Economic and accounting volatility for insurance companies arises from changes to estimates of fulfilment cash flows and from changes to financial markets that impact asset values and the discount rate used to measure insurance liabilities.
We explain the different sources of economic volatility for insurance companies, how these are reflected in financial statements, and why accounting volatility may not always equal economic volatility. Some economic volatility is deferred and smoothed in financial statements, and some accounting volatility may not actually be economic gains and losses at all.
All companies experience volatility in earnings. For most companies this is mainly due to the volatility of their operating results, including the impact of non-recurring gains and losses. For some companies, volatility primarily results from changes in financial markets, such as changes to the market value of financial instruments and changes in market interest rates. Insurance companies are affected by both. One of the reasons why insurance stocks are difficult to analyse is that performance is driven by a combination of an operating (or insurance service) result that is subject to insurance risks and a net financial result that is affected by financial risks.
The insurance service result arises from the provision of insurance and other services, such as investment management. Premiums and fees are charged, and expenses (including insurance claims) are incurred. The net financial result includes the income from and change in value of financial assets, and changes in insurance liabilities arising from financial market effects, such a change in interest rates.
While similar volatility affects US GAAP reporters, the accounting for financial instrument assets and insurance liabilities differs from that under IFRS. This article only considers insurance reporting under IFRS 17.
Reporting options available to IFRS reporters affect how volatility is reported
For IFRS reporters, the recently applied IFRS 17 provides much more transparency regarding the effects of volatility compared with the previous accounting. However, the accounting is still challenging for investors, and further complicated by accounting choices available in respect of both the asset and liability side of the balance sheet. Volatility is presented in different ways, and economic volatility is not always the same as accounting volatility in a particular period.
We regard economic volatility as where a change in financial markets, or a change in expected insurance cash flows, result in a corresponding change in shareholder wealth1We use the term shareholder wealth to mean the fundamental value of a business and, if the market is efficient, the stock price.. Accounting volatility arises when these gains and losses are reported in comprehensive income – either in net profit or in other comprehensive income (OCI).
There are four distinct scenarios regarding the relationship between economic and accounting volatility under IFRS 17:
- Economic volatility is deferred by adjusting the unrecognised insurance profit.
- Economic volatility is recognised immediately in income (either in profit and loss or OCI).
- Economic volatility is not reported at all due to the use of cost accounting.
- Economic volatility is (arguably) zero, but accounting results are nevertheless volatile.
There are several sources of volatility for insurance companies. The significance of each source, and how they interact, largely depends on the nature of the business and the type of investments held. How volatility is presented in financial statements also depends on the accounting methods applied, particularly whether insurance contracts are accounted for using the IFRS 17 general measurement model or using the modifications of the variable fee or premium allocation approaches.
If you are unfamiliar with the IFRS 17 methods of accounting for insurance contracts mentioned above, or with IFRS insurance accounting jargon, such as fulfilment cash flows, CSM and risk adjustment, we suggest you read our earlier brief (and hopefully generalist investor friendly) explanation available here, before reading on in this article.
Insurance underwriting result volatility
An insurance liability comprises two main components2There is also the risk adjustment component, but this is generally relatively small compared with the CSM. To simplify, we have ignored the risk adjustment for the purpose of this article – this does not affect the overall message. For short-term contracts accounted for under the premium allocation approach, these two components are rolled into a single unearned premium liability. These contracts result in less economic and accounting volatility, and we do not consider them further in this article. – the present value of forecast cash flows (premium inflows and claims and expense outflows), referred to as the fulfilment value, and the unearned profit. At the inception of an insurance contract, unearned profit or contractual service margin (CSM) is the difference between the present value of premium income and the present value of expected claims and other expenses. Even though in value terms CSM represents an immediate gain, for financial reporting it is deferred (as part of the insurance liability) and recognised in profit and loss over the period of insurance coverage.
CSM is initially an estimate; it is only when the claims and expenses related to this insurance coverage are known that the realised insurance service profit becomes certain. Estimates of insurance contract cash flows (the fulfilment cash flows) are constantly updated under IFRS 17. Each change in estimate represents an economic gain or loss3At least it should be if the previous estimate was unbiased, as required by IFRS 17. If prior estimates are, for example, overly conservative and investors realise this, a change in management’s estimates of insurance cash flows that merely reverses this bias in measurement is not an economic gain. For more about measurement bias in insurance reporting see our article ‘Prudent versus unbiased: IFRS 17 insurance liabilities’..
