IFRS 17 – EU ignoring annual cohorts?
Potential inconsistency between group and local reporting for international insurers
IFRS 17 has been a long time in the making. One of its most controversial aspects discussed this year is the annual cohorts requirement. On the one hand, the IASB hopes to shed light onto possible onerous insurance contract generations. On the other hand, most of the insurance industry argues that the requirement is against the basic principle of sharing the risk among contracts and essentially their business model. Meanwhile, the European Financial Reporting Advisory Group (EFRAG) is divided in forming an opinion on this matter.
Additional information based on annual cohorts
In the financial industry, reporting is mostly conducted on an individual contract basis. For example, thinking about loan loss provisions, banks are asked to calculate a provision for each exposure and monitor each contract’s default risk. However, the business model of an insurance company revolves around the risk sharing and mutualization of contracts. Therefore, the IASB allows insurance companies to aggregate insurance contracts with similar properties under IFRS 17. This grouping may not contain contracts that originated more than one year apart. In an article written by Hans Hoogervorst (chair of the IASB), the annual cohorts are viewed as essential to ensure prudential accounting and prohibit early profit recognition and late loss realization. The annual grouping is regarded as sufficiently granular to ensure the risk mutualization principle and provide detailed information about profitability.
Concerns about the approach
Many voices from the insurance industry responded disappointedly to the IASB’s decision to keep the annual cohorts in the standard. Seven European insurance associations formulated a joint statement addressing their concerns. They claim that the intergenerational sharing of risk will not be adequately reflected under IFRS 17 with annual cohorts present. Additionally, they call upon the European Commission (EC) and member states to establish a solution. The EFRAG informed the EC about their opinion regarding the implementation of IFRS 17 in the EU. In a draft letter the EFRAG mentioned that almost half of the EFRAG board members believe that the information produced based on annual cohorts may not be relevant nor reliable. Additionally, the complexity and costs involved might not offset the added benefit of the additional information in the reports. Given these opinions expressed towards the EC, it is not unrealistic that we might see a different implementation of IFRS 17 in Europe.
EU’s own adoption of IFRS 17 without annual cohorts
A so-called ‘carve-out’ of the specific elements is permitted before the local implementation. What does it mean if the European legislators do not agree with the annual cohort requirement? It would create unpleasant complexities for European insurers that also operate outside of the European economic area. Likewise, international insurance companies with European subsidiaries could also be affected. It can be expected that international reports need to adhere to international requirements whereas the local reports can have less strict aggregation rules.
Therefore, these companies might need a two-fold implementation (EU and IASB conform). This will drive up the IT costs and potentially impact timelines. Furthermore, the actuarial computations must be performed twice. The local reporting, where the risk and returns are mutualized among similar contracts across generations, is the first run. The second calculation is expected to be performed to create consistency of the consolidated group figures. These take the annual cohorts into account.
Analysts expect that IFRS 17 will gradually change managers’ views on profitability. As a natural consequence, risk management needs to be redesigned to include valuation technologies. This also entails the development of new hedging strategies and potentially integrating everything into new systems. In general, business decisions and KPIs will be impacted, which influences the management’s performance results. Due to the potential of two different measurements of profit recognition, conflicts between national and group management are likely. Lastly, analysts and accountants have an additional challenge to reconcile and compare IFRS 17 results across an insurance group and international peers.
It remains to be seen how the standard will be adopted in Europe. Regardless of the decision by the legislators, the implementation is already a challenge and insurance companies might face an even bigger burden. As the profitability – also considering low interest rates – will be impacted, insurers must increase their focus on balance sheet management and pricing to reduce the stress on their balance sheets.
How can we help?
We have an elaborate track record at financial institutions regarding regulatory reporting and topics related to balance sheet management. Our support could include, amongst others:
- Performing an impact analysis based on IFRS 17 implementation approaches
- Setting up and validating implementation requirements for IFRS 17
- Streamlining processes between Risk and Finance for regulatory reporting
- Helping clients to perform market risk scenario calculations
- Building and validating valuation models for best estimate of liabilities (BEL)
- Asset-liability management (ALM), hedging strategies and pricing
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