After 20 years of debates around insurance accounting, phase II of IFRS 4 will be issued imminently as ‘IFRS 17’. With a likely effective date of 2021, what can we expect?
We all know just how much hype there had been around the introduction of IFRS 9, and its far-reaching impact. IFRS 17 is likely to rival this hype and is already being touted as the ‘IFRS 9 of the insurance industry’. The new accounting standard provides a fresh perspective on financial reporting and requires a complete change in mindset. To compete most effectively under this reporting regime, insurance companies need to start visualising and strategising for the IFRS 17 journey on which they are about to embark. Insurers will have their hands full as they grapple with accounting requirements and try to keep pace with the changes required, as well as their far-reaching implications. These changes include their impact on regulatory reporting, tax legislation, risk, product design, controls, and decision-making.
IFRS 17 places significant emphasis on the principles around profit recognition and requires enhanced disclosures. An example of the latter relates to the insurance liability: entities will be required to disclose information at a far more granular level. These disclosures, together with solvency-related requirements, are expected to result in consistency and transparency of reporting across all sectors of the insurance industry.
In view of the recent amendment to IFRS 4, which addressed issues arising from the differing effective dates of IFRS 9 and IFRS 17, insurers should consider whether they wish to apply either the overlay or the deferral approach. It should be added, however, that it is expected that very few South African insurers will choose to apply these approaches.
Any changes in tax legislation are bound to have a significant impact on insurers. Although the legislation is still in the process of being finalised, the determination of an insurer’s tax is expected to move away from a statutory basis, and towards principles similar to those contained in IFRS 17. This means that significant time and effort need to be invested in financial reporting, since it will ultimately impact cash flows to SARS. On the upside, as a result of these changes insurers will not be expected to pay tax on their unearned profits.
In certain markets, IFRS 17 will likely contribute to substantial changes in insurance product design, pricing, and product offerings. Information that will become available to management as a result of the implementation of IFRS 17 will provide insight into the profitability of new business, and will probably assist insurance companies in gaining a better understanding of the risks and uncertainties associated with individual business lines or portfolios. As a result, the cross-subsidisation of underperforming lines may become more transparent and therefore less likely to arise.
As IFRS 17 places an increased focus on risk, it is possible that insurance companies may review their demand for reinsurance products as part of their overall risk management strategy. Perhaps this will result in a decision to manage risks in a different way. On the other hand, as insurers continue to look for ways to mitigate their risks and focus on reducing financial reporting volatility, it is possible that the demand for reinsurance products may actually increase once IFRS 17 has been implemented.
DATA AND IT
Transitioning to IFRS 17 is expected to be a complex process requiring multiple layers of change. At a core level, insurers may find it necessary to make significant changes to, or even re-engineer, their financial reporting processes. Nothing in life is free: entities should consider the impact on their budgets as a result of the need to implement the appropriate systems and models, train staff, and possibly recruit experts.
As was the case with IFRS 9, IFRS 17 is likely to present insurers with a major challenge in the area of actuarial modelling. Certain insurers may be forced to develop highly sophisticated actuarial models, due to a lack of observable data for certain model inputs. Insurers would need to estimate future cash flows driven by the time value of money, investment markets, and customer behaviour. While the first two components are relatively simple to predict, forecasting customer behaviour is expected to be far trickier!
Accurate estimates are key. Should there be a change in an assumption, the effect cannot be recognised in the current year’s earnings, but will rather form part of the contractual service margin (CSM). The CSM is the insurance contract’s unearned profit reserve, which is amortised over the remainder of a contract boundary. The accuracy of an insurer’s estimates becomes an extremely powerful source of information about the ability of a company’s management, its systems, and its resilience.
The process to transition to IFRS 17 could also prove challenging, since it would require retrospective application. Estimating the CSM on transition will be a significant area of complexity. The transition will undeniably be easier to manage if the right level of historical information is available. This will enable historical and future business to be measured and monitored on a consistent basis.
Should it be impracticable to apply the fully retrospective approach, it will be necessary to estimate the CSM at transition date by using simplifications to determine discount rates and the risk adjustment at inception. Whichever transition approach an insurer applies, the opening statement of financial position will need to be sufficiently robust to ensure management compliance with IFRS 17.
Solvency II, which becomes effective in 2017, adds a further dimension to the ever-changing insurance environment. Although there are many similarities between Solvency II and the building blocks approach of IFRS 17, there are also numerous differences. Management should consider whether the company can leverage off its solvency models, making adjustments as necessary for the discount rate, the risk adjustment, and CSM. Other areas such as contract boundary, unbundling and short duration contracts will also need to be taken into account.
Management needs to ensure a good understanding of both the IFRS as well as the solvency requirements. Merging finance and actuarial teams may well lead to optimal efficiency and the achievement of improved decision making.
Although there are numerous challenges related to the changes arising from the introduction of IFRS 17, the industry is certainly heading in the right direction. Greater transparency is expected to lead to greater accountability for a company’s risk management practices, similar to what has been seen as a result of the introduction of other new accounting standards.
Amid this backdrop of change, insurance companies need to consider how their business strategies will be influenced, and how the insurance marketplace will evolve. Without a doubt, IFRS 17 will add complexity to financial reporting in the insurance industry and management will need to learn to survive this seismic change. IFRS 17 can offer an opportunity for differentiation for those insurance companies adopting a proactive approach in understanding how its implementation will impact the key areas of their business. Bon voyage!
Author: Lizelle Muller CA(SA), Technical Advisory Group, Absa