How insurers can prepare for the transition to IFRS 17

Rachel Cromarty

Hello everyone and welcome to EY’s IFRS 17 podcast series. A series that brings you news and views on IFRS 17, the new International Accounting Standard on Insurance Contracts.

My name is Rachel Cromarty and I’m in EY’s UK Life Actuarial team based in London working with a number of national and multi-national clients on IFRS 17 implementation.

Throughout this podcast series we’ll be asking a number of our global insurance professionals to discuss key topics and interpretative issues in IFRS 17, and to consider the implementation approaches and challenges the new standard presents.

In today’s episode we will discuss some of the challenges our clients are facing in preparing for the transition to IFRS 17 with Brian Edey. Brian is a Partner in our UK Actuarial team and is EY’s Global IFRS 17 Actuarial Lead.

Hello Brian and welcome.

Brian Edey

Thanks Rachel, pleasure to be here.

Cromarty

Our clients have been progressing their IFRS 17 transition workstreams, and have raised a number of issues and challenges, both with us and with the IASB.

When we refer to transition, we mean the accounting for the insurance and reinsurance contracts that exists on the date of implementation to IFRS 17. Because IFRS 17 requires the production of comparatives numbers, the transition date is the beginning of the earliest period presented under IFRS 17 in the first set of IFRS 17 financial statements. For most insurers with a December year end, the transition date will be 1 January 2021.

Accounting for the contracts existing on this date is complex because the contracts may have been written many years before that date meaning that obtaining information necessary to apply IFRS 17 may be particularly difficult.

Edey

That’s right Rachel. There are significant data requirements and a number of areas that are open to interpretation.

Some of these areas have been raised with the IASB, who have discussed these topics at their monthly Board meetings and produced a new Exposure Draft with proposed amendments, including some relating specifically to transition.

Cromarty

Before we discuss challenges with transition to IFRS 17, could you give a quick recap of the transition approaches available to insurers?

Edey

Of course Rachel. 

In the view of the IASB, full retrospective application of IFRS17 provides the most useful information to users of financial statements by allowing comparison of contracts written before and after the date of the Standard’s initial application.

The full retrospective approach requires insurers to apply IFRS 17 from the inception of an insurance contract, i.e. the calculations should be carried out as if IFRS 17 had always been in force.

As you can imagine, this can be extremely difficult. There are policies that have been on the books for many, many years. Some companies have policy data that has historically been recorded on multiple administration systems and has been subject to data migration. In many cases information regarding policies which are no longer in force is no longer held.

The IASB recognized these difficulties, and so has provided two alternative approaches, which can be used when the full retrospective approach is not practical.

These are the modified retrospective approach and the fair value approach.

The modified retrospective approach aims to produce a result that resembles, as closely as possible, the full retrospective approach with some simplifications which are prescribed in the Standard.

However, the modifications allowed are very specific and may not allow for simplified approaches that insurer’s may consider to be more suitable.

In its draft comment letter to the IASB, the European Financial Reporting Advisory Group (or EFRAG – the body that advised the European Union on the adoption of IFRS standards) raised concerns around the modified retrospective approaches to transition stating that it was concerned about implementation challenges faced by preparers and the possibility of unduly strict interpretations that would restrict the use of simplified retrospective approaches.

The fair value approach allows an insurer to  take the fair value of groups of insurance contracts on to the balance sheet at transition date as the liability for remaining coverage. The fair value approach allows an insurer to determine the value of the contractual service margin at transition date as the difference between the fair value of a group of insurance contracts and the total fulfilment cash flows as at that date.

It’s really important for insurers to select the most appropriate approach, as the results will affect not only the actual balance sheet on transition to IFRS 17, but also future profit emergence.

Cromarty

Thank you Brian.

As you have said, the full retrospective approach to transition has, in particular, proved challenging to implement for certain types of business.

Our clients have raised a number of issues and challenges, but by far the two most common are concerns around availability of historic data and around the application of the Standard to past periods without using hindsight.

Let’s look at the data requirements first. Data required includes policyholder data for those that have lapsed, premium variances, investment component variances, amortization periods and more. As the CSM calculation will need to be replicated for each reporting period in the past, each of the data items will be required for each period.

The IFRS 17 Standard requires that, for the full retrospective approach, insurers identify, recognize and measure each group of insurance contracts as if IFRS 17 had always applied. This means that historical data will be required for all insurance contracts right back to inception. This will include, not just policyholder data, but data around pricing and the expected profitability of the contract at the time of issue. For many of our clients this is either not available or is stored on redundant systems.

