IFRS 17

Managing earnings volatility: Non-GAAP versus OCI

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The remeasurement of financial assets and liabilities to current value can be a source of significant earnings volatility. Many companies mitigate this by presenting an adjusted (non-GAAP) performance metric or by reporting some gains and losses in other comprehensive income (OCI).

The insurance sector, and the recently introduced IFRS 17, provides a good example of the communication challenge arising from volatile markets. IFRS reporters are split, largely along geographical lines, between applying the OCI option in IFRS 17 and a non-GAAP approach. Both approaches present challenges for investors.

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IFRS 17 insurance: Economic versus accounting volatility

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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.

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Insurance company profit and the illiquidity premium

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The profit of insurance companies that report under IFRS is affected by three rates of return – the liability pricing rate, the return from investments, and the IFRS 17 discount rate. The first two largely determine the magnitude of aggregate profit; the last mainly affects the timing of profit recognition and its classification as a service result or net financial result.

We use an interactive model to explain how interest rates determine the reported results of insurance companies. The illiquidity component of the IFRS 17 discount rate is subjective, likely to vary by company, and plays a key role in how insurance companies are valued.

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Prudent versus unbiased: IFRS 17 insurance liabilities

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A hidden conservative bias in the form of ‘prudent’ reserving has previously been a common feature of insurance accounting. This practice has made analysing the performance of insurance companies extremely difficult for investors.

Hidden prudence is eliminated under the new IFRS 17 and the allowance for insurance risk in measuring liabilities should be fully transparent. However, considering some recent company presentations, we wonder whether this benefit for investors will be fully realised.

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IFRS 17 Insurance – More comparability and new insights

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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.

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