IFRS 17 to lift insurance investorsWednesday January 11 2023
Effective January 1, 2023, insurance companies entered a new financial reporting standard known as International Financial Reporting Standard 17 (IFRS 17).
Fundamentally, the standard changes profitability measurement in insurance companies.
Insurance contracts say that you are receiving a premium in advance, and then there is an expectation of claims in the future.
Of course, actuaries— the professionals who price the insurance contracts— would be looking at the profitability and the modelling of that particular contract or a group of contracts to price with a return on capital in mind.
Nonetheless, measuring the profitability of longer-dated contracts was already complicated under the old standard.
In addition, in life insurance, for instance, the price is set at the point of sale but the costs of the product run over the lifetime of the contract.
READ: What insurers should expect in IFRS17 regime
Essentially the timing of an insurer’s cash flow is reversed from most industrial companies. Industrial companies invest now to capture cash inflows later. It’s the reverse for insurers.
Additionally, insurers write many different contracts with very different features. A term insurance, for example, is very different from a savings contract with financial guarantees.
Consequently, a life insurance balance sheet is a conglomeration of many different contracts written over many years and each type of contract may contribute in a different way to the business year of a life insurer.
As a result, profitability as reported in accounting is difficult to interpret and one can hardly draw any meaningful conclusions on how a company creates value and earns profits.
One of the big changes that IFRS 17 brings is the ability for investors to know the source of earnings.
This will be achieved through the separation of underwriting earnings (also known as insurance service results) from non-underwriting earnings, mostly investment income.
There has been an off-setting practice where insurance companies group loss-making contracts together with profitable ones (which has been the common practice prior to IFRS 17), making it difficult to determine earnings drivers.
Further, the presentation of the balance sheet by insurance companies will be much simpler and consistent.
Another change is revenue recognition. At the moment, one of the problems is that the topline of an insurance company isn’t really consistent with the whole of income and expense measured on an accrual basis.
Many insurance companies present the topline as a cash flow, which is essentially premiums received.
Also, showing cashflow inflows as revenues have meant showing deposit components within revenue.
In the case of a commercial bank, this would be like saying deposits made by customers are revenues and repayments of those deposits are expenses.
The standard now defines insurance revenues as considerations received for services provided (and not cashflows).
So how will profitability be measured under IFRS 17? Broadly, premiums received over the life of an insurance contract are inflows.
READ: Navigating IFRS 17 compliance pitfalls
There are also outflows in the form of claims, and acquisition costs (underwriting costs, commissions to agents and costs related to the servicing of the contract). And, of course, the claims are all about expectations.
The insurance company cannot be certain about what the claim is going to be. Finally, when you sell insurance contracts to a group, there would be lapses, adjustments to the experience and even time value of money.
The Standard says that an insurer assesses all these things on the first day of the contract. Essentially, the modelling should be able to tell if a contract is profitable or loss-making on day one, albeit notionally.
If the contract or a group of contracts is profitable, the standard asks insurers not to recognise the profits but to recognise the losses through an income statement.
And the prudence behind this is to avoid an off-setting scenario. For investors, this will provide more clarity and make it much more easier to identify profitability drivers.
The writer is an investment analyst.