Seven reasons for taking interest in IFRS 17
IFRS 4 „Insurance contracts“ was published in March 2004 and the work on comphrehensive solution for insurance contracts accounting started. During this 13 year period, proposals for new regulations were published regulary and often provoked heated discussions. The IASB has received more than 600 formal letters with comments from potential users of the new Standard.
The prolongation of the process and the frequent changes in the key assumptions of the project have created expectation that the standard will never be published and that is why the acceleration of work in recent years has been accepted with astonishment. The revolutionary changes that took on more and more real-life examples have often provoked resentment, especially as memories of the organizational and financial efforts associated with Solvency II implementation are fresh in memory. Up until May 18 2017, there was still hope for further modifications that would delay the implementation of the standard, but after the official announcement of IFRS 17 there is no longer a possibility of retreat from profound changes in the reporting.
The main practical challenges associated with the implementation of IFRS 17
1. Choice of the valuation model of liabilities
The General Model introduced by IFRS 17 assumes that insurance liabilities will be measured as the expected future cash flows (discounted at market rates), plus risk adjustment and service margin.
The above general model allows for two modifications and one simplification.
The "Premium Allocation Approach" (PAA) is similar to the current model used in non-life insurance and premium reserve. Using this approach, there is no need to set a separate risk adjustment and contractual service margin, and that significantly simplifies the valuation of liabilities. The use of the PAA approach is permitted primarily for short-term contracts (no longer than 12 months).
2. Unit of account
A portfolio is defined as group of contracts subject to similar risks and managed together as a single pool. IFRS 17 requires the Company to disaggregate the portfolio into groups of inusrance contracts that at inception are:
- profitable with significant risk of becoming onerous, and
- other profitable contracts.
Further disaggregation of the specified groups is permitted and only contracts issued within the same twelve months period are permitted to be grouped (groups for shorter periods are permitted). The groups are established at the inception of the contracts and not subsequently reassessed.
3. The need to adapt IT systems
The need to carry out calculations at the level of units of account entails many practical implications for IT systems. The requirement for separation of several units of account means that the Company will have to have access to a significant number of specific data within the IT system.
Moreover, due to the interaction between the changes in future cash flow forecasts generated by the actuarial systems and the contractual service margin level, actuarial calculation tools will have to be more integrated into the accounting systems.
4. Risk adjustment methodology
One of the significant elements of the measurement of liabilities under IFRS 17 is the risk adjustment, which is measured and presented separately. The concept of adjustment is similar to that of the risk margin, which is a component of technical provisions for solvency purposes. However, there are significant differences between them.
While the risk margin calculation methodology does not leave room for significant modifications and is imposed by the requirements of the Delegated Regulation, the IASB's approach is based on Company's own judgment and risk perception. Companies will have considerable discretion in defining their own risk-adjustment methodology. Using synergies with Solvency II calculations can be a cheap and quick solution, but perhaps not entirely optimal from the point of view of capital management.
5. Reinsurance contracts
In the new standard, reinsurance contracts will be treated as separate insurance contracts. This will require, for example, the need to specify contract boundaries, risk adjustment and, where appropriate, the amount of the CSM service margin. Consequently, reporting on reinsurance may become more demanding than it is today.
6. Choice of transition method
Recognizing an existing portfolio as required by the new Standard seems to be one of the biggest challenges for insurers. The importance of this issue is highlighted by the IASB appointing a special working group to deal with the practical aspects of the Transition issue.
The IASB indicated that companies should value all insurance contracts in their portfolio as of 1 January 2020 using full retrospective approach. This means that all contracts sold in the past and still in the contract portfolio will need to be re-priced at the date of sale. Companies will have to apply assumptions that have historically been applied and used to rate the contract.
The above requirements are very restrictive and put into question the possibility of using a full retrospective approach cases of contracts that were sold many years before the Standard became effective. Information about the actual implementation of all assumptions for individual contracts, information about actual costs incurred (including acquisition costs), etc. would be required for this. Applying a full retrospective approach seems realistic in the case of historical sales of up to several years (depending on the quality of databases available at the Company).
IASB, recognizing the difficulties that may be involved in applying a full retrospective approach, proposed two simplifications - a modified retrospective approach and a fair value approach. Simplifications are only acceptable if the Company demonstrates that applying a full retrospective approach is impracticable for a given group of insurance contracts. Where the standard has already been published and the scope of data required for a retrospective approach has been determined, it may be difficult for companies to argue that collecting such data (and applying a full retrospective approach) for sales from 2018 to 2019 was not feasible.
7. New form of reporting
One of the important reasons for the development of new standard is the desire to make reporting accross industries more consistent.
The solution proposed by the IASB refers to the principle of equivalence of benefits and contributions. As a result, when presenting revenue, the information about contributions is replaced with information about the benefits and deductions for risk adjustment and CSM.
The change in approach proposed by the IASB may have a number of implications, both market and internal. Greater comparability with other industries and broader disclosures will allow analysts to get more information about the financial health of individual insurers, which may result in increased interest in investing in the insurance industry.
Given the significant changes and challenges imposed by IFRS 17, the three-year transition period should be used wisely for preparation. The introduction of the required changes will have to be a large scale project involving accounting, actuarial and IT departments. At this crucial stage, it is important to prepare a plan for such a project, secure its funding and promote knowledge of the implications of the new standard among executives.