New insurance accounting rules threaten to be just as complex as their forebears.

If investors believed recent accounting reforms would improve understanding of insurers' financial statements, they could well be disappointed. For some time such documents have been technical, complex and largely incomprehensible to anyone outside the sector.

Seeking to improve the reporting quality of insurers, this spring the International Accounting Standards Board (IASB) issued complex rules under IFRS17 – but will they clarify company accounts or just add to the technical confusion?

Overly complex

For many years, two topics have particularly confused readers of financial statements: reporting financial instruments and the financial reports of insurers.

Even former IASB chair Sir David Tweedie disparaged the complexity of his own former financial instrument standard (IAS39). He was not being too flippant when he told an audience: 'Those of you who have read the standard on financial instruments and understood it have not read it properly.'

Although IFRS17 has been introduced with the best of intentions, it remains technical and complex for those coming from outside of the industry.

The former reporting requirements of insurance contracts were first issued under IFRS4, more than 13 years ago. This was mostly a hotchpotch of tangled rules, obscure methods and various accounting techniques, with some parts merely a stopgap until something better came along.

IFRS4 even allowed local accounting treatments to be applied in different countries. The rules lacked consistency, comparability and transparency – and were unfit for purpose.

"IFRS4 was mostly a hotchpotch of tangled rules, obscure methods and various accounting techniques, with some parts merely a stopgap"

Similar charges can be levelled against IFRS17, with the complexity and technical content of the rules potentially restricting the use of them to insurance professionals and specialist accountants. It is not as if they were written in hurry; these new rules for reporting insurance contracts have been discussed and prepared for nearly 20 years.

IFRS17 has attempted to rectify some of its predecessor's limitations and its impact is wide-ranging in insurance. The changes will affect any company writing insurance and re-insurance contracts. The IASB believes the new standard will affect more than 450 insurers listed on global stock markets with a combined asset value of around $13 trillion.

Informed readers

The standard is intended to help users of insurers' financial statements be better informed, and provide easier comparisons between companies. It is also predicted to hit different insurers' earnings differently, with life insurers expected to be more severely affected than property and casualty insurers.

Under previous accounting rules, annuity earnings of life insurers were generally recognised in the income statement immediately on sale. Now these insurers will be required to spread the profits over the lifespan of the insurance contracts.

The new rules will also remove the insurers' ability to distort their financial statements by boosting immediate profits through long-term contracts. Deloitte suggested this alone could reduce reported earnings at some insurers by 10–20%.

Building blocks

The new standard requires that most life insurance contracts are reported under a building block approach – in some ways a method similar to the requirements under the Solvency II regime, which established the amount of capital that EU insurers must hold to reduce insolvency risk.

This building block method is mostly based on 'following the cash flows' and making suitable adjustments in the contracts. As a result, insurers will calculate their 'best estimate' of the projected net cash flows arising from the contracts.

Insurers will subsequently apply a 'market consistent risk-free discount rate' – but with the inclusion of an allowance for an illiquidity premium, which forms the basis of what is termed 'fulfilment cash flows'. Finally, insurers will need to adjust the risk to incorporate all other risks not included in the 'market consistent' variables.

A key aspect is determining the unearned profits contained in insurance contracts. This unearned profit will involve the calculation of a 'contractual service margin' (CSM), which will now represent the total unearned profits in these contracts.

"In effect, the new rules mean insurers will not take all profits under an insurance contract immediately on issue"

Insurers will now have to measure how these margins – the unearned profits – are released over the years to the income statement and adjust this release by various insurance assumptions and investment factors.

In effect, the new rules mean insurers will not take all profits under an insurance contract immediately on issue. In future, profits will be released and recognised on a systematic basis over the length of the contract.

Another key feature of IFRS17 is the requirement for insurers to categorise contracts into portfolios containing a product line with a similar risk profile. The insurers are then required to decide which contracts within each group are likely profitable and which may generate losses. This process will normally have to be conducted yearly.

