IFRS 17: the new cloud on the horizon

Companies: International Accounting Standards Board, KPMG, Allianz, Axa, Prudential, PwC, Deloitte, Aon Benfield, Willis Towers Watson

Could IFRS 17 be even more burdensome and costly than Solvency II? A final text is due to be published in March and insurers are looking for fundamental changes – otherwise some will face a long and expensive path to compliance. Sarfraz Thind reports

After two decades in the making, the final text for IFRS 17 – previously called IFRS 4 Phase II – is pencilled for release on 17 March next year, with the International Accounting Standards Board (IASB) requiring industry implementation by 1 January 2021.

Earlier this year, the IASB conducted field testing with 12 insurers using a questionnaire that included draft wording from the final standard. The idea was to prepare the market for what is to come. But, with Solvency II issues still fresh in the mind, many in the industry are nervous about the new rules.

"There is some way to go for the industry to get ready for this," says Danny Clark, insurance partner at KPMG. "It is going to be a complicated standard to implement particularly for life insurers. For many insurers, planning, budgeting and a high-level roadmap are worth doing now."

"The different IFRS practises among insurers globally makes the comparison of the financial statements of insurers tricky." Danny Clark, KPMG

There are a number of benefits envisaged for the industry. Current accounting rules provide only high-level guidance but no substantive directions on how to value insurance liabilities. This has led to different accounting policies across regions and sometimes within organisations. IFRS 17 is intended to solve this.

"The different IFRS practises among insurers globally makes the comparison of the financial statements of insurers tricky," says Clark. "The new rules will benefit the user by making them more comparable. Also the broad principles are good in requiring current assumptions for future cash flows."

Degree of granularity

Danny Clark, KPMGThat, of course, is the intention. However, even before the final text has been confirmed, people have started to point out the potential for trouble ahead. IFRS 17 essentially calls for insurers to build a new profit and loss (P&L) accounting system with a significantly more granular approach to measuring insurance contracts – the so-called "unit of account."

"The granularity aspect is the most important issue we face," says Roman Sauer, head of group accounting and reporting at Allianz. "To what extent you have to be granular has an impact on IT and architecture cost."

Allianz was one of the 12 companies that took part in the IASB testing in the summer along with Axa and Prudential in Europe and nine outside the continent. The company has been running its first pre-study into IFRS 17 this year.

Contract aggregation aggro

Based on tests carried out with the IASB, Allianz has uncovered a huge challenge around contract aggregation. The IASB originally required insurance contracts to be grouped together according to similar expected profitability and where cash flows respond in a similar manner to key assumptions, something that is quite different to the practice now where insurers pool risk at a high aggregated level. This is a potential ticking time bomb.

"If you have to assess each and every contract – whether it is profit or loss making – it is a huge amount of work breaking down what we now do on a homogenous risk group level," says Sauer. "It is critical because we will have to include information in the final reporting which is not available now and which will be very cost intensive but of little benefit to the business."

"We recognise a significant improvement with the November decisions. However, the onerous contract identification at inception might require a very granular view." Roman Sauer, Allianz

Small relief

In a meeting held in November, the IASB said it had decided to revise the contract aggregation rules – but only a little.

Now, insurers will be able to separately group what the IASB calls "onerous contracts at inception" – in other words loss-making contracts – from those with no significant risk of becoming onerous and a third grouping of "other contracts".

Gail Tucker, PwCAt the same time, the revised proposals will require insurers to group contracts in cohorts of individual years, depending on when they were originated.

"The idea is to recognise loss-making contracts at inception but also not to cross-subsidise future losses against profitable contracts," says Gail Tucker, a partner at PwC. "If you have got a loss you recognise it. But this new proposal is still likely to be costly and will involve storing data for lots of different groups."

While this is a relief from the virtually untenable proposals before, it will still take a huge amount of effort for insurers to carry out.

"We recognise a significant improvement with the November decisions," says Sauer. "However, still, the onerous contract identification at inception might require a very granular view, contract by contract. This could trigger huge operational implications, though it will depend what the final wording looks like."

Sauer believes that this "cluster" approach is at least better than grouping according to similar profitability as was required before. However, he says that a serious problem might occur with the allocation of contracts to each cluster potentially changing from reporting period to reporting period which would be operationally "very challenging".

All points in time

There are other bones of contention. While Solvency II is a point-in-time standard, IFRS 17 introduces a requirement to explain movements in P&L arising from reserves in different periods.

Valuing and reporting reserves based on assumptions over different time frames is again new and will require a shift in the way data is analysed, with a move from a prospective to a retrospective analysis. So closely after Solvency II, participants fear another a leap in the volume of data to be handled.

"You would need to collect, store and track a significantly larger amount of data than under current IFRS to build the new model for the first time and run it thereafter," says Prashanth Ariyam, audit director at Deloitte. "This is expected to cover the full spectrum of the reporting landscape, from the front-end policy admin and claims processing systems to actuarial and finance systems. It could affect several ancillary processes like pricing, remuneration, asset liability management and budgeting and forecasting."

"We expect the IT spends for IFRS 17 for many insurers to be bigger than for Solvency II." Andreas Schroeder, Willis Towers Watson

Uncertain costs

Roman Sauer, AllianzIFRS 17 also necessitates a move away from implicit to explicit margins for risk and asks insurers to disclose the confidence level they have in provisions. While some insurers already do this, it has been mostly on the life side. Doing so on the non-life liability side "could be an eye opener," says Clark.

