IFRS 17 & 9 series: Drivers of profitability - underwriting vs investments

In the first of a three-part series on the international financial reporting standards (Ifrs) impacting insurers’ financial reporting, Vincent Huck explores how the new accounting standards Ifrs 17 and 9 bind both sides of the balance sheet together. 

Now that European insurers have factored in and successfully implemented the changes brought about by Solvency II, they are about to get hit by the most significant accounting overhaul for the sector in the last 20 years - one that might affect the way they look at their asset allocation.

These changes come in the form of two new international financial reporting standards (Ifrs). While Ifrs 9, which addresses accounting for financial instruments, has been adopted and came into force at the start of this year, insurers had the option to defer implementation until 2021 when Ifrs 17 comes into force. Ifrs 17 addresses accounting for insurance contracts.

Like most compliance rules of the last 10 years, Ifrs 17 and Ifrs 9 are inheritances of the financial crisis. The first replaces Ifrs 4, the second replaces IAS 39.

Ifrs 9 background

During the 2008 financial crisis, the view emerged that IAS 39 had become too rules-bound at a time where financial institutions were undergoing a dramatic change in strategies and in the types of financial instruments that they were holding.

“IAS 39 tied you in to what you'd previously said was your strategy,” says Darrel Scott, a member of the International Accounting Standard Board (IASB), a body which sets the international standards. “Ifrs 9 was intended to allow to better reflect the underlying business strategy and accept that this strategy might change from time to time.”

This is really important for insurers, he says. “They will have mixed strategies as far as assets are concerned: some assets are held for quick turnaround, some are held purely for liquidity, and some are held long term, sometimes for the longest term possible.”

The second impetus behind Ifrs 9 was a strong feeling that banks in particular had been aware of the looming bad-debt crisis before it happened, but that they felt constrained by the accounting about doing something. IAS 39 was a ‘look-backwards’ model, whereas its replacement Ifrs 9 is a ‘look-forward’ model asking the financial institutions that adhere to it to estimate what they think is going to happen.

Ifrs 17 background

The old method for accounting for liabilities wasn't particularly definitive, and allowed for a lot of divergent practices. This made it impossible to compare accounts from one insurer to the next, and between countries.

“It wasn’t an acceptable situation, as one of the core benefits of an international accounting standard is comparability,” Scott says.

Ifrs 17 aims at ensuring that comparability, as well as at strengthening the quality of the reports. Insurers used historic accounting before, where they would make assumptions on the day of the transaction about future cashflows, future interest rates, but then never updated the assumptions. Ifrs 17 requires insurers to reflect any such changes [in assumptions], introducing volatility onto the liability side of their balance sheets.

Scott explains: “Ifrs 17 says, if the interest rates change, the liability must change. If future cash flow changes, the liability must change. So you’ll see a moving liability on a fairly constant basis. This is why it is important that insurers see Ifrs 9 at the same time as Ifrs 17. Because Ifrs 9 will now allow them to treat their assets in the same way as they treat their liabilities.”

Drivers of profits: underwriting vs investments

Another aspect of Ifrs 17 that will have an impact on the relationship between the liability- and asset sides of the balance sheet is that it will clarify what the drivers of an insurer’s profits truly are.

Traditionally, the primary drivers of an insurer’s profitability are underwriting risk and investments made using the money generated out of the polices it has underwritten.

“Insurers have often muddled those two things up and it is hard to tell whether it is an investment strategy that means they are profitable, or whether it is good underwriting that makes them profitable,” Scott says.

Under Ifrs 17, in the income statement, insurers will have to split between what was the outcome of their risk activities, and the income made from their assets under Ifrs 9, set off against the rolling cost of their liabilities.

“If today I promise to pay you $1m in 10 years’ time, I'm not going to record $1m in my liability but I’m going to record $800,000,” Scott explains. “And each year I’m going to step up with the interest effect of that $800,000 until I get to $1m.”

That step up goes into the income statement as the financial expense on the liability, he continues. “So my balance sheet now shows the income I earn from my assets, less the financial expense of my liabilities. Comparing the two, you can see if I’m making good money on what I’m holding for my own bucks.”

As a result, an insurer like Berkshire Hathaway, which also invests separately to its underwriting activities would show a big profit on its overall investments, and its insurance activities may show an underwriting loss, whereas an insurer with a more conservative investment strategy would show a flat return on its investment.

Ifrs 17 and 9 will introduce more volatility on both the asset and liability sides of the balance sheet. It will also give valuable information to investors about whether the assets and liabilities move in time with each other or not, Scott adds.

Going back to the $1m over 10 years liability example, he says: “If I've been smart and bought an asset that matures in 10 years’ time, my asset is going to move by exactly the same amount [of volatility], because I’m measuring the liability in the same way I’ m measuring the asset - so the two move together.”

If, on the other hand, an insurer decided to be clever and buy a short-term asset, either the asset value is going to change by more than the liability value changed, or by less.

“In either circumstance there will be a mismatch, and you’ll be able to see that this insurer is running a risk between its assets and its liabilities.”

Impact on capital

Ifrs 17 will also have an impact on capital, which could then snowball into the investment strategy of the insurer.

Returning to the example above of the conservative and aggressive companies, Scott says: “The conservative company built up huge reserves over time that are not capital from an accounting perspective, because they treat those reserves as a liability which means the company has got relatively little capital for the size of its liability, as it has not released those reserves to profit.”

The aggressive company, on the other hand, has released everything to profit, Scott continues. As it applies Ifrs 17, the company’s capital is going to go down.

“Our argument is now [with the new accounting standards] we have put both of those companies on the same basis, their capital now means the same thing and we think that is important,” Scott says. “Ifrs 17 should not affect what companies are allowed to do, but it may affect what they want to do.”

Companies with a low equity base are bound to get a bit nervous, he adds. Already some South Korean insurers have raised capital in anticipation of Ifrs 17, he says.

This is the first of a three-part series on the new accounting standards.
Part two is available here: IFRS 17 & 9 series: Asset allocation considerations
Part three is available here: IFRS 17 & 9 series: a fork in the road

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