- It’s about the customer, stupid
- Great changes shaping investment managers
- The future of financial reporting for insurance contracts
- The IFRS 9 ‘hold to collect’ business model
It’s about the customer, stupid
The impact of FinTech on financial services has yet to be fully felt, but if we think of it as apps and cool technology then we are wrong: it’s all about the customer. By Paul Mitchell
The current US election campaign reminds us that the world’s best speech writers and strategists are employed to get people elected. They need to sum up complex issues in a sound bite, and in 1992, Bill Clinton’s campaign team came up with the classic ‘It’s the economy, stupid’. This focused voters on the issue that the Clinton team thought favoured their man. The complexities of FinTech can be similarly distilled to their essence: it’s not about the cool apps, the agile approach, the new business models; it’s about the customer, stupid.
The most visible FinTech companies are those who are focused on radically improving the customer experience. They understand the customer’s needs and they are seeking to address a specific part of the customer journey, or just to develop a better way of doing things. Talking about ‘design thinking’ is rapidly becoming devalued by over-use, but this approach is terrifically powerful in creating a deep understanding of customer types and their needs, then building, testing and rebuilding solutions for those customers. As a model, it can be seen as a way of deconstructing what some companies do by instinct, but at its core it is simply about starting with the customer, then continually returning to the customer and their needs as the process goes on. It is as much a mindset as a process. As one senior banking executive said in PwC’s global FinTech survey (March 2016), ‘We thought we knew our customers, but FinTechs really know our customers.’
Large financial institutions have accumulated their customers over time by providing them with important services. From this mindset of service provision stems a focus on efficiency and on looking for ways to improve that efficiency and make the services as cheap, accurate and risk free as possible. The focus often tends to be inward looking, and does not usually start with the customer. There have been many exceptions to this rule in recent years, but the efficiency-focused, often intermediated, model was the norm for a long time and is ingrained in many of the practices and policies of large financial services companies. The wiser incumbents are using their relationships with start-ups to learn about how things are done, as well as what can be done with the available technology. They are learning about agility and rapid testing and development, and absorbing those lessons into their businesses.
Customer behaviour has moved ahead more quickly than many companies have been able to cope with. While in the insurance industry, for example, buying behaviour has changed from the traditional broker model to buying direct by phone, to buying online, through affinity models, aggregators and then on a usage basis. The products have remained broadly the same throughout this process, while customer behaviour has been driven by what we have learned in the digital world. We have become accustomed to transacting with businesses on our phones and through apps. The speed at which our buying behaviour changes is the defining factor in how fast industries must change. It doesn’t pay to be behind this curve, but too many financial services companies are slow to accommodate changes in buying behaviour.
Startups like SnapScan, Covestor and Dwolla have seen the opportunities that lie at the intersection of customers who are both profitable and poorly served. They have used an understanding of how the experience can be improved, allied to the flexibility and speed that come with a start-up culture using new technology, and they have created engaging customer experiences. When entrepreneurs look at an opportunity, they are typically looking for three things: first, something broken they can fix – often stemming from a personal frustration. There must also be an attractive market for the solution. And the solution must be scalable. There are many other factors, and when an investor looks at the business he may use a different lens, but from the start-up’s perspective, let’s deal with these three things in turn.
SOMETHING TO FIX
Maybe referred to as a ‘pain point’, this is something that a customer will either pay to resolve, or will regard as enough of a problem to overcome the hurdle of going for something new. Perhaps it is frustration with not being able to transact efficiently, or being treated poorly by a large institution – something that creates an itch to be scratched.
The number of people who have this problem and want to fix it must be large enough and lucrative enough to make the business plan work. The problem in South Africa is often that the market is relatively small: taking a great idea to the USA makes it immediately more valuable, because the market is just so much larger. Ask Elon Musk.
Simply put, revenue rises faster than costs, so each incremental customer gets cheaper and the profitability increases quickly as the business grows. The impact of this exponential scalability can be seen in the valuations given to high-growth companies, or those with a new idea that are being bought by those with a large customer base.
In a world that is changing faster than ever before, innovation is a big deal. For a large financial institution, the challenge is how to innovate, and where. Many big companies might have acquired start-ups, created innovation labs and incubators, invested in venture capital, started greenfield businesses, partnered with start-ups, and built their own internal innovation structures. These may all be good things, as long as there is an over-arching strategy behind them.
