IFRS 17 will result in significant changes to insurance company financial statements as of next year. Benefits for investors include a more relevant top line, consistent profit recognition, source of earnings analysis, updated assumptions, value of new business disclosures and an end to confusing asset-based discount rates.
We think IFRS 17 will make insurance financial statements accessible to the broader investment community rather than just insurance specialists. However, compromises and options in the new standard, such as the option to use OCI, will make analysing the new information not as straightforward as we might hope.
The business of insurance is not that complex. An insurance company essentially derives profit from two distinct, albeit related, activities – providing insurance coverage and related services, and investing the premiums received in advance of providing those services. Time value of money adjustments due to the time between when cash is received and paid, and the fact that claims and benefits are uncertain until settled, are important factors that affect profit and complicate the accounting. But, fundamentally, the financial statements of insurers should not be difficult to understand.
The problem for investors in insurance companies that report under IFRS is that current financial statements are unnecessarily complex, are often not comparable, and do not clearly represent the insurance business model.
In 2023 you will see a dramatic change and, in our view, improvement in insurance financial statements due to the implementation of IFRS 17. The changes will be most pronounced for life insurers, but still important for all insurance companies and any other business with insurance operations.
Companies are actually already applying the new rules in parallel with their existing accounting that is based on IFRS 4. This is because, in the 2023 financial statements, prior year comparatives must also be reported under IFRS 17. Although the 2022 annual financial statements will still be under the old rules, many companies will likely provide some IFRS 17 information for 2022, and generally update investors on the impact of the changes, prior to publishing the 2023 results.
Many companies have already started to discuss the impact of IFRS 17. The opening IFRS 17 balance sheet is 1 January 2022 for calendar year-end companies, which means the balance sheet impact, including the effect on shareholders’ equity (for many companies we expect a significant reduction), should already be known.
Canadian insurer Manulife has already flagged a reduction in equity.
Manulife – Future accounting changes note extract
Manulife 2021 financial statements
Current accounting for insurance companies is a mess. IFRS 4 Insurance Contracts was always intended to be an interim measure pending the development of a comprehensive standard. IFRS 4 allows companies a lot of flexibility, including the ability to use their pre-IFRS national accounting practices (subject to certain constraints) with not even a requirement for consistency between different parts of a group. This led to significant differences in the measurement of insurance liabilities, including the discount rate applied, and the timing of profit recognition.
The following extract from the financial statements of Prudential illustrates the problem. The company lists several measurement bases for insurance contract liabilities, including US GAAP and prior local GAAP, adjusted to comply with a ‘grandfathered’ UK ABI SORP which is no longer maintained, and which will permit different flavours of local GAAP to affect reported IFRS results.
Prudential: Insurance liability measurement accounting policy extract
Prudential 2021 financial statements
The lack of comparability and transparency under IFRS 4 has prompted the use of alternative reporting approaches by companies and investors, including embedded value accounting and regulatory based measurement, such the European Solvency II framework. However, these approaches are primarily balance sheet focused and, in our view, unsatisfactory when it comes to performance measurement. IFRS 17 will provide current value measurement that, in some respects, is like embedded value or Solvency II. The standard, however, also includes comprehensive requirements for recognising and presenting performance.
Once investors get used to IFRS 17, we expect this to be the primary source of information about insurance companies’ financial position and performance. IFRS 17 will result in insurance company financial statements that are more consistent with those of other sectors, which should help generalist investors better understand what they are investing in. Currently, insurance accounting is largely only understood by specialists.
IFRS 17 will bring many benefits for investors. Below we explain some of what you can expect and reasons why we think all investors should welcome the new standard.
Some have even argued that the greater transparency and understanding of insurance that IFRS 17 should bring will reduce the sector cost of capital and end what some regard as an unjustified discount in valuations. Many investors who avoided insurance stocks simply because they were so difficult to analyse may well now reconsider.
Revenue not premiums
The current top line of a life insurer’s income statement is typically a confusing and complex mixture of earned and written premiums, which includes policyholder deposits (investments in savings products) as well as payments for insurance coverage services. This essentially cash based measure is inconsistent with revenue reported in any other sector.
