IFRS 17 – A New Hope

You’ve told me about the aims and the timeline, but I’m still none-the-wiser as to how it differs from IFRS 4. Care to elaborate on how you value liabilities to measure profit under IFRS 17 and whether it will satisfy our three desirable characteristics above?

We covered in the previous article how non-participating contracts were measured for profit reporting using something called the Modified Statutory Solvency Basis (“MSSB”) which involved layering up prudent assumptions and setting up Deferred Acquisition Cost (“DAC”) assets.

Under IFRS 17, for non-profit business the go-to liability measurement method will be the Building Blocks Approach (the “BBA”, or “General Model”) and the concepts of prudent reserves or DAC assets will be consigned to the annals of history. Instead, reserves will be under a best estimate basis (which merely means the most realistic view of the future cashflows without any adjustments or margins included), discounted using a yield curve and with all costs recognised when they occur. For European insurers this should be readily familiar from Solvency II. A key difference will be the granularity of calculation which will be much stronger under IFRS 17. This makes grouping contracts to hide loss making ones a lot more difficult, which in turn makes the accounts more informative; a key desirable.

In addition to best estimate reserves there will be two other items that form the liabilities; a Risk Adjustment (“RA”) to allow for uncertainty in claims and a Contractual Service Margin (“CSM”) that represents the unrecognised future profit to be released for the contract(s). The CSM is released as profit over time and is aimed at satisfying our desirable ‘timing’ characteristic above. This CSM is a fundamental change and we will devote more time to this concept in later articles.

What about with-profits – have we aligned these and fixed the issue with consistency between NP?

As we have covered previously, with-profits (participating) business, and unit-linked, have some key differences from non-participating business. An important point is that the profits to an insurer come from charges for U/L contracts, typically expressed as a percentage of the fund value, and from the shareholder transfer for with-profits, so the future profits depend inherently on future investment returns. Given that economic assumptions are likely to be among the more volatile assumptions for an insurer, this makes the BBA less suitable for these products. This point will be expanded upon more when we discuss the CSM in more detail.

For these contracts, a variation on the general BBA model is introduced known as the Variable Fee Approach (“VFA”). In this approach the liabilities that are fully defined by a specific asset pool are set equal to the assets and the total liability/income to the company is then shown as the fees received (AMCs) less any expenses, charges or cost of guarantees. This is known as the Variable Fee, and the CSM is set equal to this and released over time as in the BBA.

This does mean that there will be some inconsistency maintained between non-participating contracts and those with direct participating features (with-profits and unit-linked now covered by this term under IFRS 17) but the inconsistencies are reduced. Crucially, in both cases the CSM will be a view of the future profits that will be available for release in future years.

This seems sensible on the face of it. Are those the only two methods? There doesn’t seem to have been that much new introduced.

Don’t be fooled! The RA and CSM will both require some significant work to understand, set up and maintain. As all actuaries know, the simpler the concept, the more scope to make some crazy, overly complicated models – not that actuaries would ever be guilty of such crimes!

But you’re right, there is a third approach. The Premium Allocation Approach (“PAA”) is simplified and is permitted where the above models are overly onerous for very short-term products, typically with a lifetime of less than a year. We will not cover this method here as we don’t want to take up too much of your time, but it is a simplified method similar to current General Insurance techniques. We’ll cover this in a bit more detail later in our series.

Any questions so far?

So many questions. We have barely scratched the surface…

You are correct, so what we will do is quickly recap, showing how IFRS 17 aims to address our desirable reporting characteristics, and then we can all look forward to our next article where we will really dive into the detail.

So to recap:

IFRS 17 will be in effect from 2021 with an aim of producing relevant and reflective reporting of insurance contracts addressing key criteria 1 – Informative.
IFRS 17 will affect most major insurers in most countries (some key exceptions being USA and Japan) so it is looking to address key criteria 2 – Consistency.
IFRS 17 will have three insurance liability valuation approaches to be used in all jurisdictions also addressing key criteria 2 – consistency:
- Building Blocks.
- Variable Fee.
- Premium Allocation.
A contractual Service Margin will be introduced to release profits over the life of a contract aiming to address key criteria 3 – Timing.

Make sure to revisit us for our next instalment where we will begin to discuss the BBA, VFA and PAA in more detail.

James Nicholl

July 2018

[1] Although as a mutual does not technically make profit whether they would need to report that zero profit is a good question – not one we will address here.

IFRS 17 – IFRS 4: The Limitation Game

No, really – please would you go into the specifics of the undesirable aspects of the timing of profit emergence of non-par SP and RP contracts under IFRS 4?

Hmph, it’s rude to interrupt but it’s polite to listen, which you clearly have been. Fine…

For a single premium contract like an annuity, a company receives the full premium on day 1 and reports an increase in reserves. The prudential margins in the calculation of this liability are small relative to the premium leading to a large profit in that year’s profit and loss account. As the margins run-off we expect a small amount of profit to arise each year from the liability reducing at a greater rate than the assets reduce to pay the annuitant. Any adverse deviation in longevity experience[3] or changes to assumptions will feed directly into the profit and loss account. The combined effect of the above is volatile reported profits that depend on the quantity of new business sold that year and the experience of existing business relative to the valuation basis.

