May 17 2017
The International Accounting Standards Board has issued its long-awaited standard for insurance contracts after more than a dozen years, requiring a consistent treatment for all types of insurance contracts, with insurance obligations now being accounted for using current values, instead of historical cost.
The insurance standard, known as IFRS 17, was years in the making, and replaces an interim standard dating back to 2004 known as IFRS 4.
“IFRS 4 was not really a comprehensive international standard,” IASB Chairman Hans Hoogervorst told Accounting Today. “It was basically a standard grandfathering the use of national standards. If you look around the world, we see the use of myriad national standards, which are highly divergent and often a bit antiquated, so the quality of the information is often substandard and certainly not comparable. That’s the reason why many insurers also provide non-GAAP measures, especially if they use historical cost. They often produce the measurements based on current valuation. But the current practice is highly divergent and not of sufficient quality, so it was high time that we produced this standard.”
The IASB had been working with the Financial Accounting Standards Board in the U.S. for several years on improving its insurance accounting standard as one of their major convergence projects for harmonizing International Financial Reporting Standards with U.S. GAAP. The accounting standards for insurance under IFRS are not considered to be as rigorous as they are under U.S. GAAP, leading to a number of different approaches in different countries for various types of insurance. Due to the range of accounting methods in use today, the IASB warned that some countries will experience more significant changes than others with the introduction of the new standard.
However, as with the lease accounting and financial instruments convergence projects, the two boards eventually decided to go separate ways. FASB plans to finalize an accounting standard for long-duration insurance contracts, such as life insurance, later this year (see FASB proposes changing standards for insurance contracts). The IFRS standard applies to both long-term and short-term insurance contracts of various kinds, including life insurance, health insurance and car insurance.
“I think it’s fair to say that the biggest change will be for life insurance,” said Hoogervorst. “Short-term insurance is less affected by the new standard because that’s fairly straightforward. But obviously the measurement of the life insurance liability is much more complicated. The time value of money is very important. That’s where the biggest divergences are the case. Also, not just in terms of the measurement of the liability, but also in terms of revenue recognition in certain parts of the world, even deposits are counted toward revenue. Deposits for investment schemes will be added to revenue. Profit recognition is highly divergent. In some areas of the world, it is upfront profit recognition, and in others over time the new standard will give them homogeneous rules for both revenue recognition and profit recognition.”
Hoogervorst sees some important differences from the FASB standards. “They have three different standards covering insurance activities,” he said. “We have one standard, but with different submodels. But philosophically it all goes in the same direction. The major change in U.S. GAAP will be that time value of money will be much more important than is currently the case, although for short-term contracts the FASB has decided not to require discounting. The present valuing of the liability we have introduced even for P&C [property and casualty] business, for example. That is one big difference.”
IFRS 17 will require insurers to provide a balance sheet valuation of their insurance liabilities combining a measurement of the expected probability-weighted future cash flows based on updated assumptions, with the recognition of profit over the period that services are provided under the contract.
“This standard represents the most significant change to insurance accounting requirements in 20 years,” said Martin Bradley, Ernst & Young’s global insurance finance, risk and actuarial leader, in a statement. “In line with the IASB’s stated intention to provide greater consistency in financial reporting, the insurance industry will now have to change the way in which insurance liabilities are measured, while also providing far higher levels of disclosure compared to existing financial reporting processes. These changes will coincide with other changes to the reporting for financial assets under IFRS 9 Financial Instruments, and will potentially bring more volatility in reported profit.”
The effective date for applying the new standard will be Jan. 1, 2021. “That’s more than three and half years from now, which we think is a sufficient time to prepare,” said Hoogervorst. “But obviously they will have to start working on it as soon as possible, and actually we know of many insurance companies who have already started work on implementing the new standard because obviously it was not created out of thin air, and many of the decisions have been taken in the past.”
Despite the long lead time, Ernst & Young is warning insurance companies to start preparing for the new standard, as insurers will be required to estimate historical amounts when transitioning to the new standard. “The new requirements will make the understanding of reported profit and how it has moved between reporting periods more challenging,” said EY global IFRS 17 accounting change lead Kevin Griffith in a statement. “While the standard will not become effective for a few years, the impact is likely to be felt much sooner by insurers. Investors are likely to ask for expected impacts ahead of the implementation date, and the decisions made by insurers at the date of transition to the new standard will have a significant impact on future profitability. Understanding the commercial impact of IFRS 17, and reconciling reported results and equity with the equivalent numbers computed under regulatory and other reporting frameworks (like Solvency II and Embedded Value) will be important. New systems and processes will have to be built to produce and report the numbers, and metrics for steering the business will change. Ultimately, the implications of IFRS 17 will go well beyond the reporting function and affect many parts of the organization.”
IFRS 17 requires a company that issues insurance contracts to report them on the balance sheet as the total of both the fulfillment cash flows (the current estimates of amounts the company expects to collect from insurance premiums and payout for claims, benefits and expenses, including an adjustment for the timing and risk of those amounts) along with the contractual service margin—that is, the expected profit for providing insurance coverage. The expected profit for providing insurance coverage will be recognized as a profit or loss over time as the insurance coverage is provided.
Companies will be required under the new standard to distinguish between the groups of contracts that they expect to make a profit from and the groups of contracts that are expected to produce losses. Any expected losses arising from loss-making, or onerous, contracts are accounted for in profit or loss as soon as the company determines that losses are expected. IFRS 17 also requires companies to update the fulfillment cash flows at each reporting date, using their current estimates of the amount, timing and uncertainty of cash flows and of discount rates.
“It’s going to require regular updating of measurement of the liability, including losses,” said Hoogervorst. “It will also be less easy to compensate loss-giving onerous contracts with profitable, newer contracts. Especially onerous contracts will become visible much earlier than is currently the case.”
A company accounts for changes to estimates of future cash flows from one reporting date to another either as an amount in profit or loss or as an adjustment to the expected profit for providing insurance coverage, depending on the type of change and the reason for it; and chooses where to present the effects of some changes in discount rates—either in profit or loss or in other comprehensive income. IFRS 17 also requires disclosures to enable users of financial statements to understand the amounts recognized in the company’s balance sheet and statement of comprehensive income, and to assess the risks the company faces from issuing insurance contracts.
Transition Resource Group
The IASB intends to set up a Transition Resource Group, as it did with FASB when the two boards rolled out the revenue recognition standard in 2014, to help companies adjust to the new standard. “We will tomorrow announce our plan to do so and ask candidates to come forward,” Hoogervorst said Wednesday. “We will probably install the Transition Resource Group in the fall of this year, and we believe that is a very important instrument to help preparers with the new standard.” The IASB has issued a call for nominations here.
With the revenue recognition, leasing and financial instruments standards already set to take effect over the next few years, the insurance contracts standard will give companies more rules to digest. But Hoogervorst pointed out it won’t have as far-reaching an impact.
“This is the last of the four big standards that affect companies,” he said. “Obviously this standard will mainly affect the insurance industry and not so much other parts of the economy. Regular companies will not be affected by this. Leases will affect almost everybody, but insurance mainly the insurance industry.”
On its IFRS.org website, the IASB is providing the complete IFRS 17 standard, along with illustrative examples and an explanation of the board’s basis for its conclusions. Also accompanying the standard are a number of other documents, including an Effects Analysis that outlines in detail the expected costs and benefits of the new standard, a Project Summary that offers an overview of the project for develop the new standard, and a Feedback Statement summarizing the feedback received by the IASB during the various consultations it undertook over the course of the project.