The present complexity can be seen in the following extract from the financial statements of Manulife. The top line of gross premiums is included in a subtotal labelled as ‘total revenue’, although it does not actually represent revenue consistent with other sectors. Part of the problem is timing – premiums received in advance of the provision of insurance coverage. A further problem is that premiums include policyholder deposits when an insurance policy has a savings element, such as for participating contracts. These flows belong in the balance sheet rather than profit and loss in the same way that bank deposits received and repaid are balance sheet movements and not income and expenses items in bank financial statements.
The non-revenue components of the Manulife top line are removed lower down the income statement, partly in the ‘change in insurance liability’ line and partly in ‘claims and benefits’. However, because these line items include other components, it impossible to work out how to adjust premiums to obtain a more recognisable revenue measure.
Manulife – Revenue and change in insurance liability under IFRS 4
Note 6 (extract)
Manulife 2021 financial statements
Under IFRS 17 the top line of the income statement becomes insurance contract revenue and is essentially the same as revenue recognised for services provided by any other company (although derived differently). This means that the confusing adjustment lower down disappears entirely, with components either not needed (because revenue is measured more sensibly) or reclassified to reflect exactly what they are, such as the interest accretion for insurance liabilities.
No more confusing ‘change in insurance liability’ income or expense
The ‘change in insurance liability’ line that currently appears in insurance company income statements is one of the most confusing aspects of their reporting. Even though companies present this item as income or expense in profit and loss, only part should actually be reported as such.
Part of this line item represents adjustments because the top line is premiums received rather than revenue earned. But it also includes other adjustments, such as the effect on the liability of interest accretion due to the passage of time, interest rate changes and cash flow estimate changes. Furthermore, due to the different accounting policies adopted, these adjustments are not consistent between companies. For example, some companies use locked-in assumptions rather than updating discount rates and cash flow estimates.
A further complication is that the change in liability line also includes the movements in the deposit component of participating contracts. This is evident for Manulife above, where the reduction in the change in liability ‘expense’ between 2020 and 2021 is due, in part, to the reduction in investment income shown in the revenue section.
Combining these items into the single ‘change in insurance liability’ line is all extremely confusing – no wonder generalist investors have often avoided the insurance sector. In the case of Manulife there is some help from the supporting disclosures but we still find it impossible to understand what is included in the change in insurance liability line, and what the resulting profit figure actually represents.
The good news is that under IFRS 17 the change in insurance liability line disappears entirely. Those components that represent income or expenses remain in profit and loss but are labelled for exactly what they are, such as the insurance liability interest accretion. Components that are balance sheet items, such as customer deposits, are removed entirely.
Source of earnings analysis
Insurance coverage produces a profit, called the underwriting result, when the premiums received are greater than the cash paid in respect of claims and related underwriting expenses, after allowing for the time value of money. A time value of money adjustment applies if premiums are received significantly in advance of when claims are paid. In this case the premiums are accreted (the insurance liability increased, and an interest expense recognised) before the profit is calculated.
Investing the premiums received produces a profit, called the net investment result, if the resulting investment income is greater than the ‘cost’ of these funds; in other words, the accretion of the insurance liability.
Prior to IFRS 17 the underwriting and investing components of profit were typically not visible, mainly because there was no disaggregation of the change in insurance liability to separately identify the accretion component. Going forward the components of performance will be clearly visible on the face of the income statement.
Switching to IFRS 17 will not change the total profit reported over the life of a portfolio of insurance contracts – this is simply equal to the difference between cash in (including investment returns) and cash out. However, IFRS 17 will change the timing of profit recognition (such as not permitting day 1 gains) and the disaggregation of that profit.
Here is a simplified before and after IFRS 17 profit and loss statement to illustrate.
