An accounting ‘big bang’? The implications for insurance investors from IFRS 9 and 17
- New regimes coming into effect this year represent a significant change for insurance accounting requirements - with challenges, but also opportunities, for how asset portfolios can be structured and managed
- The effect will differ according to the type of insurance business that lies behind investment portfolios, and on the IFRS 17 measurement models that apply
- Depending on their circumstances, we think insurance CIOs may consider reviewing the design and management of their asset allocation and portfolios
Sustained inflation has triggered unprecedent monetary tightening and a surge in interest rates which in turn have revived volatility and provoked changes in market liquidity conditions. This is a significant moment for insurance companies, bringing challenges in managing balance sheets and demanding a review of asset portfolios that may enable them to efficiently manage risks and restore investment margins. At the same time, insurers must also factor in the demands from a ‘big bang’ in their regulatory and accounting landscape as IFRS 9 and IFRS 17 enter into force this year.1
In brief, IFRS 9 impacts the classification and measurement of financial assets while IFRS 17 establishes principles for the recognition, measurement, presentation and disclosure of insurance liabilities. On its own, IFRS 9 cannot be classed as a game changer relative to the previous IAS 39 standard,2 although it may bring more volatility to profit and loss (P&L) statements if the right investment choices are not made.
IFRS 17, which replaces IFRS 4, has far more structural consequences. In fact, it represents the most significant change to insurance accounting requirements in 20 years and requires insurers to entirely overhaul their financial statements.
The purpose of IFRS 17 is to better reflect economic reality and to improve comparability. IFRS 17 will not change the economics, cash or capital aspects of an insurance product – an insurance business that is profitable will remain profitable. It does, however, require the measurement of insurance contracts at their current value – changing the composition and valuation of a balance sheet’s components.
In addition, profits will now be recognised as the insurer delivers insurance or investment services, rather than when it receives premiums, as could be the case under the previous regime which deferred to local rules. This will alter the amount of profit recognised in each reporting period and its presentation. What are the likely outcomes? We expect financial results to be more stable for life with-profit business lines but more sensitive to changes in interest rates and more volatile for property and casualty (P&C) and other protection business lines.3
The combined effect of these standards, depending on the type of insurance contracts involved, may also have notable implications for how insurance companies can structure and manage their asset portfolio. This makes it paramount to understand how these new regimes interact.
One important observation is that insurers who run life with-profit books of business can benefit from much more flexibility to structure and manage asset portfolios, where they are not constrained by local (i.e. different) accounting rules. This is because returns from portfolios backing certain contracts with direct-participating features (those that use the so-called variable fee approach model) do not directly hit the P&L. The effect of performance impacts the P&L only progressively through the contractual service margin which amortises returns in the P&L over the life of an insurance contract.
In practical terms, we think this could translate into more actively managed portfolios, an easier use of derivatives-based strategies and less constraints related to the formats of investment strategies (open-ended funds versus separate accounts).
For other asset portfolios backing non-participating life or P&C contracts (under measurement models known as the ‘building block approach’ and ‘premium allocation approach’),4 IFRS 9 constraints apply fully. This means insurance companies who want to minimise P&L volatility have strategic choices to make. For accounting purposes, insurers must classify the assets in these investment portfolios in one of several ways – the most pertinent in this discussion being ‘fair value through P&L’ (FVTPL) or ‘other comprehensive income’ (OCI).
Insurers who have most of their assets classified as FVTPL under IFRS 9 will see their P&L volatility partially compensated. This is because liabilities (the value of claims, etc.) are now discounted based on market-consistent interest rates, rather than a mix of regimes. This effect is recognised in the P&L by default under IFRS 17. In this case, we think a proper asset liability duration matching should allow clients to maximise this compensation, which advocates for well-designed and liability-aware fixed income portfolios
Insurers who have most of their assets classified as OCI are highly likely to have elected the OCI option under IFRS 17. This has the effect that the impact of interest rate changes on their liabilities’ value is recognised in the OCI and not in the P&L. In this case, we think that maximising the portion of assets that can be classified as OCI is key to mitigate P&L volatility.
Our view is that affected insurers may wish to favour dedicated fixed income solutions and assets compliant with the ‘SPPI’ test rather over open-ended funds, which are classified as FVTPL by default under IFRS 9.5 We think insurers should also increase diversification to reduce their impairment risk, which is based on an expected credit loss model under IFRS 9. When investing through open-ended funds, strategies exhibiting lower volatility, such as short-duration high-yield strategies, may be preferred
Insurers should also reconsider the nature of their equity exposure depending on whether they have elected the equity OCI option or not under IFRS 9. Under IFRS 9, equity investments are classified as FVTPL by default, and so here again insurers may prefer low volatility or risk-managed equity strategies to mitigate their net income volatility.
An option to classify equities as ‘fair value other comprehensive income’, or FVOCI, is offered but in this case only dividends can be recycled into the earnings, which prevents the recognition of full equity performance potential in the bottom line. Those who classify their equity investments as OCI could be tempted to enhance the dividend yield of their portfolio to maximise underlying earnings, but they should pay attention to any potential equity factor biases or environmental, social and governance effects that this could produce.
A moment to act
There are other concerns for insurance chief investment officers from the changes. As an example, for P&C contracts under the IFRS 17 ‘premium allocation approach’ model, current year claims – which may not be paid out for several years – are accounted for using current year interest rates. This can have the effect of boosting results as a nominal claim amount can be discounted, thereby lowering the combined ratio (claims set against earned premiums). However, as time goes by the discounting of prior years’ claims reserves is unwound at locked-in rates, which may negatively impact the P&L. This could make the P&L of P&C insurers more sensitive to changes in interest rates and thus more volatile under IFRS 17.
In other words, a significant decrease in interest rates following a period of high interest rates would hit the P&L of the current year (increase in the combined ratio). Insurers have always sought to manage their reinvestment risk, but we think this should now become even more important. Specific hedging techniques can be more easily implemented in custom fixed income solutions combining bond and derivatives investing.
Given the complex combined effects of IFRS 9 and IFRS 17 (and potential interaction with local accounting frameworks), insurance investors may not yet have fully grasped the consequences of these new accounting regimes on their investment portfolios. Time taken to manage the impact, however, will be time well spent. Some will be offered more flexibility to manage portfolios; others will have new options to adapt their P&L. Ultimately, we believe that successfully navigating these new standards may suggest important changes in portfolio structuring and asset allocations and will involve strategic decisions that could help optimise financial results.