Eve Pastor reports on the interaction between IFRS17 and IFRS9, and its implications for asset liability management, valuation and financial reporting
At the Actuary: https://www.theactuary.com/features/2019/06/where-standards-intersect/
Insurers will see a new era of financial reporting ushered in on 1 January 2022. As of then, International Financial Reporting Standard (IFRS) 17 for insurance contracts, and IFRS9 for financial instruments, will be effective for insurers and reinsurers. As insurers and reinsurers are preparing for these changes, it is worth considering the interaction between the two standards. Asset liability management (ALM), valuation and financial reporting implications could create unintended consequences in financial statements for years to come, so it is important to take a holistic view of the possible financial statement impacts, rather than making decisions in isolation.
In April 2019, the International Accounting Standards Board (IASB) approved proceeding with an Exposure Draft of Amendments to IFRS17. The IASB also confirmed that it has not seen any early adopters of the standard. The announcement was a pivotal moment in the IFRS17 and IFRS9 journey; many insurers had been waiting to see how delayed the effective date for IFRS17 would be, and how many changes would be made to the standard. The IASB also made the tentative decision to extend the temporary deferral of IFRS9 for insurers so that both IFRS9 and IFRS17 can be applied at the same time. The Exposure Draft brings much more clarity on these points, and it is now time for insurers to move ahead with implementation.
A collaborative journey
On a practical level, implementation of IFRS17 and IFRS9 often resides in silos – one for IFRS17, involving actuarial, accounting and IT participation; the other for IFRS9, involving accounting, asset management, IT and sometimes limited actuarial participation. Siloed implementation can impede good outcomes, particularly when decisions are made in isolation and sequentially, rather than together and holistically. There is plenty of interaction between IFRS17 and IFRS9. Navigating that interaction, and making the best choices, requires objectives to be established and outcomes prioritised.
There are choices within the implementation of IFRS17 and IFRS9 that allow insurers to potentially reduce accounting mismatches, reduce volatility in their income statements and, in certain jurisdictions, affect the amount they pay in taxes. Insurers need to consider the purpose and audience for their IFRS financial statements: are the statements prepared for shareholders, insurance regulators, tax authorities or all of the above? Sometimes what is operationally easiest does not result in the most decision-useful financial statement or optimal cash effect. A cost-benefit tradeoff should be considered. For example, if insurers approach fair value options as a practical expedient, while assets that are fair valued do not need to then be addressed by the impairment requirements, this approach could lead to increased volatility and cash impacts on a taxation basis.
Interaction and implications
Some of the implications from the interaction between IFRS17 and IFRS9 come from the requirements of the standards themselves and are first-order effects. Other implications are second or even third-order effects. For example, the decision to fair value assets (a first-order effect) could result in more prominent volatility on the financial statements, and a decision to change the investment allocation (a second-order effect). This, in turn, could lead to regulatory scrutiny (a third-order effect). Investment allocation and regulatory scrutiny involve meaningful economic consequences, affecting the risks insurers take. D uring implementation of IFRS17 and IFRS9, then, it is important for insurers not just to work out the decisions for first-order effects, but to consider various outcomes on second and third-order levels. This will help mitigate risk and serve policyholders.
IFRS17 and IFRS9 implementation offers insurers a significant opportunity to gain an end-to-end understanding of the financial reporting process and to enhance the usefulness of their financial statements. This will facilitate better business decisions. Rather than operating
in silos, where inputs are received as if on a factory assembly line, technology offers collaborative platforms that allow teams to share their expertise in order to meet the challenges of new requirements. In these collaborative platforms, actuaries can see their work’s impact on the financial statements, and accountants can see the underlying calculations and data that drive the results.
Actuarial expertise has always been a key driver of an insurer’s success. The implementation of IFRS17 and IFRS9 is an important time for actuaries to be involved across the enterprise. Actuarial involvement in IFRS9 implementation is important because even if the first-order impacts are not their responsibility, actuaries will be coping with the second and third-order impacts. Their expertise and recommendations therefore need to be incorporated into IFRS9 projects.
Under IFRS17, some of the most impactful decisions to be made are around the level of aggregation and insurance contract groupings for both measurement and presentation; the change in discount rate through profit and loss (P&L) versus other comprehensive income (OCI); the choice of methodology for the discount rate; the risk mitigation option; and transition methods. IFRS9 provides for changes in classification and measurement, impairment and hedging, as well as the most immediately impactful decision: which assets to fair value.
The ALM perspective
Even though IFRS17 and IFRS9 provide financial statement users with a more current view of the underlying economics of an insurer, there will still be differences between economic and financial statement results. ALM strategies will need to be evaluated on how they impact economic results, as well as how financial statements will appear as of 2022. ALM implications from the interaction of IFRS17 and IFRS9 include:
- Grouping of insurance contracts and the equivalent grouping of assets to back those liabilities
- Mismatches that can be caused by fair valuing assets when the related liabilities are not fair valued
- Changes to the investment allocation and/or hedging programme
- Possibilities that assets will be impaired through the expected credit losses process of IFRS9 and need to be reconsidered for their ALM effectiveness
- The liability discount rate is now meant to reflect the characteristics of the liabilities and not the assets that back the liabilities, creating a disconnect that might need to be addressed when the financial statement results are explained.
Valuation implications from the interaction of IFRS17 and IFRS9 vary. A few areas that are likely top of mind for insurers include:
- Decisions such as whether changes in the discount rate go through P&L or OCI with the opportunities to reduce accounting mismatches – or exacerbate them
- IFRS17 decisions around defining portfolios and how that then relates to IFRS9 regarding which assets back which liabilities. This is also an example of where valuation and ALM intersect
- Comparison of transition approaches under IFRS17 and IFRS9 to see how aligned those should or can be
- Which components of the insurance contract can be unbundled under IFRS17 and then accounted for under IFRS9 – these are the distinct investment components and embedded derivatives, which are not closely related IFRS9 decisions around the possibility of electing fair value through profit or loss for assets
- Economic assumptions used across the enterprise for both IFRS17 and IFRS9. For example, are the actuaries and the asset managers taking the same view of the long end of the curve and of the macro-economic environment?
Implications for financial reporting
There are several financial reporting implications from the interaction of IFRS17 and IFRS9. Management and investors are often concerned by volatility, even if well mitigated through risk management programmes. As such, making valuation decisions that could increase the volatility of the results may lead to negative market perceptions.
Another interaction that is intriguing because it cannot be predicted in advance is how the economic environment in 2022 – the year IFRS17 takes effect – will interact with transition methods and potentially create long-lasting effects on balance sheets. The counterargument is often simply that all insurers will be facing the same economic environment on the same transition date. Of course, that oversimplifies the reality, which is that insurers operate in different jurisdictions with different economic environments, have different product mixes, and will make different implementation choices regarding accounting policy and actuarial methodology. As a result, not all will be equally impacted.
Historically, insurers have operated with handoffs of data between departments; however, the interaction of IFRS17 and IFRS9 calls for an end-to-end understanding by all functions involved. One of the greatest benefits of IFRS17 and IFRS9 is the opportunity to foster collaboration across teams to achieve a winning outcome for all. Actuarial expertise is essential to the ongoing success of insurers. It is important for actuaries to be involved not only in their own actuarial decisions that have first-order actuarial effects, but to participate across the enterprise to help the team achieve the best second-order and third-order effects. Collaborative platforms that make actuarial calculations transparent to the finance function and the financial statement impacts of such calculations transparent to the actuarial function are already becoming the new normal.
Eve Pastor is director at Moody’s Analytics