The New Math

Canadian insurers have already adopted International Financial Reporting Standards (IFRS) effective for 2011, but the initial adoption of IFRS has not changed most aspects of insurance accounting. A new global accounting regime for insurance contracts is in the works, and adapting to the next wave of changes will be a challenge for Canadian insurers.

The proposals to revise the accounting rules for insurance contracts under IFRS were released in draft form last year. A final version is expected before the end of 2011. When the proposals will take effect is still unknown, but they are expected to apply to fiscal periods starting as soon as 2015. Canadian insurers are planning for these changes by:

• examining the impact of the proposals on their financial results, particularly for long-term insurance products
• considering whether the expected increased volatility in financial results can be mitigated by creating new products and/or re-pricing existing ones
• enhancing communications with analysts, brokers, and investors to prepare them for changes in how reported results are presented
• re-engineering their processes and systems to capture any additional data or key metrics needed under the new standard.

Increased Volatility & Product Innovation

As a result of the proposed IFRS changes, net income is widely expected to become more volatile, especially for life insurers and others offering long-term insurance products, to such a degree that some life insurers may consider changing their product strategy and re-evaluating their product pricing.

The increased accounting volatility would arise since the proposed new standards force the de-coupling of the interest rate earned on the assets from the interest rates used to calculate the insurance obligations, even when these risks are mitigated by good asset-liability matching practices. This could lead to significant ups and downs in both income and capital, particularly for long-term life products, making them less attractive to insurers, and possibly less available and more expensive for policyholders.

Life insurers are particularly concerned by these changes, and may shift their offerings away from longer-term products with explicit or implicit investment return guarantees, toward products in which more of the investment risk is borne by the policyholder (e.g., unit-linked and other variable products). Products that lock in a guaranteed interest rate or investment return may become less available or for shorter terms, to reduce interest rate exposures.

For property and casualty insurers, with their shorter-term products, the problem of volatility is less pronounced, but still very real. Several P&C insurers have been frustrated by the “accounting volatility” from discounting of claims under existing accounting rules, something that will not be helped by the proposed new IFRS standards. However, the IFRS proposals seem unlikely to affect the design or pricing of P&C insurance products. 

Communication with Stakeholders

The IFRS proposals would change not only the way insurance contracts are measured, but also the traditional format of financial statements and add substantial additional information. Performance reporting will likely change in format, and some traditional performance metrics will be less familiar due to changes in definitions or measurement. Some insurers may make greater use of non-GAAP (generally accepted accounting principals) measures in their external reporting, to explain or isolate the expected increases in “accounting volatility.” Additionally, multi-line businesses will become more complex to explain.

To help their investors and analysts understand how and why the accounting and presentation changes will affect reported results, insurers will need to devote more effort and resources to stakeholder communications. Investors and analysts may need guidance on how to find the information they need to correctly interpret and compare the results with past performance and other industries. Brokers will need to understand these changes to be able to respond to customers who may have questions about the safety and security of their coverages with insurers.

Optimizing Systems & Processes

Measuring and communicating operational performance cuts across all parts of an organization. Converting to the new standard will affect insurers’ information technology systems and processes, including its actuarial modeling and valuation systems and financial reporting systems.

Depending on an insurer’s current accounting and internal reporting framework, the type and amount of data needed may differ significantly from current reporting under IFRS. Some insurers may face the need to support multiple reporting platforms for IFRS, US GAAP and internal reporting. Many are dependent on a web of legacy systems and have significant and extended close processes. Transition plans need to address the type of enterprise resource planning system, whether it has been kept current, the level of customization, and the use of outsourcing. Complying with these IT requirements will have hard deadlines, and will compete for the time, attention and resources needed for other technology priorities affecting customer service.

Developing a common understanding of the proposal’s impacts will involve many different functions within an insurer’s organization, including client-facing functions and processes, as well as the back office. Clear and open communication with IT will be vital. Making strategic and tactical decisions about the potential impact on information systems and business processes early in the transition project will help limit both costs and risks to insurers arising from duplication of effort of changes in approach at a later stage.

The systems changes could also be designed to capture new demographic and market data to help design new specialized products for niche markets.

Changing processes and procedures also means changing roles and developing new skills for an insurer’s people. The success or failure of the transition hinges on how effectively an insurer can inform, mobilize and educate them. For example:

• Finance teams may need to improve their understanding of actuarial concepts and accounting changes.
• Actuaries may need to improve their understanding of accounting issues and constraints.
• Senior management and investor relations team will need to understand how to explain the financial statements, especially the new presentation and the potential for increased volatility.

Planning for the transition is more than an accounting exercise. Insurers will need to take a company-wide approach that considers the needs and interconnections between accounting and reporting, systems and processes, people and the business. Insurers will also need to ensure their plan makes the most of opportunities to develop new products and new markets, eliminate duplication of effort in both internal and external reporting, and present a more integrated view of the business a whole. As mentioned above, brokers will need to understand some of the same issues to the extent they need to respond to questions and concerns of customers who may notice differences in what their insurers communicate to the public.

Transition from the Broker’s Viewpoint

As key intermediaries between policyholders and the insurers, brokers will need to understand the proposed IFRS changes too. As currently proposed, the new accounting will take some getting used to. There will be substantially more information available for brokers to sift through, and the headline statistics for profit and capital will be more “jumpy.” Accounting changes will affect the reporting of both operating results and capital, but not the economic reality of the business, and responsible insurers will seek to bridge that gap in explaining their results. Brokers will need to understand and critically evaluate the new financial reporting from insurers. Hopefully, the final version of the standards will not, as feared, lead to less choice and availability in the long-term products that Canadians have come to value and rely on.

Neil Parkinson is national insurance lead at KPMG. He can be reached at nparkinson@kpmg.ca. Kathy Cunningham is partner at KPMG. She can be reached at kacunningham@kpmg.ca.

This story was originally published by Canadian Insurance Top Broker.