Note: Although we have shown the same net profit in this example, this is unlikely in any one period. However, over the life of a portfolio of insurance contracts the profit must be equal. The lower claims we show under IFRS 17 is because we have assumed that these insurance contracts include a savings as well as protection component – unlike IAS 4, IFRS 17 excludes these balance sheet flows from the income statement. In practice the income statement will be more complex than we show – for example we have ignored contract acquisition costs, the effects of reinsurance, and have assumed no use of OCI.
In our view, the new source of earnings analysis (combined with supporting liability roll forward disclosures) will provide investors with far better insight into the performance of insurance companies.
However, a word of caution: the split of insurance company profits between underwriting and investing under IFRS 17 depends on the allowance for the time value of money – the discount rate will generally need to be estimated – and the application of the so-called variable fee and premium allocation approaches. We will explain more in future Footnotes Analyst articles.
Liability measurement at current value
Under IFRS 17, insurance contract liabilities are the sum of a present value of forecast cash flows discounted at a current rate, plus any unearned profit,1There are two components to unearned profit – the risk adjustment which represents the amount the insurer charges for assuming insurance risk, and the contractual service margin (CSM) which is a balancing figure. The CSM is the amount charged for providing insurance coverage and, potentially, other services. with the components of the liability separately disclosed.2The separate identification of unearned profit and updating of assumptions does not apply to the liability for remaining coverage if an insurer chooses to apply the so-called ‘premium allocation approach’ that is permitted for short-term contracts. For these contracts, updated assumptions are only required for the liability for incurred claims. While under current accounting some liabilities were previously updated, many were not, which led to an accounting mismatch because most financial assets owned by insurers are reported in the balance sheet at current value.
In the current rising interest rate environment, this led to asset losses but no corresponding reduction in the insurance liability which consequently distorted performance metrics (although the effect was mitigated by at least some of the effects being reported in OCI). Due to current measurement of insurance liabilities under IFRS 17 this mismatch will largely no longer occur. The result will not be perfect – other mismatches will arise – but it will be a lot better.
Not only are discount rates updated under IFRS 17, but so too are cash flow assumptions. Previously many assumptions were ‘locked-in’ and only effectively updated if a contract was assessed to be onerous, which itself may not a reliable indicator due to the often too high discount rate applied.
The IFRS 17 current value measurement will also be ‘market consistent’. This is important where the liability is complex, such as savings components that include a minimum return guarantee. Currently insurance liabilities may fail to include the full economic value, including time value, of such guarantees.
Consistent profit recognition
Currently the timing of profit recognition for insurance contracts depends on the company’s accounting policies and typically varies by both product and jurisdiction. In some cases, the full expected profit is recognised at inception (although generally it is a prudent estimate and more profit is recognised later). In other cases profit is spread over the period of insurance coverage or even later. The variation in how profit is currently recognised has been a major reason for some investors to disregard IFRS reported profits and instead focus on supposedly more comparable measures, such as market consistent embedded value.
Under IFRS 17 profit will be recognised based on a combination of when the insurer provides coverage services (and potentially other services inherent in an insurance contract, such as investment management) and when and how it is released from insurance risk. The current practice of recognising some or all forecast profit on day 1 will no longer be permitted (although there may sometimes be day 1 losses if onerous contracts are written).
There are some issues regarding the timing of profit recognition, but IFRS 17 should introduce far greater consistency and comparability than at present.
Unearned profit disclosures
Under IFRS 17, the expected profit arising from an insurance contract (the difference between forecast cash inflows and outflows, after allowing for the time value of money) is reported as a component of the insurance liability until that profit is deemed earned, at which point it is recognised in the income statement.
But what will provide investors with much more information about insurance contract profits are the related disclosures. You will receive a full roll forward of the insurance contract liability analysed between the cash flow and expected profit components. This will enable you to see exactly what profit is being recognised each period, the balance of unearned profit that will be expected to boost profit in future periods, plus the new expected profit that adds to the balance due to insurance contracts issued in the period. The last component, the value of new business, will enable investors to view performance in two ways: firstly, on an IFRS 17 basis to reflect services provided in a period and, secondly, (with some additional computation) to reflect the value of new business written in the period.
