Written By: Diana Bailey – Corporate Finance
The International Accounting Standards Board (IASB) has agreed on the internationally standardized accounting standard IFRS 17 to be included in the International Financial Reporting Standards (IFRSs) after two decades of consulting and engagement with the insurance industry. At its February board meeting in London, the most recent amendments were accepted, and the chairman of the IASB, Hans Hoogervorst, underlined that there would be no further meetings. This leaves the way open for the publication of the standard in May 2017.
Until now, accounting principles for insurers all over the world have been very different. For many years, IASB, which is in charge of harmonizing the accounting principles for the European Union, has faced several issues:
- Previous standards, such as IFRS 4, authorized in fact insurers to keep their local and historical principles;
- IFRS 9 was more specific regarding debt provisioning for banks, and IASB issued amendments to IFRS 4, which allowed them to postpone the application of IFRS 9 to 2021 (instead of 2018).
And now the insurance industry needs to deal with planning for this new “megaproject”, according to current annual financial statements. IFRS 17 is due to enter into force on January 1, 2021, and therefore requires an opening balance for 2020. Mandatory application applies in the European Union, especially to all listed companies.
The impact of IFRS 17 for insurers is multiple.
- Insurers should report earnings that reflect the services being provided rather than the cash received;
- Estimates of future cash flows should be based on current assumptions rather than historical assumptions;
- Measurement includes an allowance for risk and uncertainty.
Among those new principles, the second one is going to change drastically the perception of profitability of an insurer. Indeed, IFRS 17 is expected to introduce a new method of valuation for contracts, which will oblige insurers to compute an actualised value of the future engagements for their contracts. It will force them to take into account their future obligations at market value, while today they book into their accounts the historical values of their debt at cut-off date. The revolution could be similar to that of bankers, who will be obliged to book their possible future losses instead of proven losses, with the IFRS 9 entering into force in 2018.
The willingness of the IASB to unify practices is to be praised. The goals of better quality and transparency of financial information could be achieved. Comparing financial statements from one insurer to another to estimate their profitability would be possible; this would meet expectations of investors. But the main change brought by the new framework is the assessment of future commitments for life insurance. Today the historical cost to estimate insurers’ debt on life insurance is admitted; tomorrow booking life- and investment-insurance contracts at current value by discounting future cash flows at current interest rates will mechanically increase the commitments stated in financial statements. And with today’s level of rates, the increase will be very important for life insurers.
And there are immediate consequences to the increase in the value of insurers’ debts:
- Assets to be put in front of long-term contracts, and estimated at market value, can be lower than the commitments;
- Equity may have to be heavily strengthened (following Solvency II rules);
- Fluctuations from one year to another of the insurer’s balance sheet will certainly have to be explained in detail to investors, as today there are not such fluctuations in the balance sheet of the insurer.
One more consequence is that the principle of evaluating each and every contract raises two additional issues:
- It conflicts with pooling principles of the risk for insurers: usually insurers’ accountants do not enter into detailed contract analysis, contract per contract. Pooling the risks is a normal activity for an insurer when assessing its debt; it works on portfolios of contracts that form a whole. It is thanks to this nonhomogeneous set of contracts that risks can be pooled;
- It leads to the implementation of new complex methods and systems that can be taxing and costly.
After publication of the standard, expected in May, insurers will certainly have to perform estimations of impact, and this process could even lead to some changes in strategic decisions on long-term contracts. Only three years are left to manage this huge project.