Economic gains and losses due to estimate changes related to future services are deferred
Estimate changes that relate to the current period claims and to past insurance service (changes in the liability for incurred claims) are immediately recognised in profit and loss. However, if estimate changes relate to future insurance coverage, for which there is an unearned profit4If a negative change in estimates is greater than the CSM balance, the excess is recognised as an immediate onerous contract loss., the change in expected cash flows is offset against the CSM balance. Future profits are affected due to the different amount of CSM to be released, but there is no immediate profit impact.
Current underwriting results are therefore insulated from the effects of many changes in estimates, even though all such changes represent economic gains and losses. This is consistent with the accounting practice of recognising profit as services are provided, and no different from how revenue and expenses are recognised in other industries.
Due to the long-term nature of insurance, investors may evaluate performance based on the value of business written in each period rather than the profit earned due to insurance services provided in that period5For more about this and the other benefits of IFRS 17 see our article ‘IFRS 17 insurance – More comparability and new insights’.. One of the main benefits of IFRS 17 for investors is the value of new business information. If performance is viewed this way, all estimate changes become current period gains and losses.
Below, we show how to find the relevant figures using disclosures by French insurer CNP Assurances.
CNP Assurances insurance liability roll-forward disclosure
CNP Assurances 2024 financial statements (yellow highlighting added)
The first highlighted row in the table shows an economic loss (an increase in the insurance fulfilment value liability) due to an increase in expected cash outflows related to future coverage. This is absorbed by a reduction in the CSM unearned profit6The fulfilment value component of the insurance liability increases but the CSM component falls. There is no overall change to the insurance liability and no immediate impact on profit. However, future profit will be lower than previously expected due to there being less CSM to release..
The other two highlighted rows are, respectively, the changes to cash flows (compared with previous estimates) for current period claims and those incurred in prior periods but not yet finalised – in this case, an experience loss in respect of current period claims and a gain due to a revised estimate of the ultimate cost of prior period claims; both are included in profit and loss as part of the service result.
Insurance CSM (mismatch) volatility
Although changes to the estimates of fulfilment cash flows related to future service are deferred by adjusting CSM, there is a complication arising from the process of discounting. This results in accounting volatility even though some argue (it is a contested aspect of IFRS 17) the adjustment does not represent an economic gain or loss. The issue is the effect of interest rate changes on the fulfilment value compared with CSM.
Fulfilment value cash flows are updated each period for both changes in estimates of cash flows (the gains and losses we discuss above) and for changes in the discounting effect, including changes in the discount rate itself. However, the CSM balance is not updated when discount rates change. CSM is also a present value, and it is adjusted (accreted) each period to reflect the unwinding of that discount. However, the CSM balance is not adjusted for changes in discount rate7At least it is not under the general measurement model. If the variable fee approach is applied, CSM is fully remeasured and there is no ‘mismatch’ problem or volatility., and the annual accretion takes place at the discount rate applicable at the inception of the contract (the so-called locked-in rate).
The lack of CSM remeasurement for discount rate changes results in two sources of volatility:
- Changes in estimates: When the estimates of insurance cash flows change, the effect on the fulfilment value and the CSM differs. The fulfilment value adjustment is the present value of the change in cash flows discounted at the current rate, but the CSM adjustment is the present value of the same change in cash flows discounted at the ‘locked-in’ CSM discount rate. The difference between these two adjustments is recognised as part of the insurance finance income and expense and adds to income volatility. If the OCI option is applied to that portfolio this gain or loss is recognised in OCI, otherwise it is included in earnings.
- Remeasurement of assets backing CSM: The assets that, in effect, back the CSM component of an insurance liability will probably be measured at fair value in the balance sheet, with remeasurements either reported in profit and loss or OCI. This means that asset values react to changes in interest rates. However, the related CSM liability is not updated for changes in the insurance liability discount rate. This produces volatility much like that applicable to excess capital (see below). Again, this volatility could be reported in profit and loss or OCI (or potentially not at all if assets are measured at cost – see Just Group below).
(Artificial) volatility arises because CSM is not remeasured for changes in discount rate
These sources of volatility are a controversial aspect of IFRS 17. Some argue that CSM should be remeasured each period to reflect changes in the insurance discount rate. Doing so would not eliminate gains and losses but (it is argued) would result in these being reported in a manner that better reflects the economic gains and losses, and with no mis-match between the assets and liability.
However, the IASB took a different view when developing IFRS 17, regarding the CSM as being distinct from the rest of the insurance liability and that the accounting should be consistent with that applied more generally in revenue recognition. Furthermore, because the CSM component of the insurance liability does not represent actual cash outflows, it is difficult to see exactly how it could be remeasured. Nevertheless, this topic will no doubt be hotly debated once again when the IASB commences its post-implementation review of IFRS 178We note that PWC have already highlighted this topic as a priority for the IASB’s post implementation review of IFRS 17. See the recent PWC publication ‘IFRS 17 FY24 – Analysis for UK life insurers’ and ‘How we could enhance IFRS 17’ on page 20..