Alternate approaches

Many insurers will adopt the general model above. However, IFRS17 provides for alternative approaches for other business models. In short-term non-life contracts, discounting of premiums is not conducted and fewer disclosures are made.

Alternatively, a 'variable fee method' can be used where the policyholders participate in a share of a clearly identifiable pool of underlying assets. Part of this method would entail taking unrealised changes in fair values of these assets directly to the income statement.

IFRS17 now insists that all types of insurance liabilities are made at current value and not at historical costs. This change alone should ease comparisons of financial statements between insurers and help in evaluating current and future profitability of insurance companies.

The increased use of current values and 'mark-to-market' accounting further adds to the reporting requirements and will also cause more volatility in profit levels.

Substantial costs

The Association of British Insurers (ABI) has urged some caution on IFRS17. Hugh Savill, the group's regulation director, explained that the requirements of the new standard have only been subject to 'limited operational testing'.

He diplomatically adds that the standard's ability to 'support adequate communication with the market has not been evaluated'. The ABI is also concerned that implementation costs of IFRS17 are likely to be 'substantial'.

Critics of IFRS17 point to the previous experience of EU insurers in adopting the Solvency II regulations. In that case, the implementation of those capital adequacy measures is estimated to have cost these firms €3–4 billion.

The impact from introducing new financial, actuarial and reporting systems for IFRS17 is estimated to be on a similar scale – and perhaps with greater costs. Tom Stoddard, CFO of the insurer Aviva, said implementing Solvency II cost his firm more than £500 million, adding that the cost of implementing IFRS17 would be less, but still 'another large number'.

Further concerns

The Association of Chartered Certified Accountants warned the insurance reporting changes will be 'very significant'. Richard Martin, the body's head of corporate reporting, said that IFRS17 will produce 'new accounting numbers' and new data will have to be assembled.

Investors and other users of insurers' financial statements will also have to adapt and understand new financial information that is produced.

Alex Bertolotti, an insurance specialist with PwC, considers IFRS17 to be the 'biggest shake-up of insurance reporting for decades', and believes the rules could affect some banks with equity release contracts, and other financial institutions that write insurance contracts.

"Some questioned whether IFRS17 would be worth these 'eye-watering costs'"

More criticism of IFRS17 comes from the CFO of the Prudential Group, Nic Nicandrou, who warned that implementing the rules could cost between £1–2 billion in the UK alone. He even questioned whether IFRS17 would be worth these 'eye-watering costs', adding that the new standard will mean undertaking 'extensive re-engineering of data storage, actuarial and finance systems'.

Nicandrou stated that insurers were facing 'fundamental operational as well as accounting change', and asked whether the benefits of IFRS17 justifies the investment and time to implement the new rules.

Many of the costs associated with the introduction of IFRS17 are not one-offs. The complexities of the new standard mean that information will needed to be regularly updated. Further work will entail collecting data about profits on contracts that are expected to be recognised in future, and in adjusting and explaining assumptions in measuring contracts at current values.

Net disbenefit

IASB chair Hans Hoogervorst is more optimistic about the standard's prospects. He states that it 'will provide investors and others with comparable and updated information.'

This is true: IFRS17 will provide new and different types on information. Unfortunately, it is unlikely that IFRS17 will enable more investors and many other stakeholders to more easily understand the financial statements.

Insurers' financial statements were certainly complex for most users to understand before IFRS17. After the adoption of IFRS17 these documents will remain complex, and may become more so.

It is also debatable whether such a specialised topic as insurance contracts should even be subject to a formal international standard. It may have been preferable to have followed the FRCs practice in the UK by issuing a Statement of Recommended Practice on specialised topics, which provides additional guidance and advice to preparers and users.

IFRS17 does have some benefits. It standardises things, eases comparisons and introduces more timely valuations. But for many larger insurers, the cost of the changes to internal reporting and systems modifications may well undermine any advantages.

On the plus side, at least insurers have until 1 January 2021 to adopt it.

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