Labelled as the truly global accounting standard for insurance contracts, International Financial Reporting Standards (IFRS) 17 Insurance Contracts is effective for fiscal years beginning January 1, 2023, or later. This standard replaces its predecessor, IFRS 4 Insurance Contracts, and establishes common worldwide principles for the recognition, measurement, presentation, and disclosure of insurance contracts. 

IFRS 17 is a complex standard. To help financial statement users better understand this standard, The Analyst interviewed Bobby Thompson, CFA, CPA, CA, Partner, Insurance at KPMG Canada, and Ralph Ovsec, Senior Director, Insurance Consulting and Technology at Willis Towers Watson. In this article, we summarize their thoughts on the changes, benefits, and impacts of IFRS 17 that analysts should be aware of when assessing the financial performance of insurance companies.

Can you provide an overview of IFRS 17? What has changed compared to IFRS 4?

Under IFRS 4, Canadian insurers used the Canadian Asset Liability Method (CALM) to project out the cash flows needed to fulfill an insurance contract. The cash flows included premium inflows, claims, and expense outflows, adjusted for a measure of risk called the provision for adverse deviations (PfAD). They calculated the gains and losses by taking the present value of inflows and subtracting the present value of outflows. The discount rates for those cash flows were linked to the current assets, the company’s investment strategy, and the future yield projections on those supporting assets. Expected future earnings equal the gradual release of those PfADs over time. Current period variances resulted from updates to assumptions, differences between actual and expected experience, and the difference between the market value of assets, offset by the change in liabilities from the change in discount rates.

Under IFRS 17, we have best estimate liabilities (BEL) and risk adjustments (RA) for life insurers. They have similar fundamental principles to what we had under IFRS 4, but with subtle differences. Maintenance expenses are only those that are directly attributable to the policies. Market-consistent assumptions are used to determine the discount rate for the BEL. Explicit cost of guarantee (COG) is also a new item under IFRS 17. The other big difference compared to IFRS 4 is the day one gain, to the extent that where future premiums exceed claims and expenses and the measure for risk adjustment, that amount is deferred as a contractual service margin (CSM). This is in contrast to any losses on first recognition, which will be recorded through the income statement. Such contracts are referred to as onerous contracts. CSM is a new concept under IFRS 17 and represents the unearned profit that an entity expects to realize over time as it provides insurance services. Under IFRS 4, gains at initial recognition were recorded immediately as the new business was issued. Under IFRS 17, unearned profit is amortized into earnings as the services are provided.

The figure below illustrates how CSM is amortized into income over time under IFRS 4 versus IFRS 17, while earnings remain the same over the lifetime of the contract.

Figure 1: Amortization of CSM into income over time under IFRS 4 vs. IFRS 17

Source: Fadous, Stephanie. IFRS 17: Effective January 1, 2023, for Canadian-Based Insurers. Presentation, June 2021. Manulife. https://www.manulife.com/content/dam/corporate/investors/MFC_IDS_IFRS_2021_EN.pdf

Under IFRS 4, there was a natural hedge on the balance sheet because the market yield on assets and the discount rate on liabilities were linked. That’s how the insurance industry accounted for contracts for a long time. That goes away under IFRS 17. The discount rate under IFRS 17 is a risk-free rate plus an illiquidity premium and ignores the impact of higher-yielding assets such as equities, mortgages, and real estate. The value of that higher yield is recognized as it occurs.

Compared to IFRS 4, what are the benefits of IFRS 17 for financial statement users?

First, being a global accounting standard, IFRS 17 brings consistency to insurance accounting.

As IFRS 4 was an interim standard, it did not prescribe the measurement of insurance contracts. Consequently, companies often followed the practices set by local accounting requirements. For example, as mentioned above, Canadian insurance companies have adopted the asset–liability method to account for an insurance contract. However, globally, there are many different accounting and reserving standards in place.

IFRS 17 requires all insurance contracts to be accounted for in the same way. This greatly improves companies’ comparability, which helps analysts achieve a common understanding of the performance of insurance companies to make better investment decisions.