But the key question is often, ‘What problem are you trying to solve?’ If that problem is, ‘We don’t have any cool stuff going on’ – which can be stated in many different ways, and wrapped in business cases, strategy plans and digital initiatives – then you don’t have a strategy. Companies need to be clear about where their opportunities are, where the threats are coming from, and what their view of the future is. Then they can go and create it.
AUTHOR l Paul Mitchell, Associate Director, PwC
GREAT CHANGES SHAPING INVESTMENT MANAGERS
While many investment management firms are changing their operating models, impacted by changing customer needs, the financial regulatory environment in South Africa is in the midst of significant change with extensive regulatory reforms in the pipeline. By Gustaaf Kruger and Justin Chait
New models of engaging with customers are emerging across all sectors in the financial services industry. Peer-to-peer lending services, low-cost online only banks and do-it yourself portfolio management services are competing directly with established business models. An increasing trend in the investment management sector is the use of automated digital investment management services, or so-called robo-advisors. These disruptive technologies have the potential to significantly transform the operating models of many investment managers.
MARKET CONDUCT REGULATION
An overarching theme for the regulatory changes in the South African financial services sector is market conduct aimed at consumer protection. While South Africa has made progress on market conduct within the current legal framework, there is a view that these initiatives can be significantly strengthened through structural change. Central to this regulatory reform is a shift to a Twin Peaks model of financial regulation, which will be a significant change from South Africa’s current regulatory framework.
South Africa currently has multiple regulatory authorities that regulate and supervise financial institutions on a very sector-specific basis. The Twin Peaks model, through structural reform, envisages that the financial services sector will have two primary regulators, being a prudential regulator (the Prudential Authority) and a new market conduct regulator (the Financial Sector Conduct Authority, or FSCA).
The Prudential Authority will replace the Bank Supervision Department of the South African Reserve Bank, with its primary objective being to maintain and enhance the safety and soundness of financial institutions that provide financial products. The FSCA will replace the Financial Services Board and will be responsible for supervising the business conduct of all financial institutions as well as the integrity of the financial market.
Treating Customers Fairly (TCF) is an important focus area and it is envisaged that the TCF outcomes will be adopted by the FSCA as the blueprint for its regulatory mandate.
Investment managers should ensure that they embed TCF principles throughout the organisation and clearly evidence these in dealing with customers.
RETAIL DISTRIBUTION REVIEW
As part of the financial regulatory reform and informed by the TCF principles, the Financial Services Board (FSB) implemented the Retail Distribution Review (RDR) in November 2014. The RDR has been undertaken against the background of the proposed shift to a market conduct model of regulation and supervision (as discussed above) and as a result of continuing and significant concerns about poor customer outcomes, conflicts of interest, and mis-selling of financial products.
The RDR outlines a ‘proactive and interventionist regulatory approach’ by moving away from a purely rules-based compliance approach to an approach that also interrogates and impacts structures (with the aim of changing incentives, relationships and business models in the market) so that the consistent delivery of fair customer outcomes is supported and enhanced. Ultimately, the RDR proposals seek to rekindle customers’ confidence in the retail financial services market and foster customers’ trust that product suppliers and advisers will treat them fairly.
The RDR is extensive and includes 55 specific proposals which cover the types of services provided by intermediaries, relationships between product suppliers and intermediaries and intermediary remuneration. These proposals are likely to be implemented in three phases aligned to the broader reform of financial regulation in terms of Twin Peaks.
While RDR is still in the process of being finalised, and some concessions have already made, the proposals are likely to impact the distribution models of many investment managers.
Hedge funds have been largely unregulated in South Africa, with only the conduct of hedge fund managers being regulated through the Financial Advisory and Intermediary Services Act. In accordance with its G20 commitment, National Treasury and the FSB released a proposed framework for the regulation of hedge funds in South Africa in September 2012. The intention of the framework is to regulate hedge funds as a special Collective Investment Scheme (CIS) with the regulatory objectives being to provide greater protection of investors in hedge funds, prevent systemic risk, promote market integrity, and enhance transparency. Regulating hedge funds should therefore enhance financial stability and improve investor confidence both locally and internationally.
In March 2015, a determination on the requirements for hedge funds was issued by the Registrar of Collective Investment Schemes and became effective on 1 April 2015.