It is the ability to analyse performance based on new business written using IFRS 17 data that we think will soon result in the discontinuance of embedded value reporting.
Discount rate reflecting the characteristics of each insurance liability
Where discounting is currently applied in measuring insurance liabilities there is little consistency in methodology. A common practice is to base discount rates on the expected return from the assets that back insurance liabilities. This practice is conceptually wrong (even if a prudent estimate of return is used) and inconsistent with the approach applied in other IFRS standards, such as that for measuring pension liabilities.
The current value of a liability should not depend on how assets are measured unless the amount payable when the liability is settled is linked to the return on those assets, such as for ‘participating’ or ‘universal life’ policies. This means that for insurance contracts where payments to policyholders do not depend on asset returns (such as a simple life policy) the discount rate should not include any premium or spread for investment risk. A risk-free rate with a premium for the (il)liquidity characteristics of insurance contracts must be used.
By removing the asset return basis for discount rates in cases where there is no asset linkage, IFRS 17 will produce more consistent and realistic insurance liabilities, and a more relevant split between underwriting and investing results. It will also ensure that a risky future investment spread is not used to hide onerous insurance contracts.
The following extract from the 2021 financial statements of Manulife illustrates the change. Currently Manulife uses a Canadian specific approach to determining discount rates called ‘CALM’ in which asset returns determine (with some adjustments) the liability discount rate. In this note the company explains how this will change to a rate that is not influenced by asset returns under IFRS 17, and the implications.
Manulife – Future accounting changes note extract
Manulife 2021 financial statements
The final bullet point above illustrates our earlier comments about IFRS 4 permitting different recognition points for profit, including day 1 recognition. Manulife currently recognises profits on day 1; however, due to their prudent approach in measuring those insurance liabilities, some profit is effectively deferred. The problem is that it is almost impossible to work out how much is deferred and whether this is comparable with other companies.
Separately identified risk adjustment instead of hidden prudence
All insurance liabilities measured under IFRS 17 (except the liability for remaining coverage under the premium allocation approach) include a separately identified risk adjustment. This addition to the present value of expected cash flows is the amount the insurer charges to accept insurance risk. The size of the adjustment depends on the methodology applied and input factors selected by the company. While the potential for differing approaches to the risk adjustment will reduce comparability, particularly of profit and onerous contract recognition, at least under IFRS 17 the size of the allowance for risk will be clear and there will be disclosures to help investors make comparisons.
Differences in allowances for risk are much more of a problem at present. Insurance liabilities currently include such an allowance, but companies typically do not separately identify the amount or explain the calculation. So-called ‘provisions for adverse deviation’ are built into the liability through a degree of prudence applied in estimating cash flows and, potentially, the discount rate. Companies can change this level of prudence applied and change reported profit without investors being much the wiser. Removing this ability, and making the risk adjustment transparent, will help investors.
Challenges for investors
Although we see great benefit for investors in the application of IFRS 17, the new standard will not be without its challenges, some of which we have hinted at in our comments above.
Part of the problem is that the development of IFRS 17 was highly controversial, particularly because of the very different accounting presently applied. The diverse views of insurers resulted in compromise and options in the standard that will complicate matters for investors.
Here are some of the challenges we think you will face:
The use of OCI: IFRS 17 allows certain components of the net investment result to be reported in other comprehensive income (OCI). We expect many (but not all) companies to use the OCI option because doing so will result in less volatile earnings. However, using OCI will introduce accounting mismatches, will confuse investors, and will fail to correctly reflect the economics of insurance in profit and loss. We do not think that reducing earnings volatility by putting some in OCI will lead to the premium rating that some companies might hope for.
Unobservable discount rate: For non-participating insurance contracts the IFRS 17 discount rate is the illiquid risk-free rate. However, risk-free but illiquid investments are difficult to find and, in practice, the rate is essentially unobservable. We have no doubt that estimates of the illiquidity premium will vary, which will impact reported results, particularly the split between underwriting and investing. You will receive ‘yield curve’ disclosures which may help in identifying outliers, but it is unclear how much of a problem this estimate will prove to be.
