IBOR Reform impact on IFRS 17
As a new accounting standard for insurance contracts, IFRS 17 is seen as one of the big regulatory disruptions for insurance companies in the coming decade. The determination of discount curves is crucial for the implementation of the standard. Underlying complexity will be further increased by a second disruptive change in financial markets: the IBOR reform.
Discount rates for IFRS 17
With the effective implementation date of January 1, 2021 (and a proposed deferral of one year to January 2022), there is little time left to adopt organizational processes to the new IFRS 17 standard. Before we analyze the impact of the IBOR transition, let us briefly touch upon the discount rates themselves.
The derivation of a discount curve under IFRS 17 is not a straightforward task to begin with. In contrast to Solvency II, the International Accounting Standard Board (IASB) does not exactly prescribe how to derive an appropriate curve. However, according to its new standard, the discount factors must:
- Reflect the time value of money
- Be consistent with observable market prices (market-consistent)
- Exclude any effects included in the market prices but which do not impact the cash flows of the underlying insurance contracts.
Bearing in mind these requirements, two high level methods are introduced. The ‘top-down’ approach starts with a reference portfolio for the assets. Then, the portfolio’s yield curve needs to be adjusted for factors not applicable to the insurance contract. These include credit risk and term duration spreads, but nonetheless liquidity differences can be neglected.
The other method, referred to as ‘bottom-up’, requires a ‘risk-free’ rate as a basis. Factors including timing differences, currency and liquidity are added on top to arrive at the final curve for discounting. Unfortunately, the principle-based standard does not reveal any examples of a risk-free rate. An exposure draft by the International Actuarial Association identifies three possible sources for construction – government bond rates, swap curves or corporate bond rates. For Solvency II, the term structure is derived by using overnight indexed swap data and applying a credit rate adjustment. However, for IFRS 17, it is ultimately up to the insurer which financial products are taken into consideration. This hampers the increase of comparability for the results of different insurance companies.
Due to concerns about the reliability and robustness of the inter-bank offer rates (IBORs), the Financial Stability Board (FSB) recommended to develop an alternative risk-free reference rate. The considerations of the new Euro short term rate (€STR) were outlined by Zanders at the beginning of last year (read more
). Since October 2019, the new €STR is published marking a transition phase which ends in December 2021. From 2022 onwards, the €STR will have replaced the EONIA as an overnight rate. However, the method to determine a term structure is still indefinite.
What does the IBOR reform imply for IFRS 17 discount rates?
The values of bonds and swaps are determined based on their discounted (expected) future cash flows. In the Euro area, the EONIA and EURIBOR are typically employed for this purpose. Starting in January 2020, EONIA is determined by the new short-term funding rate, €STR, plus 8.5 basis points. Although it is still not clear whether and how a term structure will be derived from the €STR, a phase out of the EURIBOR will almost certainly lead to a price impact of bonds and swaps. Nevertheless, an €STR swap curve is expected to become the new risk-free Euro interest rate curve.
As bonds and swaps can form the basis of the ‘bottom-up’ approach, a switch from one reference rate to another will imply a change in the resulting discount curve. Moreover, these financial products can also be used to construct a reference portfolio for the ‘top-down’ method. Hence, the IBOR reform affects both yield curve determination methods.
Additionally, IFRS 17 requires the risk-free rate to be based on liquid market data. Currently, market participants are wondering about the implications if the new rates’ volumes are not building up to their expectations. In that case, the liquidity requirement in the standard can be questioned and further adjustments might become necessary. Determining an illiquidity spread is not a trivial matter and could lead to more misalignment within the insurance industry.
Potential effects for insurance companies
Under the new reporting standard, insurance companies are given two options to report changes in the discount curves since the contracts’ inception. Either the difference flows through the profit and loss (P&L) statement or gets listed as a separate item in other comprehensive income (OCI). The decision should be motivated by the goal to reduce accounting mismatches and results’ volatility. However, if the discounting curve at the contracts’ origination was calculated using the pre-reform EONIA/EURIBOR, a sudden large change in the balance sheet item’s value will be observed. We will now attempt to provide a high-level assessment of the impact.
Figure 1 depicts the zero rates based on a 50-year swap curve with monthly payments. Missing data points have been determined by interpolation. Comparing the curves for the €STR and the 3-month EURIBOR, the differences vary between 14 and 19 basis points. To put these differences into perspective, we assume that an insurer’s typical defined benefit (DB) pension portfolio has a duration of 20 years. While ignoring other effects, such as convexity, a discount curve shift would lead to a portfolio’s valuation impact of about 3.6 percent.
Figure 1 – Zero rates based on interest rate swaps
While it is not yet clear whether the EURIBOR will ultimately vanish, it is already certain that the US Dollar LIBOR is going to be discontinued. After examining the respective curves, being the Secured Overnight Financing Rate (SOFR) and the 3-month USD LIBOR, an even larger spread compared to the Euro case becomes noticeable. It varies between 21 and 34 basis points over the entire curve and would affect our hypothetical portfolio’s valuation by approximately 5.2 percent.
Even though these figures represent only rough estimates, it is certain that the impact will have a significant leverage effect on the available capital. Potential damping effects on the asset side can still be investigated.
The technical implementation of IFRS 17 is one of the major challenges for an insurer in the coming years. The IBOR reform could increase the difficulty if money market turbulences occur and the reporting framework is not flexible for alterations. Assuming that the implementation date of the standard gets deferred to January 2022, it will align with the end of the transition phase of the benchmark rate reform. If EURIBOR continues to exist, it can be utilized as a fallback rate, however, questions regarding good market practice will arise. Companies that keep postponing trial runs of the new reporting standard will encounter difficulties in reconciling and verifying results after the go-live date. The uncertainty resulting from a change of the benchmark rate must be considered in the roadmap of IFRS 17.
How can we help you?
- By comparing and advising on the choice between ‘bottom-up’ and ‘top-down’ approach to calculate a discount curve
- By assisting in identifying the impacts of IBOR reform on your portfolio and support in the transition
- By providing support in making results comparable after the benchmark reform
- By assessing the accounting implications of reporting changes in the discount curve, either through the P&L or through OCI.