The impact of the declaration and determination is that any person operating a hedge fund (as at 1 April 2015) was required to lodge applications to register as a collective investment scheme manager and establish a scheme (including a portfolio or portfolios) in terms of the Collective Investment Schemes Control Act (CISCA) by 30 September 2015.
New hedge funds (those established after 1 April 2015) will have to be approved in terms of CISCA before it can operate as a hedge fund and the hedge fund must be fully compliant with CISCA with effect from the date of registration/approval.
The determination establishes two categories of hedge funds – Retail Hedge Funds and Qualified Investor Hedge Funds (QI Hedge Funds), which are regulated differently in some respects. Retail Hedge Funds are more strictly regulated as these are defined as hedge funds in which any investor (including lay persons) may invest, while QI Hedge Funds are less strictly regulated as the investor pool is limited to ‘qualified investors’, namely persons who have demonstrable experience and knowledge in financial and business matters and who are relatively wealthy (that is, who are investing R1 million per hedge fund). Although regulated to different extents, the regulations aim to provide sufficient protection to both types of investors.
The regulation of the hedge funds is a significant development that supports the customer protection agenda and also creates new opportunities for investment managers.
The regulatory and operating model challenges impacting investment managers are many. While the cost of regulatory compliance cannot be underestimated, regulation also protects established investment management firms by creating barriers to entry. The demographics in Africa – which include a younger population and rising middle class, the increasing demand for infrastructure development, and government initiatives to increase the savings pool – reflect positive macro-economic factors that support the investment management industry. Investment managers that are truly customer-centric and that are agile enough to embrace new technologies and adapt to new regulations will be well placed to succeed in the new customer era.
AUTHORS l Gustaaf Kruger CA(SA) and Justin Chait CA(SA)are Partners at KPMG
THE FUTURE OF FINANCIAL REPORTING FOR INSURANCE CONTRACTS
The way insurers measure and report the results of insurance contracts as we know it will change significantly in the near future. By Dewald van den Berg and Daleen Smith
In February 2016, the International Accounting Standards Board (IASB) voted unanimously to begin drafting the final new insurance contracts standard (it will most likely be IFRS X17, but we will refer to it as IFRS XX). They expect to complete the drafting of the standard towards the end of 2016.
For most insurers there will be some methodology, process and systems similarities between IFRS XX and the regulatory reporting requirements under SAM (solvency assessment and management). There are, however, fundamental differences, because IFRS is also concerned with reporting profit over time, while the main objective of SAM is to measure an insurer’s solvency position at a point in time.
The current accounting standard for insurance contracts allows entities to continue with existing accounting practices for the measurement and presentation of insurance contract liabilities and assets. In South Africa, life insurers generally follow the guidance under SAP 104, Calculation of the Value of the Assets, Liabilities and Capital Adequacy Requirement of Long-Term Insurers, while non-life insurers mostly follow the guidance that was included in SAICA Circular 2/2007, Recognition and Measurement of Short-Term Insurance Contracts.
IFRS XX will introduce prescribed insurance measurement models as well as presentation and disclosure requirements for insurance contracts. However, welcome relief is provided for non-insurance entities that issue contracts similar in nature to insurance contracts, for example product warranties or certain fixed-fee service contracts. These contracts will be excluded from the scope of IFRS XX and covered instead by IFRS 15, Revenue from Contracts with Customers.
IFRS XX will introduce significant implications for key areas of an insurer’s financial reporting. This article will briefly explore three of them, namely the insurer’s IFRS-reported earnings, insurance contract revenue, and movement analysis disclosures.
The first financial reporting implication of IFRS XX relates to its impact on IFRS-reported earnings. It includes the impact of the change in the measurement of insurance contract liabilities/assets and an accounting policy choice with respect to the presentation of changes in interest rates either in the income statement or in other comprehensive income.
Measurement of insurance contracts
Under SAP 104, life insurers add certain compulsory and discretionary margins to their insurance contract liabilities. The guidance around particularly the discretionary margins is currently very broad, and entities apply significant judgement in the measurement and release of these margins. For example, some insurers include additional discretionary margins to absorb the impact of future market fluctuations, while others add discretionary margins which are reset at every valuation date to reflect the underlying profitability of the portfolio of insurance contracts. IFRS XX will change this.
