The deadline of 1 January 2023 for transition to IFRS 17, Insurance Contracts, is approaching. The best prepared insurers and reinsurers are getting ready to run their IFRS 4 accounting and reporting processes in parallel with their new IFRS 17 processes next year. This will create comparative results ahead of the transition from IFRS 4 and provide comfort that their IFRS 17 operations and reports are fit for purpose.
Now is an opportune moment to reflect on some of the challenges faced and lessons to be learned by the insurers in IFRS 17 transition. This article examines three of the most salient themes.
First, off-the-shelf packages will have an embedded interpretation of the IFRS 17 methodology, one that seeks to address the needs of the market as a whole rather than those of an individual insurer.
The most radical change to internal operations will be the incorporation of a contractual service margin (CSM) calculation engine (see ‘Mythbusting’, AB November 2019). This has generally been the case for life and composite insurers, which have often selected an off-the-shelf CSM and accounting subledger package. Seeking to understand the off-the-shelf package’s functionality while simultaneously developing their accounting policies would seem a reasonable approach.
No matter what budget an insurer has for IFRS 17, investment in test cases is a must
However, there have been several areas of divergence between accounting and audit experts around the world. Software vendors cannot wait until the dust settles, but must programme an approach in order to have a solution to sell. The most significant examples of these divergent areas, and the generalised approach being taken, are the order in which calculations must be performed, the applicability of foreign currency to the CSM, and the categorisation of risks as either financial or non-financial. All will have a material impact on the financial results.
While an off-the-shelf package offers insurers faster implementation than developing their own software would, it may constrain them in how the standard is applied. Insurers should bear in mind that their chosen technology may not be able to accommodate their accounting policy judgments. The associated range of how the requirements of IFRS 17 can be applied in practice when data flows through the solution’s CSM calculations and posting framework may be limited.
Second, insurers need to plan how to test the CSM engine and its associated accounting output. Typically in system testing, a series of manufactured scenarios is generated, with each successive scenario ever more realistically replicating a future business-as-usual state. For each test scenario there is an expected result against which the actual result is compared.
This begs the question of what the expected result is that includes the CSM and its behaviour. This is not easy to answer, as the IFRS 17 standard brings a whole new concept to insurance accounting, integrating the previously segregated worlds of the accountant and the actuary.
The more sophisticated the business and its insurance products, the harder it is to derive expected results from first principles. The most advanced have commissioned advisers to configure a CSM engine and accounting subledger from Excel. These insurers are then able to run low-volume use cases through the Excel model to provide a robust comparator for key areas of functionality. No matter what budget an insurer has for IFRS 17, investment in test cases is a must.
Third, the misconception that many property and casualty insurers may have been labouring under to date can be summarised as ‘no CSM, no problem’. The simplification of the premium allocation approach, which does not contain a CSM, is so similar to IFRS 4 that only marginal operational changes will be needed – or so the thinking goes. Proving eligibility is the battle to be fought; thereafter, it is relatively plain sailing.
Perhaps the most surprising lesson to be learnt is that the biggest impact of IFRS 17 may not be the CSM, but the level of contract aggregation because of its applicability across all measurement models. The level of aggregation was conceived to limit the extent of offsetting loss-making contracts against profitable ones.
Aggregation requires the business to be divided into portfolios and annual cohorts so that the offsetting benefits can be taken only for similar risks that are managed together and are bound by a 12-month limit for income statement reporting.
The lower the level of contract aggregation set, the more likely that losses will be realised on initial recognition
In other words, the open-ended portfolios are made up of a sequence of closed books of insurance contracts, with each book limited to a 12-month span. This requirement increases the chances that a loss component will need to be recognised and a hit to the income statement taken immediately. The lower the level of aggregation set, the more likely it is that losses will be realised on initial recognition.
Also, other things being equal, facts and circumstances resulting in a loss component are more likely to come to the fore during the lifetime of the contract group.
Insurers in keenly priced product markets, such as retail household and automobile cover, may find the assessment and remeasurement process has as big an impact on their operations and reporting timetables as integrating an off-the-shelf CSM calculation engine. Deciding against the purchase of such a tool, even if IFRS 17’s general measurement model is not applied, may be a false economy – all the more so if discounting the liability for incurred claims is a new requirement for the insurer.
A clear vision of the IFRS 17-compliant operating structure from 1 January 2023 and a comprehensive strategy to get there will make the challenges here easier to manage. The key is to select and test the right tool, and understand the future data needs and the incremental asks of the process while adopting a pragmatic approach to interpretation and policy.