IFRS 17 – Episode 1: Profit Returns
In 25 May 2017 the International Accounting Standards Board (IASB) completed Phase II of its insurance accounting project and released its hotly anticipated new standard; International Financial Reporting Standard (IFRS) 17: Insurance Contracts.
There were some in the actuarial reporting community who thought this day would never come given that Phase I of the project had been completed on 1 March 2004 and had resulted in the publication of IFRS 4 (also helpfully suffixed “: Insurance Contracts”), which could almost be summarised as “keep doing what you’re doing”. Others of a more understanding nature, this author included, argued that 4,833 days was a reasonable period of time for accountants to understand actuarial concepts and besides, the IASB needed to wait for the introduction of Solvency II (SII) and the “copy-edit-paste” opportunities it presented. Interestingly the IASB has only given companies until 1 January 2021, or 1,317 days, or 27% of the deliberation time that they granted themselves, to turn their vision into reality.
Given the challenge this step-change in requirements will pose to our clients, a small group of APR employees have embarked on a quest to write a series of articles to introduce the Nearly / Newly Qualified Actuary to this brave new world as painlessly as possible. These articles will cover the following topics, some of which may even become a mini-series in their own right:
- The Purpose of Profit Reporting (this article).
- The limitations of IFRS 4.
- IFRS 17 – the Introduction.
- IFRS 17 – the Liability Measurement Approach.
- IFRS 17 – Implementation and Transition.
What is Financial Reporting?
Insurance companies are obliged to report for, broadly, two distinct purposes:
- Solvency Reporting – proving to their regulator that they are solvent.
- Profit Reporting – providing information to interested parties (investors) about the company’s performance, and calculating the company’s tax bills for HMRC.
From 1 January 2016, UK solvency reporting has been prescribed by the European Insurance and Occupational Pensions Authority’s (EIOPA) SII regulations. Amongst a plethora of other objectives the target of SII is to ensure that companies hold at least enough capital that they can remain solvent over the next year, even if they experience adverse conditions that are only expected to occur once every 200 years. While this is great for the regulator’s and policyholders’ peace-of-mind, it does not tell investors very much about the returns the company is generating for them. The company returns and financial performance is the realm of profit reporting, and so is the focus of IFRS 17 and this article series.
Profit Reporting Regulation
Profit reporting involves releasing a set of consolidated accounts showing: the assets and liabilities of the company at the start and end of the reporting period (the balance sheet); and the income / outgo of the company over the period (the income statement or profit and loss account). Notes to the accounts are also required, which may include extensive additional disclosures. For all companies in the UK, profit reporting is governed by the Companies Act 2006, which states that the company can adhere to either:
- UK Generally Accepted Accounting Practices (“UK GAAP”), or
- International Accounting Standards (“IAS” – note that IASs were the forerunner to IFRS, and now in fact IFRS is often used to include both IFRSs and IASs; however, the legislation still refers to IAS).
Listed companies do not have this choice: EU legislation dictates that they must use IFRS for their accounts.
What does this have to do with actuaries?
All this talk of accounts runs the risk of sending the typical Nearly / Newly to sleep – think CT2 or, if you’re reading this from the future, CB1. Surely this is for the accountants – how does it involve us?
Well, primarily actuaries are involved in the valuation of the liabilities presented in the balance sheet, and in producing tables of movements and stresses for these liabilities, presented in the notes to the accounts to give added insight. Currently there are three classes of contract presented separately in the balance sheet:
- Contracts with discretionary participation features (dpf)*.
- Insurance contracts without dpf, and
- Investment contracts.
*Note that participating (par) contracts are split between insurance and investment in the notes to the accounts, so really four splits are needed.
The definition of an insurance contract is what you would likely expect; they transfer significant insurance risk[1]. Non-insurance contracts are investment contracts and not measured according to IFRS 4 or IFRS 17. While these articles (and their authors) are not interested in investment contracts, the interested reader might like to know that their cash flows are separated into a “management services component” and a “financial services component”, and measured adhering to the two standards “IAS 18: Revenue” and “IFRS 9: Financial Instruments” respectively.
…and how are insurance contracts measured?
The fastidious reader will already know the answer to this one but the dramatic opportunity necessitated repetition. Currently insurance contracts are measured according to IFRS 4 but shortly they will adhere to (deep intake of breath…) IFRS 17!
Let’s step back – a company sells something, it makes a profit. Why are different standards needed for insurance contracts?
Reporting the profit of an insurance company is not as simple as for a “normal” retailer like Carphone Warehouse. When Carphone Warehouse buys an iPhone for £500, sells it for £1,000 and has £300 of expenses, it is clear that its profit is £200.
