arguments:
The clear focus of IFRS reporters and their investors is P&L, which is used to measure performance. Much less attention is paid to the IFRS balance sheet, and those who do start with the balance sheet to assess company value inevitably make fundamental adjustments. (A topic for another day is the degree to which IFRS 17’s Contractual Service Margin [CSM] and Risk Adjustment [RA] might reduce the need for analysts to make these adjustments.) It is notable that most of the newest life insurance solvency regimes – which are essentially measuring the value of the business in different scenarios – created their own prospective economic balance sheets instead of using that of IFRS.
The most prominent of these regimes is Solvency II, which does not include an income statement. This makes us wonder whether an economic balance sheet is simply incompatible with traditional performance measurement. Our conclusion is that some of the persistent dissatisfaction with IFRS 17 comes from the new standard introducing value measures to the balance sheet that can be difficult to reconcile with income statement expectations.
Two examples of this are Deferred Acquisition Cost (DAC) and Loss Component (LC). Neither appears on the IFRS 17 balance sheet because the prospective economic liability valuation naturally captures the DAC effect and produces the relevant LC effect and passes them via the P&L statement into balance sheet equity.
The theoretical IFRS 17 income statement, therefore, does not need to include future explicit amortizations of either of these values (they happen naturally, implicitly via the liability revaluation). However, presumably to satisfy pre-IFRS 17 practices regarding performance measures that need reporting, the income statement post-IFRS 17 will include amortizations of DAC and LC. Each of those amortization values will actually show up twice in each income statement – once as a minus and once as a plus – in order to reflect their net-zero impact on the balance sheet.
Financial statements generally provide supplementary disclosures that are valuable to investors, but to take this information and insert it into the mathematically derivable income statement is a new step and contributes significantly to the implementation challenges of IFRS 17.
While reinsurance solutions will help address new IFRS 17 issues, much of the transition will require familiarizing stakeholders with earnings patterns that simply look different but are fundamentally neither better nor worse.
Consider an income statement to be the difference of differences among four large numbers:
For IFRS, the P&L is seen as the “more accountable” subset of that total result, and parties involved generally prefer that it not be volatile. There are at least two layers of challenge in getting P&L stability from this liability volatility:
As IFRS 17 has evolved, numerous amendments to address both issues have emerged. Synchronizing the asset and liability accounting, for example, is aided by discretionary policy elections and classifications in IFRS 9 and IFRS 17. The split between P&L and OCI, meanwhile, was refined late in the process with the introduction of the Variable Fee Approach (VFA) and the extension of the Risk Mitigation Option to also apply to reinsurance.
It is our impression that the IFRS 17 P&L remains more volatile than many stakeholders would like. We believe, however, that there are meaningful limits to the effectiveness of further attempts to reach greater P&L stability without changing underlying beliefs.
Many commentators have written about the late emergence of profits under IFRS 17, especially for business which falls under the VFA. This phenomenon is a direct result of IFRS 17’s decisions to (1) initially not account for some of the significant investment profits that companies do, in fact, expect; (2) defer all initially expected profits; and (3) further defer unexpected investment profits when they do arise.
The first element in that chain refers to the setting of liability discount rates that include only partial credit spreads. The two subsequent elements are simply the intended effects of the Contractual Service Margin (CSM). The CSM mechanics on their own would likely have produced late-emerging profits, but the extra effect of the VFA and credit spreads has produced a situation clearly at odds with the wishes of management and investors.
We have shared these ideas in ongoing discussions with life insurers, who have found them helpful in selecting more effective commercial paths.
To respond to insurers’ challenges with IT systems, we have found some small ways to make their lives easier. We can’t reduce the number of times they need to fully project individual policies (twice as often if it is reinsured), but we can modify reinsurance conditions or underlying policy conditions to make some of those projections simpler and better aligned.
As far as reducing income volatility, a significant portion of the “solution” has been companies gradually starting to accept the inevitability of this effect and the need to address it in their explanations when rolling out each period’s results. In addition, the usual full range of reinsurance solutions can play a role.
Finally, accelerating the pattern of income emergence is the most active area of our current IFRS 17 client engagement. The basic story is very similar to that of volatility, both in acceptance and reinsurance relevance.
The generalized lesson from these last two paths is that reinsurance can indeed help with volatility or the natural shape of earnings, but that reinsurance is generally most helpful to insurers who have a range of financial priorities and constraints (not just IFRS) and who have a clear strategy for how to prioritize and optimize those challenges.
