Pain and Gain

On January 1, 2021, Canadian insurers will be subject to a new International Financial Reporting Standard (IFRS) designed to enforce a fundamental overhaul of insurance accounting.

Announced in May 2017 by the International Accounting Standards Board (IASB), IFRS 17 will replace IFRS 4 Insurance Contracts with new guidelines governing the recognition and measurement of insurance contracts, as well as presentation of operating results.

Its intent is to give investors and other stakeholders a better understanding of an insurer’s risk exposure, drivers of profitability and financial position by bringing greater clarity and transparency to the financial reporting processes.

“The insurance industry plays a vital role in the global economy; high-quality information to market participants on how insurers perform

financially is, therefore, extremely important,” board  chairman Hans Hoogervorst said in a recent IASB press release. “IFRS 17 replaces the current myriad of accounting approaches with a single approach that will provide investors and others with comparable and updated information.”

In broad strokes, the new standard will require companies to do the following:

• report insurance contracts on the balance sheet as the sum of the fulfillment cash flows and the contractual service margin;
• update the fulfillment cash flows at each reporting date, using current estimates of the amount, timing and uncertainty of cash flows and of discount rates; and
• provide greater clarity and information about profitability on financial statements.

IMPACT ON P&C INSURERS

Property and casualty insurers will naturally be among those bound by IASB’s new standard. Fortunately, most will also qualify for a simplified measurement model — the premium allocation approach — which deviates somewhat from how insurers currently value their insurance liabilities.

Still, IFRS 17 will require p&c insurers to be more granular in their note disclosures than they have been in the past. They will also have less leeway to perform their accounting processes at the high level of aggregation than they may be used to.

Also worth highlighting are several IFRS 17 changes that may not be as well-known, but are significant, nonetheless. Today, where Canadian insurance companies discount their liabilities, they typically use an asset-based rate or the yield earned on the assets backing their liabilities. By 2021, this will no longer be allowed.

Instead, insurers will need to use a discount rate that reflects the timing, duration and currency of their liability cash flows, thereby requiring them to track and manage potentially a large volume of discount rates on an ongoing basis.

As well, there are insurers who offer multiple lines of business and different products. Where these risks offset one another, insurers now get to take that diversification benefit into account when determining their risk margins. This is a more holistic alternative to current margins for adverse deviation.

By and large, the biggest differences between today’s standards and IFRS 17 are the granularity of information that insurers will be required to manage and present. This will, no doubt, make processes like period-end closes more onerous — especially for insurers offering more specialized products with longer-term timelines (for example, mortgage insurances, title, surety and warranty business) who will see significant changes in the actual numbers that end up not only in their financial statements, but also their profit emergence patterns.

For insurers who rely on earnings before interest and taxes and depreciation and amortization (EBITDA) as a key performance metric, they will need to pay particular attention to these changes as it may alter the way their profits emerge over time.

GLOBAL COMPARISONS

One of the most common concerns related to IFRS 17 is that it will move Canada’s accounting practices further away from its neighbour to the south. While many p&c companies have the option of using a premium allocation approach that retains existing similarities to the Generally Accepted Accounting Principles (GAAP) in the United States, there are some who will see greater disparities.

Particularly, that includes insurers with longer duration contracts, who will fall under the general measurement model, and those who report to a U.S. parent (or vice versa). For them, IFRS 17 will require more adjustments; meaning more work, more energy and a wider margin of error. And on the investor side, IFRS 17 will make it more difficult for some to compare their financial statements to their U.S. GAAP peers.

Comparisons across the pond are also worth exploring. Once issued by the IASB, IFRS is required in Canada. However, in some jurisdictions, a new IFRS is only required once endorsed and subjected to a cost-benefit analysis.

For example, IFRS 17 is not required for European insurers until the European Financial Reporting Advisory Group (EFRAG) has endorsed it to the European Union (EU). Then, and only then, will European insurers be required to comply with IFRS 17.

Depending on how long this process takes, the EU could adopt IFRS 17 well after Canada’s January 2021 deadline, and that time gap will likely cause comparability issues. The good news is that it is not a matter of if the EU will adopt IFRS 17, but when.

UPSIDES TO IFRS 17

It is true that IFRS 17 will require more time, investments and manpower from insurers. If done correctly, however, the IASB contends that the advantages will outweigh these expenses. Canada will become more comparable to global jurisdictions; financial forecasts will be more accurate; and enhanced reporting standards will paint a clearer picture for all stakeholders in regards to how money is being earned, what is working well and how they compare to their peers.

Lastly, any major transformation presents an opportunity to “clean house.” Many insurers are taking this opportunity to update business practices, properly implement legacy books or correct Band-Aid solutions from their past. Since the road to IFRS 17 requires a review of everything from the initial recognition through to financial reporting, now is the time to identity where improvements can be made.

PREPARING FOR IFRS

IFRS 17 has been in development for nearly 20 years, so its arrival is far from a surprise. Nevertheless, it will require large-scale company changes that will, no doubt, be subject to hiccups, delays and human error.

For that reason, it is best to prepare for these changes early. Begin with a high-level impact assessment to determine what changes need to be made and then draft a project plan outlining how they will be made, who will make them and the key milestones along the way.

Given the granular focus of IFRS 17, that plan should include stronger collaboration among all insurer departments. It will also need to identify systems that will require upgrades or replacements and keep IT professionals in the loop.

After all, whether a p&c or life insurer, there are going to be changes to the general ledger and journal postings that will require greater automation. That means making sure that IT has enough time and money to bring the company up to speed.

Ultimately, IFRS 17 will mean more work and investments for Canadian insurers. Done right, however, the benefits of stronger financial accounting standards will more than make up for these growing pains. And with companies expected to begin testing IFRS 17 as of January 1, 2020, the time is now to ensure a solid plan, the right people and access to the best resources to help get the company where it needs to be, when it needs to be there, are in place.

Dana Chaput, Insurance Accounting Change Lead, KPMG in Canada