IFRS 17 & 9 series: Asset allocation considerations

In the second of a three parts series on the impact of the international financial reporting standards (Ifrs) on insurers' financial reporting, Vincent Huck looks at the potential impact of the new accounting standards, Ifrs 17 and 9, on asset allocation.

Through the introduction of Ifrs 17 - which prevents underwriters from recognising the full profits from long-term contracts on the day they win them, but only gradually and stepwise over a contract's life - and the introduction of Ifrs 9 which forces insurers to look forward in regards to their investments, insurance companies' financial statements will clearly show up mismatches between an insurer's assets and its liabilities.

The potential for mismatches between an insurer's assets and liabilities depends on whether the entity's insurance contracts will be accounted for under the Ifrs 17 general model, the premium allocation approach (PAA) or the variable fee approach (VFA).

Monica Rebreanu, director at EY says says: "To avoid or reduce accounting mismatches, the classification of investment portfolios under Ifrs 9 should contemplate the measurement models for insurance liabilities under Ifrs 17, as well as options available under the two standards."

Evaluating whether to use the other comprehensive income (OCI) option for insurance liabilities, and how to best align it with the mixed measurement model for the assets is one of the main considerations for an insurer around Ifrs 9/ Ifrs 17.

"Ifrs 17 allows recording the impact of changes in discount rates either through the P&L, or through the OCI," Patrick Menard, partner at EY says.

Rebreanu adds: "An entity may elect to record changes in discount rates on insurance liabilities through OCI if the corresponding assets are at fair value OCI under Ifrs 9 'hold to collect or sell' business model, which is expected to be applied to large portions of insurers' fixed income portfolios."

While accounting mismatches between certain assets and liabilities can be avoided, others cannot either because the assets are not measured at fair value - for example real estate investments under IAS 40 - or because the classification measurement of financial assets under Ifrs 9 is purely not an option.

Portfolio mix and investment strategies should continue to be driven by economics, and appropriate risk/return management strategies, considering insurers' obligations to policyholders, according to Rebreanu.

Menard adds:"While accounting considerations, such as the implementation of Ifrs 9 and Ifrs 17, will typically not affect asset management mandates in terms of their risk/ return objectives, the considerations may bring potential changes to the form of investments insurers prefer to hold."

Some of the asset restructuring considerations being explored are around general fund segregation, buying real estate directly or using property funds, and the use of managed accounts.

"Under current Ifrs 17, the requirement to measure insurance liabilities at the level of a group of contracts implies that the returns from investment assets may not be fully 'mutualized'," Menard at EY says. "In countries where assets are held in general funds, such as France, Luxembourg or Germany, the implications of Ifrs and local generally-agreed accounting principles (GAAP) are being evaluated, together with tax and operational and asset management implications."

SPPI test

Ifrs 9 defines 'solely payment of principle and interest' (SPPI) with the broad intention that there should be certainty around cashflows from investments – that is, that cashflows are representative of a basic lending arrangement.

Insurers need to think about how to change guidelines in their investment mandates to make sure the fixed income instruments in their portfolios are SPPI-eligible, if they want to account for their fixed income securities under fair value through OCI. Some insurers and managers have conducted this evaluation of SPPI eligibility themselves, others used third parties to help.

Although Ifrs 9 came into force this year, insurers have an option to defer implementation until 2021 when Ifrs 17 is expected to come in. However, insurance subsidiaries of banks and some bank-owned insurers have already implemented Ifrs 9.

Insurance Asset Risk understands that such is the case of Credit Agricole Assurance, La Banque Postal, HSBC, Lloyds, ING and ABN Amro.

Prashant Shama, head of international fixed income insurance at JP Morgan Asset Management says his firm has been helping some insurance clients to implement Ifrs 9, and that one of the main initial challenges for implementing it has been the SPPI test.

The basic 'problem', he says, is that if a fixed income investment fails the SPPI test, any changes in its market value will be accounted for in the insurer's P&L.

Insurers do not want any short-term market fluctuations in the value of their investments to be included in their P&L. They are long-term investors, they say. But the accounting standard implicitly questions this, and introduces a test to see if the asset they hold will bring them the income they expect, or if there is a risk of that income fluctuating, or not materialising at all.

"If the investment fails the SPPI test, this risk of uncertainty needs to be accounted for in the insurer's P&L, according to the accounting standard. This outcome threatens to impact the insurer's income in the P&L," Shama says.

There are question marks over whether many investment funds would get the desirable classification, and therefore would be included in an insurer's P&L not its balance sheet, he continues. "Insurers are examining segregated accounts, which would more readily win the desired classification and fall onto the balance sheet."

Hybrid securities and contingent convertible securities may not qualify if they face some trigger event that could stop payments on the security related to capital cushions.

Real estate & managed accounts

Under IAS 40, insurers' real estate investments are generally measured at amortised cost, considering the accounting treatment of insurance liabilities under Ifrs 17 and in particular if those are accounted for under the VFA approach, some insurers may consider repackaging these investments into real estate funds.