In practice, the attitude of companies to this ‘mis-match’ volatility depends on whether the OCI option is used for insurance liabilities – if it is, the above volatility is reported in OCI. These gains and losses in OCI are still difficult to explain but, because most investors are focused predominantly on earnings, this ‘mis-match’ volatility probably does not matter too much. However, for companies that do not use the OCI option, these gains and losses present a greater communication challenge.
UK insurer Aviva (which does not use OCI) gives the following disclosures:
CSM mis-match volatility disclosures by Aviva
Aviva 2024 financial statements – highlighting added
Aviva separately discloses the impact of the apparent mismatch related to estimate changes in the note that disaggregates the net financial result. It also includes this mismatch in its adjusted (non-GAAP) profit calculation – see the highlighted sections above.
Insurance fulfilment value liability and underlying assets volatility
Insurance premiums are typically received in advance of claims being paid, which means that insurance companies can build up significant financial investments, particularly life insurance companies. Some of these investments will be realised to pay claims and expenses, with some eventually becoming available for distribution when the related insurance profit is recognised.
To the extent that financial assets cover the fulfilment value component of the insurance liability (we discussed the CSM component above), volatility arises if the remeasurement of the assets and liability, due to market movements, differs. The insurance liability fulfilment value is a present value, discounted at a rate that reflects the characteristics of the liability, which in practice for non-participating contracts means an illiquid risk-free rate9See our article ‘Insurance company profit and the illiquidity premium’. of the appropriate duration and currency. (We discuss participating contracts below.)
Duration differences and investment risk taking add to volatility
If the related financial assets comprise illiquid risk-free assets to match the characteristics of the liability, the remeasurement of the assets and fulfilment cash flow liability for changes in market interest rates would exactly offset, and there would be no economic (or accounting) volatility. However, such asset-liability matching rarely occurs exactly and almost all companies will show some sort of asset-liability mismatch volatility as a result. This could be due to a duration mismatch or because of investment risk-taking that produces changes in asset values that are not mirrored in the insurance liability.
How this economic volatility appears in the financial statements depends on the accounting choices made by the company. Some will elect to report all value changes for both assets and insurance liabilities in profit and loss (in which case volatility may be managed or explained through non-GAAP measures). Alternatively, companies may report some or all of this volatility in OCI subject to the OCI rules in IFRS 9 and IFRS 17. In addition, some assets could be measured at cost, and this could be combined with an OCI approach for the insurance liability, to insulate earnings from volatility (but in this case not insulate comprehensive income from volatility). It is these multiple accounting choices available to insurers that make the analysis of the net financial result reported under IFRS 17 particularly challenging for investors.
Risk taking volatility for assets backing fulfilment value may be difficult to separately identify
It is not always possible to separately identify this component of economic volatility. The effect is generally combined with other sources of volatility we identify, namely that related to assets backing capital and assets backing CSM. Furthermore, to the extent that financial assets are measured at amortised cost, some of this volatility may go unreported and replaced by volatility caused by the mismatch between the amortised cost measurement of the assets and the updated measurement of the fulfilment value component of the insurance liability.
Shareholder share of participating contract investments volatility
Under IFRS 17, a modified version of the general measurement model, called the variable fee approach, is applied to certain participating contracts. A participating contract is where coverage for insurance risk (typically life risk) is combined with a savings product. Policyholders receive a payout based on the returns on designated underlying assets in addition to a payout, if and when an insured event occurs.
Although the insurance risk element of the contract must be significant for insurance accounting to apply, the remeasurement of the liability may in practice be dominated by the change in value of the underlying assets. As the underlying investments increase in value so too does the insurance liability.
Shareholders’ share of underlying assets creates economic volatility (unless hedged)
Typically, in these contracts, policyholders only receive a share of the returns on underlying assets; the remainder of the asset returns then benefit shareholders, often called the ‘shareholders’ share’. The change in value of the shareholders’ share of underlying assets creates economic gains and losses and volatility for the insurer. This volatility may even be greater than that arising from investment mismatches for non-participating contracts because there may be greater risk-taking in the underlying assets to satisfy the policyholder demands for high returns from the savings component of their policies. As a result, many insurers hedge this exposure to investment risk through derivative contracts, such as by taking a short position in equities where the shareholders’ share of underlying assets has significant equity exposure.
