Reinsurers’ IFRS 17 struggles are a reminder that one size does not fit all

Reinsurers’ IFRS 17 struggles are a reminder that one size does not fit all

The IASB issued IFRS 17 in a bid to standardize insurance contract accounting, but reinsurance firms, because of their particular idiosyncrasies, will struggle to comply. Unless the IASB makes significant modifications to the standard, reinsurers everywhere will have to reassess the nature of their life insurance contracts.

Maryam Akram ([email protected])

Reinsurers Image

Standard setting

IFRS 17 is the latest instalment of the International Accounting Standards Board’s (IASB’s) ‘risk-aware accounting’ regime, which also includes IFRS 9 and Current Expected Credit Losses (CECL). As insurers hasten to comply with the standard (which is due to be fully implemented in 2022), reinsurers are having a particularly tough time of it. Despite representing a small fraction of the overall insurance industry, reinsurers face significant and complex challenges in attempting to comply with IFRS 17. The sector is already struggling with poor return rates: in 2017 reinsurers achieved only 1.2% return on capital, their worst such result in 13 years. For firms facing many other concerns, IFRS 17 presents a new challenge.

Feeling the pain

To get a sense of the potential impacts of IFRS 17 on the insurance industry, and especially reinsurers, it’s worth remembering the key functions of each. The aim of IFRS 17 is to provide standardized methods for measuring the value of insurance services in a way that quantitatively incorporates financial and non-financial risk projections. Reinsurers, meanwhile, offer a way for insurers to diversify their risk and improve the appearance of their balance sheets. In effect, under the EU’s Solvency II directive (the last significant regulation affecting the insurance sector), insurers used reinsurance as a way to manage capital.

However, IFRS 17 marks a discontinuation in the regulatory-driven (Solvency II) reinsurance product demand. While changes to accounting practices should not change the economic substance of a balance sheet, how profits and losses are presented can affect a firm’s business strategy and adversely affect demand for the reinsurance service. Under IFRS 17, insurers must recognize any loss up front, while any gains must be amortized over the life of the contract. This includes gains achieved from reinsurance, which can make reinsurance a less attractive option as it can no longer provide quick balance sheet benefits. So one possible unintended consequence of IFRS 17 is that it may make some reinsurance contracts less desirable and potentially misrepresent their economic value.

Another source of pain for reinsurers under IFRS 17 is the potential for mismatches in accounting. In practice, reinsurance contracts are diverse and multifaceted, and serve a range of nuanced functions. As a result, they differ from insurance contracts in such a way that makes them partly incompatible with the accounting requirements of IFRS 17. Reinsurers must contend with new uniform methods of measuring bespoke and diverse contracts, including:

  • Grouping (see Figure 1). IFRS 17 requires re/insurance contracts to be aggregated by similar risk characteristics for measurement.
  • Ineligibility for the VFA. IFRS 17 uses three measurement models devised to accommodate specific contract features: the premium allocation approach (PAA), the variable fee approach (VFA), and the general measurement model (GMM). All reinsurance contracts, however, are ineligible for measurement under the VFA, compelling reinsurers to use the GMM for their contracts, even if the underlying insurance contracts were measured using the VFA. This can lead to a mismatch in the accounting of the underlying insurance and reinsurance contract(s), which could mean that the true economic value of reinsurance is not accurately represented (see Figure 2).
  • CSM amortization and calculation. In addition, insurers can gain substantial benefits from using the VFA approach in terms of discount rate* volatility, because the VFA integrates changes in the discount rate (and other financial variables) into an adjustment to the contractual service margin (CSM). To use the GMM, however, insurers must report financial variables directly into their comprehensive statement of income. This will affect how the profitability of the reinsurance contracts is reported and therefore the perception of investors and the required solvency ratio (see Figure 3).

Figure 1: Reinsurers’ challenges with IFRS 17 – grouping

Reinsurers’ challenges with IFRS 17 – grouping

Source: Chartis Research

Figure 2: Reinsurers’ challenges with IFRS 17 – ineligibility for the VFA

Reinsurers’ challenges with IFRS 17 – ineligibility for the VFA

Source: Chartis Research

Figure 3: Reinsurers’ challenges with IFRS 17 – CSM amortization and calculation

Reinsurers’ challenges with IFRS 17 – CSM amortization and calculation

Source: Chartis Research

Early preparation is vital

At the root of IFRS 17 is an attempt to improve the comparability of contracts by making them more consistent. But when it comes to measuring contracts, the IASB may have inadvertently handed reinsurers the wrong tools for the job. Because of the complexity involved in complying with IFRS 17 – not least pressure to invest in the right technology and people – reinsurers must prepare early for any transition.

Unfortunately, the mechanics required to achieve IFRS 17-compliant accounting will be an enduring source of pain for reinsurers, as will the potential for mismatches in their accounting. Simply put, the differences in characteristics between reinsurance and insurance contracts – reinsurance contracts come in many different flavors and are often highly idiosyncratic – makes the former incompatible with the measurement methodology requirements of IFRS 17.

So what can be done? The IASB is willing to amend the standard to an extent, but so far any changes have been minor. Realistically, in light of this new global standard, reinsurers everywhere will have to reconsider their portfolios and the nature of their life insurance contracts. Ultimately, it is time for insurers everywhere to evaluate the impact that IFRS 17 is going to have on their balance sheets. Realistically, the issues arising from IFRS 17 compliance will do no favors to an industry already struggling with catastrophic losses resulting from climate risk. However, the industry remains resilient and the issues arising from IFRS 17 compliance are certainly manageable. Reinsurers will have to consider and evaluate a number of areas, including innovative new ways of pricing, risk grouping, and their overall portfolio structures.

* The rate used to calculate the present value of future cash flows.

Further reading

Mapping Demand for IFRS 17 Solutions 2019

(July 2019, Chartis Research)

IFRS 17: The next stage in risk-aware accounting

(April 2019, Chartis Research)

IFRS 17 Technology Solutions: Market and Vendor Landscape 2019

(April 2019, Chartis Research)

Points of View are short articles in which members of the Chartis team express their opinions on relevant topics in the risk technology marketplace. Chartis is a trading name of Infopro Digital Services Limited, whose branded publications consist of the opinions of its research analysts and should not be construed as advice.

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