Under IAS 39 and most local generally accepted accounting principles (GAAPs), entities have control over the timing of realising gains and losses on investments they make in funds. Under Ifrs 9, the mandatory measurement-at-fair-value-through-P&L for investments via funds prevents such control over recognising of profits. Some insurers may prefer managed accounts, because the managed accounts allow accounting directly for the underlying holdings .

Access to the global market

The new standards are expected to make accounting for hedging activities easier, and so potentially will encourage such activity.

EY's Rebreanu explains that for insurance contracts that qualify for the VFA, Ifrs 17 introduces an accounting policy choice for hedges with derivatives, referred to as the "VFA risk mitigation" method.

"Similar to IAS 39 / Ifrs 9 fair-value hedges, this method allows recording in P&L the impact of changes in assumptions about financial risks on the entity's share of underlying items," she says.

To qualify for the VFA risk mitigation method, certain conditions should be met, such as documenting the risk management strategy and objective, and demonstrating the economic offset between hedged items and hedging derivatives.

"Ifrs 17's risk mitigation method will allow to mitigate accounting mismatches from hedging activities," Rebreany continues. "Although hedging financial risks remains an economic decision, [the risk-mitigation method] may encourage such activities."

The thought is shared by Gareth Haslip, global head of insurance strategy and analytics at JP Morgan Asset Management. He says that one result of making accounting for hedging easier is that it could be slightly easier for insurers to access foreign markets.

"If you are a UK or European insurer and you want to go into dollar credit, you might be put off by the complexity of getting hedge accounting treatment," he says. "But the ability to get the easier treatment of hedge accounting could make insurers more comfortable with making foreign fixed income investments."

Equities

One aspect of Ifrs 9 that insurers dislike is the accounting of equities. In Q1 2018, equities represented 13.5% of European insurers' portfolios, according to data published by the European Insurance and Occupational Pensions Authority (Eiopa).

Under IAS 38, insurers could account for this at fair value on their balance sheet, but at amortised cost on the income statement. "Essentially the only thing you would see on the income statement of an equity investment would be dividends, and if you sold the equity, the sale would show on the P&L," says Darrel Scott, a member of the International Accounting Standard Board (IASB) which sets the international standards. "The problem with that accounting is that it hides a lot of information – [and] the value of an equity goes up and down constantly."

Ifrs 9 now changes the accounting by requiring insurers to disclose movements in the value of equities that they hold in their income statements, resulting in fluctuations in the P&L.

Insurers say they are long-term investors, and even when it comes to equities, they tend to hold those for their cashflows rather than trading them.

But that is not entirely true, Scott argues. Even if an insurer holds an equity for 30 years, if it comes to the point where it needs a profit, it would sell that equity. "If I sell an equity today, I make a bit of profit in my income statement, but that is not this year's profit, it is actually the last 30 years' worth of profit, which I've just taken this year."

It is a question of performance, Scott argues. Under the old accounting system insurers would lose sight of the performance of the equity. "The P&L is about performance, and to simply make the decision to sell an old asset that's got a lot of value is not really performance," he continues. "The performance happened because of all the people who decided not to sell in the previous years."

But insurers have been vocal against accounting for equity under Ifrs 9. They argue that it is an obstacle to long-term investment. Some members of the standard-setting community sympathise with the arguments.

Patrick de Cambourg, president of the Autorité des normes comptables, the French standard setter, says: "It is not obvious that Ifrs 9 is not an obstacle to long-term investment."

The accounting for long-term investments under Ifrs 9 is a concern for insurance companies, he says. "It might hinder them from investing for the long term, which is a bad idea in general. Even if 'long term investment' appears to be not easy to define, it is a key economic goal for the European Union, as well as for other regions, and it is also a key factor in profitability for policyholders with a long-term view."

Nevertheless, Scott says the Iasb has no intention to amend the standard, even after Ifrs 17 comes into play. "We had a discussion 18 months ago. In the end we came to the conclusion that it is not appropriate [to make amendments] because Ifrs 9 does reflect the correct economics of your asset strategy, even if the insurers don't like it."

The European Financial Reporting Advisory Group (Efrag), the body advising the European Commission on adopting Ifrs, has a research project to look at whether insurers should be allowed to recognise gains or losses from the sale of equity investments in the P&L, after having recorded the fair value of those investments through the OCI – a mechanism referred to as 'recycling'.

Andrew Watchman, Efrag's chief executive, says this is a question the advisory body hopes to finalise before the end of this year. "The question is to look at whether there would be a need if recycling were reintroduced through impairment model and what that impairment model could look like."

More recently the European Commission has asked Efrag to look more broadly at possible alternative measurement bases for accounting alternatives to fair value, Watchman says. Both of the EC's requests are born of its efforts to encourage longer-term , sustainable investing.

Scott says for now the Iasb is following what Efrag is doing around those questions, but not acting independently yet.

This is the second of a three-part series on the new accounting standards. 
Part one is available here: Drivers of profitability - underwriting vs investments

Part three is available here: IFRS 17 & 9 series: a fork in the road

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