For regular premium products like term assurances, prudence in valuation assumptions often leads to an increase in reserves on day 1 that is larger than the initial premium received. This results in a reported loss known in the industry jargon as New Business Capital Strain. By contrast, under a market-consistent approach[4] like Solvency II, the Best Estimate Liability (“BEL”) for these products would nearly always be negative because the expected future premiums more than outweigh expenses and claims. IFRS 4 is effectively saying we have made the company weaker when really it has become stronger.

Deferring acquisition costs reduces this loss but it does not give investors any indication of the expected future profits on this business; it does not go nearly far enough. Subsequently, the timing of profit emergence is dictated by the run-off of prudential margins and DAC amortisation. While this will be related to the service provided, it will not be related in a transparent fashion nor necessarily in an equivalent manner between different companies. Like the SP case, experience deviation and assumptions changes are reported as profits / losses leading to profit volatility.

Put simply the timing of profit emergence for non-par insurance contracts is “all over the shop”. The fact that companies, through the Chief Financial Officer (“CFO”) forum[5], developed their own Embedded Value Standards to give investors adequate information about the true value of their existing business portfolios is testament to the inadequacy of IFRS 4.

And what about with-profits?

In 2004, the PRA was ahead of the global regulatory pack in this regard. Profit reporting under IFRS 4 is based on Solvency I, which involved a market-consistent valuation of options, guarantees and other benefits. Beyond Solvency I reserves, there was a Fund for Future Appropriations, which was the surplus in the With Profit Fund intended to enhance policyholder benefits.

Some companies also choose to disclose an Unallocated Distributable Surplus (“UDS”), which is the amount expected to be allocated to shareholders from the WP fund (but until allocation, it is a policyholder liability). This will often be allocated as bonuses are declared; eg for every £9 of bonus the shareholders receive £1. Since the timing and value of bonuses are uncertain, this is also true of the UDS, but it gives an indication of the return expected by shareholders. With profits funds have varying levels of complexity and as such so do their accounting policies, with some change over time to become more relevant or reliable.

This approach does not fail our criteria quite as spectacularly as its non-profit equivalent. The main issues are:

Point 2 is worth emphasising. The Balance Sheet liability and changes to liabilities reported in the Income Statement for both par and non-par are usually single figures and as such give no indication to analysts of their make-up or how they are expected to be realised, if at all. Additionally, as I hope you’ve gathered, their calculation is complex and requires extensive explanations of methodology in the notes to the accounts. While analysts have become familiar with this presentation, it is perhaps a naïve hope that they process this information into fair estimates of the underlying portfolio value and look past the fluctuating annually reported profits. In a perfect world, the information would be presented so that they don’t have to!

Another point is that using such diametrically different methods to value WP and NP contracts is an issue in itself and some alignment of the two methodologies would be undeniably useful. There are, however, good arguments, beyond the underlying modelling[7], to report profits arising from the two types of contract differently. For example, if economic conditions change affecting discount rates and future yields, the underlying expected future cash flows of non-profit contracts are unchanged whereas those of WP contracts will alter substantially as bonus expectations change. Therefore, it could be argued that it is the future profits WP contracts that are affected whereas the impact on NP is immediate. Our ideal standard would perhaps make this distinction in the timing of its profit distribution while presenting the two contract types in a comparable manner.

I’m convinced, the current approach fails to adequately fulfil the desirable traits for an accounting standard for insurance contracts, tell me about IFRS 17…

Slow down, we’re all busy people here and also wish to maximise traffic to this flashy website you’re viewing. Please tell all your actuarial friends about this little series, get us the clicks to satiate our managers (James Nicholl[8] is a fiend for clicks) and then maybe we’ll oblige in blowing your mind with some more readable insights into the future of insurance accounting.

Conor O’Duffy

Footnotes

[1] For example, most companies will have changed their reporting to “strip out” some of the more complex and less material aspects of Solvency 1 under this justification. Some may even have aligned financial reporting with SII – although the author is unaware of any examples and considers this unlikely given the imminent introduction of IFRS 17.

[4] As mentioned in article 1, this means the value of liabilities is derived as far as possible with reference to observable market data. It is the antithesis of prudent valuation.

[5] The CFO forum is where the Chief Financial Officers of the most important European insurers meet. Essentially “the big dogs of the big dogs”.

[6] Please note this bullet is specifically in relation to incorporating market consistent techniques in Statutory Actuarial Valuation regulation in 2004. Brexit may invalidate it as general observation (full disclosure; the author is Irish).

[7] Stochastic vs. deterministic under SII is what I’m getting at rather than the outdated valuation interest rate with prudence that non-par currently uses.

[8] Funny fact; James likes his name pronounced like the footballer James Rodriguez.

IFRS 17 – Episode 1: Profit Returns

2. A claim occurs over the contract life

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.

Conor O’Duffy

Footnotes

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)

[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.

[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.