Under IFRS XX, insurance contracts will consist of a probability-weighted estimate of future cash flows to fulfil the contract, discounted for the time value of money (best-estimate liability); an adjustment for risk to reflect the compensation the insurer requires for bearing uncertainty (risk adjustment); and the contractual service margin, which represents the future unearned profits within the closely defined boundary of the contract.
Although the measurement of insurance contract liabilities under IFRS XX will still require the use of significant judgement, for all intents and purposes insurers will have no discretion in the measurement and release of the inherent profitability. The IFRS earnings will therefore be more comparable and better reflect the specific events in the reporting year. It will fluctuate mainly as a result of onerous contracts (for which losses are recorded in profit and loss immediately) and changes to the best-estimate liability and the risk adjustment relating to current or past periods of coverage. As long as the contract is not onerous, any adjustments to the best-estimate liability and risk adjustment that relates to future coverage periods will be absorbed by an equal and opposite adjustment to the contractual service margin and will therefore have no impact on current-period profit and loss. The contractual service margin will be amortised to the income statement over the period of the contract (as defined by the contract boundary) on a straight-line basis.
Presentation of interest
Entities will have an accounting policy choice to recognise changes in discount rates (yield curves) either with the investment result in the income statement or in other comprehensive income. As a result of this policy choice, interest on the insurance liability will be recognised either at the locked-in rate at inception or at a current rate in the income statement.
Insurers would need to analyse their existing portfolios and how the assets backing insurance contract liabilities will be treated under IFRS 9, Financial Instruments, in order to elect an appropriate accounting policy for the presentation of changes in the interest rates for insurance contracts.
INSURANCE CONTRACT REVENUE
The second financial reporting implication of IFRS XX relates to the presentation of revenue for all insurance contracts, which will be in accordance with a prescribed calculation.
Today, most insurers present premium information like premiums due (life insurance) and premiums written (non-life insurance) in the statement of comprehensive income. IFRS XX will prohibit the presentation in the statement of comprehensive income of premium information that is not consistent with commonly understood notions of revenue.
Revenue over the lifetime of the contract will consist of the consideration received for the ‘insurance risk’ in the contract, taking into account the time value of money but excluding amounts relating to any investment components of the insurance contract. The investment component is the portion of the premiums that will be returned to the policyholder regardless of whether a claim occurs and will be deposit-accounted. Unit-linked insurance contracts issued by life insurers and contingency policies issued by non-life insurers typically include large investment components, and insurers will present significantly reduced revenue from these contracts.
MOVEMENT ANALYSIS DISCLOSURES
The third key financial reporting implication relates to the disclosure of the movement in insurance contract liabilities. The information required to be disclosed will be much more granular and will be more transparent to the user. Entities will be required to disclose the movements in the best-estimate cash flows, risk adjustment and contractual service margin separately, showing the effect of each change that is material. A movement analysis will also need to be presented for the portion of the insurance contract liabilities that relates to remaining coverage.
Furthermore, insurance contract revenue presented in the income statement as discussed above will need to be reconciled to the premiums received during the period in the notes to the financial statements. This reconciliation should present amounts relating to timing differences, interest and investment components of the premiums.
It goes without saying that IFRS XX will have a significant impact on investor communication and key performance indicators. Early consideration should be given to how the current IFRS and embedded-value reporting will compare to IFRS XX and how management want to communicate the results to the market. In addition, the new standard may well impact management information, and it may even be necessary for insurers to overhaul planning, budgeting and forecasting functions.
Most insurers are currently focused on SAM implementation, but it is expected that the focus will shift to IFRS XX after SAM goes live in 2017.
AUTHORS Dewald van den Berg CA(SA) is Director at PwC and Daleen Smith Senior Manager, also at PwC
THE IFRS 9 ‘HOLD TO COLLECT’ BUSINESS MODEL
Since IFRS 9 does not define ‘insignificant’ and ‘infrequent’, an entity needs to think about setting its own thresholds for sales of financial assets that form part of its ‘hold to collect’ business model. By Lizelle Muller
IFRS 9 was finally issued in 2014 and will have a significant impact on annual financial statements for periods beginning on or after 1 January 2018. The focus undoubtedly has been on the impairment implications of the new standard (and rightfully so). However, there are numerous issues relevant to classification and measurement that should also be carefully considered.