However, when an insurer sells a life insurance policy, it will have an idea of the profit it expects to make in future on an average policy[2] (its Expected Present Value of Future Profit EPVFP) but there is much uncertainty around this amount. For example:
- Will the policyholder make a claim and therefore the insurer a loss?
- Will the insurer’s investments, and please forgive the colloquialism, go “belly up”?
These questions will only be answered, and the insurer’s profit known with certainty once the policy has matured, but in some cases this may be 30 years and who wants to wait that long for their profits?
A related point is that it makes sense to report profit in a way that is related to the provision of insurance to the insured over a period of time, ie the service purchased. However the insurer has not yet actually provided this service at the point when the premiums are paid. That said, it should be remembered that attracting the customer, making the sale and setting up the policy is a large part of the effort and expense of the insurance business and so may reasonably be defined as a considerable part of this service.
Finally, it is reasonable to expect insurers to hold reserves over and above what they expect to pay out, to ensure they have sufficient means to pay excess claims if they arise and avoid financial instability and bailouts[3]. This must be balanced by not allowing insurers to hold excessive reserves in order to defer profits, and thus taxes to HMRC.
So what are the desirable features in an accounting standard for insurance contracts?
Accounts should give users a true and fair view of the company. When considering the valuation of insurance contracts, three positive attributes that would assist in achieving this vague aspiration are:
- Informative: It must give the users of the accounts, often analysts for investors, sufficient information to make informed decisions.
- Consistency: It should be useful to analysts when making comparisons between companies, both within and across countries.
- Timing: It should lead to profits appearing as and when earned, ie as the contractual service is provided and the risk transferred runs off the company’s books. Additionally, investors would prefer this profit emergence to be “smooth” with low volatility between years[4]. Amongst other points, the timing of the emergence of profit is important when calculating tax.
Modern(ish) economic theory dictates that liabilities should be valued using a “market consistent” approach. This means deriving the value of liabilities as far as possible with reference to observable market data. Where market data is not available, we must aim for our models to produce a “fair value”, which is the amount that a “knowledgeable willing party” would accept to take on the liability themselves. This constrains the methods we can use to achieve these three desirable features.
We will illustrate these features with an example[5]. Let us consider a single premium protection contract under two scenarios:
- Where the contract matures with no claims.
- Where a single claim is made at some point over the life of the contract.
Now consider two reserving standards:
- One that did not require any reserves to be held for the contract.
- A second where a reserve must be held equal to the full sum assured (“SA”).
Under the two claims scenarios above the product lives look as follows:
1. Contract matures without any claims
| Profit | No reserves need to be held | Full SA must be held as reserve |
|---|---|---|
| Initial profit | Profit of Premium - Expenses | Loss of SA + Expenses - Premium |
| Subsequent profit | Small losses from renewal expenses being paid | Small losses from renewal expenses being paid |
| Profit at maturity | None | Profit equalling value of remaining reserve |
2. A claim occurs over the contract life
| Profit | No reserves need to be held | Full SA must be held as reserve |
|---|---|---|
| Initial profit | Profit of premium less expenses | Loss of SA + Expenses - Premium |
| Subsequent profit | Small losses from renewal expenses being paid | Small losses from renewal expenses being paid |
| Profit at claim | Loss equalling SA + expenses | Small loss from claim expenses (reserve pays SA) |
And graphically:
Comparison 1: Profit when no claim occurs
Comparison 2: Loss when claim occurs
In both cases, the cash flows to / from the company are the same but the timing of the emergence of profit is wildly different. The timing in either case is poor, because profit and loss should be considered to be generated over the duration of the contract and not at either inception or maturity. Further, if a standard allowed companies to report in either fashion, even identical companies could appear entirely different.
An ideal standard would sit somewhere between these two extremes and report a smooth profit as the service is provided.
Enough of the theory – what is wrong with the current standards as they are?
Well, it’s a great question, and as it happens that is the subject of next month’s article (“The limitations of IFRS 4”) – we’ll see you then to discuss further.
To be continued…
Conor O’Duffy
May 2018
Footnotes
[1] Fine – here is the full definition “A contract under which one party (the issuer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder.” (IFRS 17)
[2] OK, the whole premise of insurance is the application of the Law of Large Numbers so it doesn’t really make sense to think about contracts individually but rather as cohorts. However, this is an article not a textbook so leave me alone.
[3] If only the same could be said of banks!
[4] The volatility of insurance companies’ reported profit is sometimes given as a reason for insurers being (arguably) traditionally undervalued. Another point is the sheer incomprehensibility of their accounts. So if we can improve these features for your company it may improve your bonus.
[5] Continuing in a fine tradition this example ignores tax, investment income and any sort of basis in reality.