Perspectives

What challenges do insurers face with the implementation of the new IFRS?

Insurers should be preparing themselves by looking ahead of the implementation of the new IFRS.

While there are many similarities between the new Insurance IFRS and Solvency II frameworks, their goals are quite different. Solvency II focuses on shareholders’ interests while Insurance IFRS is designed to protect policyholders.

1. Residual Margin - The IFRS Insurance Deferred Profit

 

Looking at the challenges insurers should be preparing themselves for, ahead of the implementation of new IFRS

While there are many similarities between the new IFRS Insurance and Solvency II frameworks, the goals of Solvency II and IFRS are actually quite different. The former focuses on shareholders’ interests while the latter is designed to protect policyholders. Although both frameworks use a common valuation for insurance liabilities (the “building block approach”) their opposite goals produce a number of detailed differences that are not easy to manage. Solvency II systems cannot deal with these differences and additional system work is necessary.


Residual margin – the IFRS Insurance deferred profit

  • One of the IFRS Insurance requirements (from IFRS 4 Phase II) requires insurers to earn their profit as they fulfil their obligations with policyholders. This deferred profit is transparently reported and accounted for in the residual margin balance. An equivalent concept does not exist within Solvency II.
  • In addition, IFRS 4 Phase II requires the residual margin to be recalibrated based on the changes in assumptions affecting the future cash flows from in-force business.
  • Residual margin data requirements will be at a granular cohort level i.e. groups of contracts by inception year, policy term and shape of earning pattern.
  • Residual margin data will provide powerful insight in an insurer’s embedded profitability and ability to price risk effectively. Linking pricing guidelines to the accounting for residual margin could introduce stronger and clearer underwriting discipline.

2. Risk Margin


Looking at the challenges insurers should be preparing themselves for, ahead of the implementation of new IFRS
While there are many similarities between the new IFRS Insurance and Solvency II frameworks, the goals of Solvency II and IFRS are actually quite different.  The former focuses on shareholders’ interests while the latter is designed to protect policyholders. Although both frameworks use a common valuation for insurance liabilities (the “building block approach”) their opposite goals produce a number of detailed differences that are not easy to manage. Solvency II systems cannot deal with these differences and additional system work is necessary.

 

Risk Margin - Diversification Benefits

  • Both Solvency II and IFRS 4 Phase II allow for the benefit of risk diversification that insurers create by assembling portfolios of insurance contracts and by running portfolios with negative risk correlations (e.g. insuring against death and longevity)
  • Diversification between portfolios is permitted under IFRS only if it aligns with the insurer’s risk appetite
    Alternative segmentation of the data within core systems  are likely to lead to different portfolio definitions
    Different computation requirements between portfolios reported in subsidiaries and at a group level will also add data layers for both Solvency II and IFRS 4 Phase II calculations


Risk Margin - Computation Techniques and Parameters

  • IFRS recommends the use of three alternative techniques (including Cost of Capital – CoC) whereas Solvency II prescribes only one method (CoC). Using CoC under IFRS could maximize systems synergies between Solvency II and IFRS albeit the systems must be able to accommodate IFRS parameters which are likely to be less conservative than under Solvency II.
  • However under IFRS, the confidence interval that produces the same risk margin under the insurer’s selected technique needs to be disclosed unless the risk margin is calculated using the confidence interval approach. This will require some actuarial systems changes.

3. Discount Rate and Best Estimate Cash Flows

 

Looking at the challenges insurers should be preparing themselves for, ahead of the implementation of new IFRS

While there are many similarities between the new IFRS Insurance and Solvency II frameworks, the goals of Solvency II and IFRS are actually quite different. The former focuses on shareholders’ interests while the latter is designed to protect policyholders. Although both frameworks use a common valuation for insurance liabilities (the “building block approach”) their opposite goals produce a number of detailed differences that are not easy to manage. Solvency II systems cannot deal with these differences and additional system work is necessary.

 

Discount Rate

  • The discount rate dominates the valuation of insurance liabilities for both Solvency II and the new IFRS Insurance. The approach to set discount rates in IFRS 4 Phase II is principle-based while Solvency II prescribes yield curves by currency.
  • In addition, IFRS 4 Phase II requires the discounting for earnings purposes to be computed on the discount rate set at the inception of the contract. The difference with the liability measured using a discount rate based on the current interest rates would go directly to equity. Storing and managing these layers of discount rates and their unwinding through earnings and equity is not covered by any Solvency II system.

 

Best Estimate Cash Flows

  • Both IFRS 4 Phase II and Solvency II require the disclosure of a probability-weighted estimate cash flows for all portfolios of insurance contracts. This estimate is based on the statistical mean of the underlying probabilities.
  • Although substantially similar, Solvency II has a couple of more conservative requirements on cash from future premiums (contract boundary) and overhead expenses that would not be found in 4 Phase II where the estimate would be lower all other things being equal.
  • IFRS 4 Phase II requires cash flows subdivided by inception year and policy term to support residual margin calculations.
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