Under IFRS 9, the classification of financial assets is principle-based, where an entity first considers appropriate business models for managing its financial assets. A business model is determined by an entity’s objectives and how it realises cash flows relating to those financial assets. To measure a financial asset at amortised cost, one of the two key criteria is that an entity’s business model needs to be that of holding the financial assets to collect contractual cash flows rather than managing the overall return of the portfolio by selling the financial assets. The second criterion is the ‘solely principal and interest’ test. Clear evidence of an entity’s business model is the level of sales associated with the financial assets held. Where an entity sells financial assets which it was holding to collect contractual cash flows, it needs to consider the implications on its documented business model.
Although the objective of an entity’s business model may be to hold financial assets to collect contractual cash flows, an entity is not required to hold these instruments until maturity. In certain circumstances, sales remain consistent with a ‘hold to collect’ business model, depending on the nature of the sale. IFRS 9 indicates that should an entity sell financial assets as a result of an increase in credit risk, these will still be considered ‘hold to collect’ as credit quality is fundamental to an entity’s ability to collect contractual cash flows. A further example of permitted sales included in IFRS 9 would be when an instrument is sold close to its maturity. Entities will have to adopt appropriate internal policies in order to govern when this will be the case, for example if the proceeds from the sale are, say, within approximately 10% of remaining total contractual cash flows.
Sales of these types, and the rationale behind them, should be clearly documented in order to prove that the sale is still in line with the ‘hold to collect’ business model. Further examples specified in IFRS 9 include sales of financial assets that are either significant in value but infrequent, or frequent but insignificant in value.
In the instance that sales are made to manage ongoing liquidity requirements, or concentrations of credit risk, it is essential to monitor the volume of these sales. Should they be significant and frequent, the entity’s business model could be brought into question.A potential way of doing so could be to compare the amortised cost-carrying amount of the sold financial assets to the total amortised cost-carrying amount of the ‘hold to collect’ financial assets. The carrying amount, rather than the selling price, should potentially be used here, as sales proceeds would be impacted by market conditions at the time of sale and this may distort the outcome of this test.
Sales over the entire life of the financial assets are relevant. Therefore, for dynamic portfolios that have constant additions and disposals, the most accurate test could be one that is done on a cumulative basis, either monthly, quarterly, or annually. Purchases should be added and assets that have matured should be removed from the cumulative balance calculation. Practically, a cumulative test would be very difficult to apply as the amortised cost of each sale would need to be tracked and updated until such time as the financial asset would have matured. An alternative approach could be to evaluate sales on a period-by-period basis. This approach is far simpler, since it includes the carrying amount of sales during a particular period only. Furthermore, consideration should be given as to whether average balances should be used in the calculations in order to eliminate the impact of cyclical sales activity, such as comparing the carrying amount of sold financial assets to the average balance of the portfolio for the quarter (being the simple average of the opening balance and closing balance.)
Although IFRS 9 refers to ‘infrequent’ and ‘insignificant’, it does not define these terms. An entity is therefore required to decide on a threshold level of sales in this regard. Would sales for a particular period amounting to, for example 5% of the closing balance, be considered insignificant in value? And if this is the case, if 5% was sold every year, cumulatively it could well be considered more than insignificant. It may make sense, therefore, for an entity to set a cumulative amount of around 10%. This way, if the threshold is exceeded over a three-year period, for example, the business model may well have changed.
Setting of thresholds and deciding on certain calculation methodologies will have to be considered carefully by entities and will require audit buy-in prior to being applied.
AND THE UGLY
So then, what actually happens once sales are considered to be more than infrequent and/or insignificant in value in a particular period? Selling activity may indicate a shift in management’s strategy, and therefore a change in business model. The accounting implication thereof is a reclassification of the financial assets into a different business model that is one of selling financial assets to achieve a particular objective. In this instance, these financial assets are required to be accounted for at fair value. An entity should therefore have a robust governance process in place to ensure that any changes to business models are appropriately accounted for.
Although IFRS 9 requires a fundamental change in how the impairment of financial assets is monitored, governed and accounted for, reporting entities should not neglect the classification and measurement paragraphs of IFRS 9 since they will lead to significant governance changes.
AUTHOR l Lizelle Muller CA(SA), Technical Advisory Group, Absa