The actuary and IFRS 17

The business of insurance is unique in that the primary cost of the product is unknown at the time of sale, and it may take many years before that cost is certain. In most businesses, accountants and business professionals can apply accounting rules to determine business results and compare to similar entities. In contrast, the insurance industry requires the application of actuarial science to determine results, and then to merge those results with accounting rules in order to produce a meaningful financial statement. Thus, the determination of financial results for any insurance business can be very complicated and contain additional uncertainty due to changing estimates of financial results, potential adjustments or policies written in the past. Past results can be uncertain whether the business is long duration, such as selling life insurance contracts that last for the policyholders’ lifetimes, or short duration with a long tail, such as selling workers compensation insurance to employers obligated to pay lifetime medical costs for employees suffering permanent injury. 

For a business as complex as insurance, accounting rules should never be expected to provide a perfect picture of results. This is not to say accounting rules do not allow users of financial statements to compare results of similar entities – they indeed do. However, with stagnant accounting rules, accountants and actuaries can become complacent and forget that the true picture of results is more complex than any set of rules could portray. 

One important consideration any potential change in insurance accounting standards is that there should be a general improvement of the actuarial soundness of the results. While this consideration is certainly subject to judgment and debate, the actuarial soundness discussion should be important to all actuarial practitioners as it is relevant even when the accounting standard in question is not directly applicable to their work. In the United States, the International Financial Reporting Standard (IFRS) is the third most important insurance accounting standard after Statutory Accounting (stat) and Generally Accepted Accounting Principles (GAAP). This article may be relevant to actuaries providing estimates under stat and GAAP due to the following: 

• The discussion on actuarial soundness may influence general actuarial practice.
• In any accounting standard, there is room for significant actuarial judgment in the reserve estimate. Therefore, it may be prudent for the actuary to consider in applying that judgment whether the results in another accounting standard may be materially different than IFRS results.
• Companies with international operations or considering mergers or acquisitions may need to reconcile their results with IFRS.
• If the actuary believes that reserves may be materially different in IFRS, that may present a risk that should be articulated in the actuarial opinion.

International Financial Reporting Standard (IFRS) 17

IFRS 17, which is now effective for reporting periods beginning on or after January 1, 2023, is the most important accounting change for the insurance industry in at least 20 years, and it has been over 10 years in the making. IFRS 17 represents an opportunity for collaboration between the actuarial and accounting professions, that happens only once or twice in a career, to create standards for the next generation. The current transformation of the insurance industry toward using increasingly complex models, analytics, IT resources and data sources increases the opportunity for companies to benefit from IFRS implementation. While the text of IFRS 17 is complete, there may be additional amendments and it will take some time for a clear set of acceptable judgments, practices and documentation to evolve.

At its core, IFRS 17 simply clarifies that contractual insurance liabilities are equal to a contractual service margin (CSM) that is amortized over the duration of the contract, plus the present value of the best estimate of future cash flows, adjusted for risk. The details are complicated by the immense variety of insurance contracts.

Below are eight areas, affecting both life and health (L&H) and property and casualty (P&C) insurers, that will require actuarial judgment and documentation for IFRS 17 compliance:

1. Risk adjustment methodology: Risk adjustment will be a key driver in determining insurance profit. IFRS 17 provides some guidance. There is significant flexibility in selecting policy, methodology and assumptions.
2. Discount rate: This rate can use a top-down (based on a referenced portfolio yield) or bottom-up approach (starting with a risk-free rate).
3. Ceded reinsurance liability: Outwards reinsurance must be estimated separately. Actuaries must analyze gross and ceded reserves separately, with net reserves being the difference between the two.
4. Reserving cohorts by inception date: Underlying contracts within each reserving cohort cannot contain contracts entered into more than a year apart. Therefore, it would seem that a policy year reserving approach is acceptable. Since the typical accident year includes contracts with inception dates up to two years apart, reserves determined based on an accident year approach alone may not be acceptable.
5. Combining contracts by counterparty: IFRS 17 requires combining contracts by counter party for reserving purposes. Therefore, a traditional line of business approach may not be acceptable for the business of counter parties that purchase insurance in multiple lines of business.
6. Onerous contracts: IFRS 17 requires contracts that are either expected to be, or have a remote possibility of becoming, unprofitable (categorized by IFRS 17 as “onerous”) to be removed from each reserving cohort and reserved separately. To do this, insurers must determine business segments that are onerous and segments with remote possibility to become onerous. Then, reserves should be determined separately for each segment.
7. Analyze building block approach versus Premium Allocation Approach (PAA): PAA is a simplification intended for short duration contracts. Insurers may use PAA if the result is not materially different for policies that may last longer than one year; such as a mortgage guarantee, warranty, surety or construction policies. Meeting this requirement likely means that actuaries will need to document calculations for both approaches.
8. Consideration of when the insurance obligation arises: The insurance obligation may begin before the insurance effective date. The use of intermediaries may require the insurer to separately consider the premium receivable under IFRS 9 from the insurance obligation. 

Due to the risk inherent in insurance, many actuarial models and analytics are used to make business decisions. These models are increasingly complex and do not necessarily comply with accounting requirements (e.g., management may want to model the impact of various discount rates or risk adjustments without regard to whether those assumptions meet accounting guidelines). Actuaries are already working with IT departments to create more complex models for analytics and other business purposes. IFRS 17 presents an opportunity to modernize financial accounting systems at the same time. Some of the benefits include team collaboration, business insight, financial transparency, regulatory compliance and a single source of financial and actuarial data. These benefits may help with adoption of predictive analytics, machine learning and robotic automation, as well as valuing mergers and acquisitions (M&A) and insurtech targets.