That said, while the overall accounting principles are aligned globally, IFRS 17 still provides various policy choices to companies. It includes judgment areas for companies to consider when setting their assumptions and valuation methods. As a result, just because companies are reporting under the same standard does not mean the financial results are going to be reported in the same way. Analysts need to read the “fine print” very carefully, such as the disclosures on significant accounting policies and management commentaries, to understand the accounting elections companies have made.   

Second, IFRS 17 provides better information about the profitability of insurance contracts.

As described above, IFRS 17 introduces a CSM, which represents the unearned profit that originates when an insurance contract is issued and that an entity expects to earn over time as it provides services. Furthermore, the standard also requires the profit or loss earned from underwriting activities to be presented separately from financing activities. The additional information on CSM and the separation of sources of income will help analysts understand the expected future profitability of insurance contracts from different sources of the business.

IFRS 17 also requires insurance companies to use current discount rates to measure insurance contracts. Unlike the discount rate used previously, which is the yield on the corresponding assets backing the liabilities, this information will reflect the characteristics of the cash flows arising from the insurance contract liabilities, but with only a liquidity premium related to the liabilities, thereby ignoring potential yields on assets such as real estate and non-fixed-income assets.

Finally, IFRS 17 contains more extensive disclosure requirements for insurance companies to provide quantitative and qualitative information to help financial statement users understand the impact of insurance contracts and any significant judgments when applying the standard. Information such as an analysis of insurance revenue, an explanation of when the entity expects to recognize revenue in profit or loss, the remaining balance of CSM, and the confidence level used to determine the risk adjustment for nonfinancial risk are beneficial for analysts in assessing the current and future performance of insurance companies.

What is the impact of IFRS 17?

IFRS 17 does not impact the fundamental economics of insurance companies; rather, it is primarily an accounting regime change that impacts how specific items are recorded on financial statements with the aim of standardizing how insurance companies value liabilities and report results.

Multiple insurance companies have stated that IFRS 17 does not affect their business strategies.1 It is worth noting that IFRS 17 generally has a greater impact on life insurance companies than property/casualty insurance companies. Life insurers have identified impacts in the following areas:

1. Decrease in equity on transition: To recognize the deferred profit mechanism, CSM is recorded as a liability and amortized into equity as the services are provided over the life of the contract. We see about a 5 to 15 percent reduction in equity for life insurance companies in Canada, compared to a less than 5 percent reduction in equity for non-life insurance companies. While balance sheet equity is reduced, Canadian companies reporting their capital ratios are given credit for the CSM in their available capital, with often a minimal impact on their capital ratios.
2. Lower earnings: The decrease in earnings is primarily driven by CSM amortization under IFRS 17 compared to the periodic impact under IFRS 4. This may reverse over time as more CSM is released into earnings.
3. Financial volatility: We are seeing a lot more financial volatility as a result of the delinking of assets and liabilities.
4. Earnings volatility: To the extent that companies have CSM on their balance sheets, adverse changes in future best-estimate assumptions, such as mortality, can be offset against the CSM. This significantly dampens the impact on earnings, unlike under IFRS 4 in Canada, where such changes were immediately recorded through profit and loss.

Key performance indicators (KPIs): Insurers are already looking at new KPI metrics, such as CSM balance growth, which will be used to demonstrate the performance of their new business and set expectations for the amortization of CSM into future earnings. 

Takeaways

IFRS 17 has had a significant impact on accounting for insurance contracts:

1. IFRS 17 does not impact the fundamental economics of insurance companies; rather, it is an accounting regime change.
2. The introduction of CSM and the delinking of assets and liabilities in the setting of discount rates are key changes under IFRS 17.
3. Analysts and users of insurance companies’ financial statements should be aware of the changes and how they impact existing metrics and KPIs when evaluating companies. 

 ¹ Great-West Lifeco, Manulife, and Sun Life. Overview of Earnings Presentation and Reporting under the New IFRS 17 Accounting Standard. Presentation, April 19, 2022. https://www.sunlife.com/content/dam/sunlife/regional/global-marketing/documents/com/ifrs-17-presentation.pdf