In addition, insurers will require assumptions for each reporting period from policy inception at an IFRS 17 group level. This is a real challenge as obviously insurers were unaware they would require this level of data when writing contracts in the past, and so have not collected or stored this information.

In fact, in a recent EY survey, 62% of respondents identified the lack or unreliability of historic data as one of the main causes of impracticability, and well over half thought that they would be unable to use the full retrospective approach because of the incompatibility of data with current systems.

Edey

Very true.

Another area our clients seem to be finding challenging is the application of IFRS 17 to past periods. IFRS 17 is principles based, and as such isn’t prescriptive. This means that there are areas in which different interpretations of the Standard can be taken.

For historic periods, it can be very difficult to apply the Standard without using hindsight. The issue here is that when these policies were written, IFRS 17 didn’t exist and so certain concepts, such as the risk adjustment just weren’t considered at the time and therefore no documentation exists on what judgements the insurers would have made at that time.

Given that some of the data requirements for the modified retrospective approach are almost as onerous as those of the full retrospective approach, we are finding insurers being pushed towards the fair value approach when the full retrospective is impracticable.

The fair value approach comes with its own set of challenges, most noticeably, insurance liabilities are not regularly traded in an active market and significant judgement is required to estimate the fair value.

Cromarty

Thanks Brian. We’ve also had a new Exposure Draft of proposed amendments to IFRS 17. Some of the amendments proposed may help address our clients’ issues, particularly around business combinations and risk mitigation. 

Edey

Yes, as discussed in our previous podcasts, there have been some proposed amendments to the Standard relating to transition.

The first amendment relates to contracts that have been acquired in a portfolio transfer or a business combination before the transition date.

Under IFRS 17, contracts acquired in a business combination or a portfolio transfer are accounted for as if the entity has issued them on the transaction date.

This means that when an entity acquires insurance contracts in their claims settlement period, the resulting liability is classified as a liability for remaining coverage and not a liability for incurred claims. This is different to the treatment of an entity’s liability to settle claims arising from contracts it issues which are classified as a liability for incurred claims under IFRS 17.

Cromarty

That sounds like it could cause real operational issues. Unless insurers have recorded claims liabilities arising from acquired contracts differently to those arising on initiated contracts, there will be no way of telling how to account for these.

Edey

That’s right Rachel, and that’s why the IASB has proposed an amendment to the modified retrospective approach. In circumstances where an insurer does not have reasonable and supportable information to apply the full retrospective approach, the amendment allows them to classify a liability that relates to insurance contracts in their settlement period acquired before transition date as a liability for incurred claims instead of liability for remaining coverage.

Cromarty

And what about insurers that are planning to use the fair value approach at transition?

Edey

Good question – those insurers using the fair value approach will be permitted to choose to classify such liabilities either as a liability for incurred claims or a liability for remaining coverage.

Cromarty

Thanks Brian. There are also some quite significant changes in relation to risk mitigation which applies only to direct participating contracts accounted for under the Variable Fee Approach in the standard.

Under IFRS 17, the risk mitigation option allows insurers to recognize some changes to insurance contract liabilities for direct participating contracts that arise from changes in financial risk in the profit and loss statement as opposed to the contractual service margin. However, this option does not apply to periods before the transition date.

This then leads to mismatches in the accounting approach between insurance contracts and risk mitigation instruments. For example, for contracts using the variable fee approach, changes in financial assumptions adjust the contractual service margin, but the effect of the same financial changes to the value of derivatives, held to mitigate these risks, are recognised in profit and loss.

The proposed amendment to IFRS 17 allows insurers to apply the risk mitigation option, allowing changes in contractual service margin due to financial assumption changes to be recognized in the profit and loss statement, to the comparative year provided that the risk mitigation approach has been documented before the beginning of that period.

Edey

There’s also been another useful amendment relating to risk mitigation, which allows insurers to use the Fair Value approach at transition for groups of contracts subject to the Variable Fee Approach, even if they could use the Full Retrospective approach.

To take advantage of this, the insurer has to:

• Choose to apply the risk mitigation option prospectively from the transition date; and
• Used derivatives or reinsurance contracts to mitigate financial risks prior to transition date

Cromarty

That’s all really interesting.

To summarize, each of the three approaches to transition being the fully retrospective approach, the modified retrospective approach and the fair value approach, have implementation challenges.

The proposed amendments are helpful in some specific areas, but there remains a number of areas which are open to interpretation or are practically difficult to implement.

 Thank you for your time today Brian. And thank you everyone for listening.

As always, we’d welcome feedback and suggested topics for future IFRS 17 podcasts.