Transition: When any new standard is adopted, the preferred transition approach is to recalculate all items in financial statements as though the new rules had always applied. For insurance this is difficult given the length of many contracts. Accordingly, IFRS 17 permits some simplified approaches, each of which will produce a different unearned profit balance on the transition date. We think this may be the source of significant comparability issues that will persist well beyond the transition year and will require careful consideration by investors.
The European ‘carve-out’: There are several aspects of IFRS 17 based insurance accounting that the European Union does not like, but their objection to one of them has led to a modification to IFRS 17 that is available only to EU companies. It affects the timing of reported profits and onerous contract losses. IFRS 17 says that profit recognition and onerous contract provisions should be based on cohorts of contracts issued during a one-year period and that different cohorts cannot be combined. The EU has relaxed this rule for certain contracts to permit ‘inter-generational’ smoothing of profit (and potentially losses). We think the carve-out is unfortunate and has the potential to place insurance profit in the wrong period and for onerous contracts to be hidden in larger profitable portfolios. It remains to be seen whether this has a material impact and, if so, whether investors will be able to tell.
Continuing the prudence buffer: The present value of insurance cash flows is supposed to be an unbiased estimate of the probability weighted expected value – in other words, the 50th percentile if the distribution is symmetrical. This will be a significant change for many insurers who are used to building prudence directly into the estimates of claims liabilities by using a point somewhat higher in the distribution than the 50th percentile. This reflects a preference for favourable rather than unfavourable experience adjustments and estimate changes. IFRS 17 requires explicit adjustments for risk rather than ‘padding’3‘Padding’ is a term that is sometimes used to describe the increase in an insurance liability to above the probability weighted expected value of cash flows (the best estimate liability) to make an allowance for insurance and investment risks. of the cash flows. However, in practice we may well see prudence continue to be built into cash flow estimates, which will mean that the full benefit of IFRS 17 may fail to materialise.
Other IFRS 17 options, policies and estimates: IFRS 17 includes several further options which will impact the results. For example, whether an insurer applies the time value of money to changes in the risk adjustment will affect the split of profit between underwriting and investing. How unearned profit is allocated between investment management and insurance coverage services, if both activities are present in one contract, will affect the timing of profit recognition. Furthermore, the accounting for insurance liabilities is inherently subjective simply because it involves the forecasting of uncertain future events – the likelihood and magnitude of insurance claims. This has always been a feature of insurance accounting and will remain so, although IFRS 17 disclosures may help investors to better understand and compare the estimates management makes.
The asset side also changes: At the same time as adopting IFRS 17 most insurers will also be applying IFRS 9 for the first time to the asset side of their balance sheet. When banks and others adopted IFRS 9 a few years ago insurance companies were given the option to defer IFRS 9 and apply new rules to both sides of the balance sheet at the same time. IFRS 9 will have less impact than IFRS 17, especially if insurers use the fair value approach to measure all their investments. If not, you will need to consider how the IFRS 9 adoption impacts debt instrument impairments and the accounting for equity investments.
Insights for investors
- IFRS 17 will have a major impact on the financial statements of all insurance companies but, most particularly, those who write long-term contracts, such as life insurers.
- Although in some respects the accounting is complex, we think the new standard will result in insurance company financial statements that are more accessible to generalist investors.
- A recognisable revenue figure, clear source of earnings analysis, more consistent timing of profit recognition, and the end to the confusing ‘change in insurance liability’ gain or loss, will all help investors better understand insurance company performance.
- IFRS 17 disclosures will enable investors to consider performance on both an ‘earned’ basis and the value of new business written in the period.
- But investors will face challenges. We expect the varied use of OCI to be confusing and we are not yet convinced that some aspects of the application, such as the discount rate, will be as consistent as we might hope. The unearned profit at transition will also need careful consideration.
- Watch out for more Footnotes Analyst articles to help you navigate the implementation of IFRS 17.
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