Misconceptions abound around the introduction of IFRS 17, the new accounting standard for insurers. Below we uncover the truth behind the 10 most common beliefs surrounding IFRS 17.
It’s been a long time coming, but it’s here at last – well, almost. Of course, we’re talking about the new accounting standard for the insurance sector, IFRS 17. What changes will this new standard bring and what will the world of insurance– or rather its figures – look like in the future? Below we take a reality check on 10 common beliefs.
1. IFRS 17 requires so many assumptions to be made that it will be impossible to compare companies with each other
IFRS 17 demands an array of assumptions for modeling and valuation purposes. To start with, there are cash flows, which are probability-weighted averages. Then assumptions have to be made about yield curves and about the granularity of calculations, measurement approaches (premium allocation approach vs. building block approach), the use of the OCI (other comprehensive income) option, the choice of coverage units and the level of risk adjustment.
All these assumptions vastly affect the results and make it harder to compare different entities side by side. The extensive reporting requirements should ensure that the information provided is very transparent. But this doesn’t necessarily mean that it will be possible to compare companies. Measurements are too complex for differences in assumptions and inputs to be readily quantified and thus enable a direct comparison between the figures for different insurers. It can also be expected that companies will use the existing level of choice for the valuations under IFRS 17.
2. Insurers will become less prudent with non-life provisions
IFRS 17 demands a probability-weighted average of all cash flows. This essentially means that provisions should be a best estimate. Currently, IFRS 4 allows a consistent level of prudence to be applied in measuring provisions. Many insurers therefore prefer to be slightly conservative with their provisions. IFRS 17 is designed to eliminate this explicit (and implicit) prudence. But an element of estimation uncertainty will remain, and this will permit a certain degree of variation, which will need to be validated by the auditor.
Additionally, a risk adjustment must be made to reflect the uncertainty. The amount of the risk adjustment is not specified and can be defined by the insurer. However, the insurer has to disclose the confidence level it uses in the notes. So the standard allows some room for creating a safety cushion, but it has to be disclosed.
3. Actuaries and accountants will have to work more closely with one another
IFRS 17 places far more exacting demands on the statement of financial position and income statement. Many actuaries have already been brought on board of implementation projects in order to satisfy these requirements. Considering that IFRS 17 links cash flow measurement and reporting far more closely, we expect that actuaries and accountants will (have to) collaborate more intensively when preparing financial statements.
4. Granularity of calculations should be as coarse as possible
IFRS 17 requires, as a rule, presentation on a contract-by-contract basis, but this is virtually impossible for companies with big volumes of business. To address this problem, contracts can be aggregated into groups. However, IFRS 17 contains the requirement to present profitable and unprofitable business separately . At first, this might seem to be at odds with the basic concept of insurance. But the aim is not to single out contracts with large claims – rather it should make deliberately unprofitable business transparent. This will, of course, render such business far more visible than it is today. It therefore seems reasonable for insurers to apply as coarse a level of granularity as possible in their calculations. But then again, this conflicts with the requirements of the standard. Dialog between auditors, companies and local regulators will be needed to achieve appropriate presentation. The chosen measurement approach (premium allocation approach vs. building block approach) will play a role, as will the question as to just what actually are “facts and circumstances”?
5. Fair value measurement is the best solution for the transition
The standard allows three different methods for the transition to IFRS 17. “Full retrospective” is the standard approach, but it has to be calculated as if IFRS 17 had always existed, which will be very time-consuming and difficult in terms of data requirements, if not impossible – at least for very long-term contracts (as are frequently found in the life insurance segment). Various exemptions exist for the “modified retrospective” approach, making it more realistic to apply it (depending on a company’s business model). The fair value approach lies at the opposite end of the spectrum and determines the contractual service margin (CSM) at the transition date using a fair value view of the portfolio. This gives rise to a degree of interpretability which can have a considerable effect on the value at transition. The choice of transition approach will therefore have a huge impact on the opening statement of financial position and, through the opening CSM, this effect will also reach into future periods. Entities are not entirely free to choose an approach, however, but must first meet specified criteria.
6. Software solutions are not yet advanced enough
One of the greatest problems at present is implementing a software solution in the IT landscape. As the standard is so complex in terms of the statement of financial position, income statement and, above all, disclosure requirements, it requires a highly complex and entirely new method of computation. It is a mammoth task to program the required software efficiently, while meeting the requirements of the standard and ensuring comprehensibility, auditability and transparency. This currently poses one of the biggest project risks in many IFRS 17 projects. The (for the time being) one-year postponement of the introduction of IFRS 17 has provided some relief, but it is not clear whether this extra time will be sufficient. Further adjustments will undoubtedly be needed after IFRS 17 becomes effective.
7. IFRS 17 was invented by the Big Four
Development of the standard began many years ago. IFRS 4 was always conceived as a temporary solution. It is fairly obvious that it was a good time to introduce IFRS 17: work on Solvency II was starting to become business as usual and IFRS 17 was a welcome source of revenue for the big advisory and audit firms. But the Big Four did not invent the standard (or Solvency II, for that matter), although they were undeniably involved in its development.
8. Choosing the premium allocation approach (PAA) for as much of non-life business as possible is the only way forward
The PAA simplifies accounting for short-term, i.e., primarily non-life, business. It is much closer to the previous method of presentation under IFRS 4 and also entails fewer disclosure requirements than the building block approach (BBA) or the general model. It greatly simplifies development work, data specifications and the subsequent reporting process. However, in most cases two different measurement approaches will need to be used side by side as some business will not qualify for the PAA and the BBA will have to be applied. What is more, the PAA doesn’t use a contractual service margin (CSM) as the BBA does. The CSM may become a key performance indicator (KPI) in reporting to investors and analysts. It is hard to tell which arguments will prevail in the end. Some argue that the PAA can be applied to the entire portfolio. However, the BBA could still be required in the event of future portfolio transfers or M&A activities. Analysts and investors have yet to form an opinion on this issue.
9. IFRS 17 increases transparency and helps to tell a coherent investor story
There is no doubt about it, IFRS 17 will lead to the transparent presentation of far more information than ever before. Another stated aim was to provide much clearer guidance on the approach in order to reduce the scope for judgment in measurement (i.e., best estimates). However, it will be a while before a consistent market perspective emerges, for example on the level of risk adjustment, which has further implications (such as an effect on the amount of the onerous contract liability). The choice of granularity can also have a substantial effect on the figures and may lead to companies applying different approaches. In addition, the standard is so complex that financial statement users will first have to become familiar with the new figures and the information they convey. We will see improved transparency, but also greater complexity and difficulty in interpreting figures. Last but not least, companies themselves will have to understand and interpret the facts and figures. It remains to be seen which KPIs will be crucial and attract the attention of investors and analysts.
10. The cost of IFRS 17 projects will be more than double of the original budget
The IT component is definitely one of the main drivers of any IFRS 17 project. But such projects involve not only rolling out new software, but also implementing an entire sub-ledger which shapes the statement of financial position and therefore also has to be approved by the auditor. On top of this, the complexity of the standard, as mentioned above, will necessitate far closer collaboration between actuaries and accountants, and with IT. Many companies have already upped their budgets for implementation considerably, and the potential future amendments to the standards will also have a bearing on costs.