Most participating contracts qualify for the variable fee approach under IFRS 17. This method of accounting requires that shareholders’ share volatility is deferred and smoothed in CSM. The CSM is remeasured each period to absorb the change in the value of the underlying items that is not reflected in the remeasurement of the insurance liability. Of course, this does not mean there is no economic volatility, it simply results in these investment gains and losses being gradually reflected in higher or lower future earnings (release of CSM) over the life of the insurance contracts.
If shareholder’s share volatility is hedged, deferring the gains or losses in CSM presents a problem. Gains and losses from the derivative hedge will be immediately reported in profit and loss but the shareholders’ share of gains and losses on the underlying items that are hedged are deferred in CSM and affect only future profit. The result is an accounting mismatch and even more (and this time uneconomic) volatility. To correct this, IFRS 17 permits insurers that hedge their shareholders’ share exposure to not adjust CSM but to take the gains or losses to profit and loss, thereby creating the accounting offset against the derivatives. This is called the ‘risk mitigation option’. In the Aviva extract shown above it is shown as a separate line item.
Variable fee approach is the perfect method to smooth out financial market volatility effects
The variable fee approach is the ultimate profit smoothing tool for insurance companies. It is not just shareholders’ share gains and losses that are deferred and smoothed, the valuation effects of minimum return guarantees (a significant risk factor in many participating contracts) are also deferred by adjusting CSM. IFRS 17 lays down strict criteria for the application of the variable fee approach but this still requires judgement. It is possible that some companies ‘push the envelope’ to get more contracts under the variable fee approach and thereby reduce volatility in profit and loss.
Of course, accounting methods do not change the underlying economics – changes in the value of the shareholders’ share of participating contracts and related minimum return guarantees result in economic volatility for insurers (after allowing for the hedging of this risk), even if it is smoothed in financial statements.
Insurance excess capital volatility
Insurance companies carry excess capital (shareholders’ equity), the extent of which is partly a policy choice by management and partly the result of prudential regulation. The assets that back capital may not in practice be differentiated from those that back the insurance liabilities, it is just that the assets exceed the liabilities. Furthermore, shareholders equity is also, in effect, backed by other non-financial assets minus non-insurance liabilities.
Economic gains and losses depend on the nature of the assets and not the method of accounting
Changes in the value of financial assets that back capital represent economic gains and losses. Some may be reported at cost (in which case little accounting volatility will be reported), some using fair value through other comprehensive income and some at fair value through profit and loss. The economic gains and losses depend on the economic characteristics of the assets and not the accounting methods applied.
Although we separate the volatility due to excess assets backing capital from the volatility due to an economic mismatch between insurance fulfilment value, the CSM and their respective related backing assets, this is generally not shown in practice. The net financial result (which may in part be presented in OCI) combines these three effects.
In the net financial (investment) result extract below, Just Group shows the different components of both investment income, and the financial expense related to insurance liabilities.
Just Group net financial (investment) result disclosure
Just Group financial statements 2024
The net result shows little volatility, partly because of the close offset of assets and liabilities but also because of the use of amortised cost measurement for surplus assets (those in excess of fulfilment value). Investors will need to investigate other footnotes to identify potential fair value changes (and we think economic volatility) for these assets.
The company also explains the drivers of the change in net investment result. These correspond to the sources of volatility we identify above. More detail of these is provided in supporting explanations. Nevertheless, for many companies it is still difficult for investors to quantify the drivers of volatility in the net financial result.
Summary of economic versus accounting volatility
The Footnotes Analyst
Note: this simplified table, and the previous explanations, are not a complete analysis of volatility for insurance companies.
In our next article ‘Managing earnings volatility: Non-GAAP versus OCI’ we examine how insurance companies deal with earnings volatility by reporting some gains and losses in OCI and by the presentation of non-GAAP performance measures. To receive notifications of new Footnotes Analyst articles, sign up to our email list here.
Insights for investors
- Understanding the sources of economic volatility and how the related gains and losses are reported in financial statements helps investors to evaluate and forecast performance.
- Economic and accounting income volatility arise from changes to insurance cash flows and from the effects of change in financial markets. Some economic volatility is deferred in financial statements by adjusting the contractual service margin.
- Shareholders’ share of the underlying assets of participating insurance contracts represents financial gains and losses, but is deferred and reported in financial statements in the service result by adjusting CSM.
- The lack of remeasurement of CSM for interest rate changes creates an accounting mismatch when CSM is adjusted to reflect revisions to fulfilment cash flow forecasts. The effect is recognised in the net financial result.
- Some volatility may be reported in OCI if companies apply the OCI option in respect of insurance liabilities and measure some financial assets at fair value through OCI.
- Volatility arising from economic differences between insurance fulfilment value and the underlying assets held, plus the variability of surplus assets backing capital and CSM, may not be disaggregated. Look for supporting explanations to identify the source of volatility.