With all these changes, the money required for this new project is getting to be a major worry. Carrying out reporting at the individual contract level could see costs rise by significant multiples. "If you have got to do it on a contract-by-contract basis this will be a killer," says Sauer. "The implementation costs will explode."

Indeed, according to some participants, the burden of reshaping the entire P&L reporting structure means the cost is likely to be even greater than that for Solvency II.

"As we expect that all parts of the reporting chain need to be revisited for the IFRS 17 requirements and because the new required IFRS P&L so far is not existent and needs to be built up from scratch, we expect the IT spends for IFRS 17 for many insurers to be bigger than for Solvency II," says Andreas Schroeder, EMEA life financial modelling and reporting lead at Willis Towers Watson.

The millions spent on Solvency II architecture by the industry may be of little help. "Companies are better able to assess the costs now and are seeing that the work done for Solvency II will help less than first thought," says a senior figure at a major insurance industry body, who asked to remain anonymous.

Actually a level playing field?

There is a further question about exactly how level a playing field IFRS 17 will create for the industry. The non-participation of the US, which decided it would continue to employ its GAAP accounting standard in early 2014, was already a poke in the eye for rulemakers in their ambitious project. And there are other potential discrepancies.

"IFRS 17 won't create a uniform standard across the industry similar to how Solvency II wasn't able to achieve that," says Marc Beckers, head of Aon Benfield ReSolutions EMEA. "You will still have many choices in how to interpret the rules – because there is so much diversity in the market – small versus big insurers, sophisticated insurers, internal models, different product mixes and so on. They are putting something in place the industry won't like nor will it be consistent with Solvency II."

Despite the concern over the rules, some have already looked to begin with a plan of implementation. Global insurers with operations outside Europe have, in particular, started aiming to ready themselves earlier than those who have been focusing energies on Solvency II. In reality, however, the majority are waiting to see how the outstanding concerns will be resolved in the coming months. And there is still time for things to change with several meetings planned by the IASB prior to March 2017.

"You still have fundamental hardliners in the IASB who say the right unit of account is on a contract-by-contract basis," says an executive at a major European insurer who asked to remain anonymous. "We say the right unit of account is at the portfolio level. It is critical to the usability of the standard. Going to the contract level is destroying the information. We hope the IASB understands this is a red line item."

With a short time until it is due, further major changes to the IFRS 17 model are unlikely, though the final wording could have an impact on things like contract aggregation. The industry may not be satisfied with everything, but it will have to get on with what is likely to be one of its biggest challenges post-Solvency II.

IFRS 17's building blocks approach to hit life market

IFRS 17 introduces a "building blocks" approach for measuring the insurance liability, which is based on a discounted cash flow model with a risk-adjustment and deferral of up-front profits through the contractual service margin (CSM).

The latter is the deferred profit calculated from the difference between expected premiums and the present value of future cash outflows at inception of contracts. The CSM has the ability to absorb changes related to estimates of future services under a contract that would otherwise impact profit or loss directly – thus providing a smoother profit recognition mechanism.

Prashanth Ariyam, Deloitte"The CSM is an important introduction in the new model," says Deloitte's Ariyam. "It will defer any profits otherwise recognised on day one and affect the profit profiles of many contracts on transition to IFRS 17. The significance of this metric will be more important for the life industry, where the CSM release will span across many years for longer term contracts."

While in theory this should offer a benefit for the industry, it is new and getting to grips with it, particularly over the long term, is seen as a further challenge.

"For the CSM you have to store it and amortise it over time – this is a big work," says Allianz's Sauer. "We don't have that in place right now."

In the November meeting, the IASB offered a carrot to insurers worried about the transition to the new rules with regards to calculating the CSM. In the previous iteration the IASB said insurers could carry out three approaches to transition – the first a fully retrospective method requiring the industry to assess the CSM at the beginning of the contract; second, a simplified approach, similar to the first but with specified exemptions; third, a fair value approach, calculating fair value and taking off the risk-adjusted discounted cash flows to arrive at the CSM.

While regulators had expected many insurers to pursue the first or second approaches, the summer testing showed this to be untenable given the industry has, on the whole, few records stretching back to the initiation of contracts. For life insurance contracts this could be anything up to 50 years in the past.

In November the IASB revised its call, allowing for a "modified retrospective" approach which introduces further short-cuts to get to the retrospective level and allowing a free option to use fair value. It is a very important matter.

"This is crucial because you are setting the profit for life insurers from the existing contracts for potentially the next 50 years," says PwC's Tucker. "The unearned CSM is the profit you release for the next 50 years and so getting the transition right is vital. Once you have chosen this you can't go back."

The CSM conditions are particularly important for the life insurance business where there are long-term contracts stretching over 30 to 50 years which will set future profits. Sauer, for one, expects life insurance businesses to suffer much more than general insurance.

"Life will be most impacted as fully current and prospective measurement will be required from day one with a complex CSM re-measurement each reporting date," he says. "For P&C, the simplified approach will be close to current practice with the biggest change coming from the discounting of claims reserves. But this depends on it not having to go to a very granular unit of account level for onerous contract testing."

Sarfraz Thind