IFRS 17 success: It’s all about the data

The following is an opinion article by Ambreesh Khanna, group vice president and general manager of Oracle Financial Services Analytical Applications. The views expressed within the article are not necessarily reflective of those of Insurance Business.

One year ago, the International Accounting Standards Board (IASB) unveiled the long-anticipated IFRS 17 standard. A year has passed with the blink of an eye, and today insurers and other affected financial firms are sizing up IFRS 17 and their obligations and options as the January 01, 2021, implementation date looms large on the horizon.

IFRS 17 ‒ coming after IFRS 9 (which focuses on financial instruments and the asset side of the balance sheet) ‒ looks to bring new levels of transparency to insurance contracts and investment contracts with discretionary participation features (which fall on the liability side of the balance sheet). The new standard is expected to fundamentally change the accounting process for all entities issuing insurance contracts. And, these organizations will need to adopt both IFRS 9 and 17 ‒ adding to the challenges ahead.

Many insurance products combine characteristics of both financial instruments and service contracts, and others generate cash flows that vary over a long period of time – creating a highly complex accounting paradigm. IFRS 17 seeks to bring new levels of transparency by requiring all companies that issue insurance contracts to account for them in a way that provides:

• “current estimates at each reporting date of the obligation created by the insurance contracts, reflecting up-to-date information about cash flows arising from insurance contracts, and the timing and risk associated with those cash flows.
• information about (i) the sources of profit or losses through underwriting activity and investing premiums from customers; and (ii) the extent and nature of risks arising from insurance contracts.”
   

As part of the quest for greater transparency, IFRS 17 also requires a company “to recognize profits as it delivers insurance services (rather than when it receives premiums) and to provide information about insurance contract profits the company expects to recognize in the future.” This information is intended to help investors and regulators assess the performance of entities and how this performance changes over time.

Challenges ahead
So, what does this mean for insurers and other financial institutions that need to adopt IFRS 17? Simply stated, it’s time to redouble efforts to focus on data – and its accuracy, aggregation, governance, transparency, and usability. Analytics and modeling are vital components in this endeavor.

Potential pain points for institutions moving to adopt IFRS 17 are plentiful and include:

• Identifying and managing insurance contract portfolios: IFRS 17 requires organizations to create portfolios of insurance contracts with similar risk profiles and manage them together. Institutions also must divide each portfolio into at least three different groupings:
  • Contracts that are onerous at initial recognition;
  • Contracts that, at initial recognition, have no significant possibility of becoming onerous; and
  • Any remaining contracts in the portfolio.

In addition to this stratification, an organization cannot include contracts issued more than one year apart in the same group.

To complete these requirements, institutions must be able to divide portfolios based on year of origination and then rapidly and effectively identify contracts that are profitable and not profitable. This task requires massive data aggregation and analytical capabilities. In addition to creating portfolios that simply meet IFRS 17 requirements, firms will want the ability to create portfolios that optimize business goals – creating further data and analytical requirements.

• Implementing a “current” measurement model. Under IFRS 17, organizations will have to re-measure contract value estimates during each reporting period based on three factors: “the building blocks of discounted, probability-weighted cash flows, a risk adjustment, and a contractual service margin (CSM) representing the unearned profit of the contract. A simplified premium allocation approach is permitted for the liability for the remaining coverage if it provides a measurement that is not materially different from the general model or if the coverage period is one year or less. However, claims incurred will need to be measured based on the building blocks of discounted, risk-adjusted, probability-weighted cash flows.”

To achieve these requirements and do so rapidly, firms must be able to calculate:

• • The sum of future cash flows that relate directly to the fulfillment of the contractual obligations;
  • The time value of the future cash flows;
  • Compensation that the insurer requires for bearing the uncertainty in the amount and timing of the cash flows (also known as risk adjustment); and
  • The amount available for overhead and profit on the insurance contract (otherwise known as CSM).
     

It is important to note that these calculations will differ from actuarial/pricing models and will need to be transparent and auditable. The impact of any changes in assumptions over time will need to be visible and reported separately.

• Disaggregating amounts recognized in the statement(s) of financial performance into an insurance service result. Under IFRS 17, firms must distinguish income and expenses from reinsurance contracts from the expenses and income from insurance contracts issued. And, they must be able to do this rapidly and accurately for each reporting period.
• Factoring and determining retrospective calculations. When transitioning to IFRS 17, an organization must apply the standard retrospectively to groups of insurance contracts, unless it is determined to be impracticable. In such cases, the institution can choose between a modified retrospective approach and a fair value approach. The approach used can have a significant impact on profit recognized in future periods. As such, organizations need the ability to accurately model outcomes to choose the optimal calculation approach for both the immediate and longer term. Most organizations would expect to adopt a full retrospective approach only for certain portfolios, where necessary data is available. However, multiple legacy systems and unreliable and insufficient data often make full retrospective adoption impracticable. Nevertheless, organizations that consider adopting the modified retrospective approach need to ensure they possess comprehensive data governance and a singular vision when transitioning to IFRS 17.
   

Preparing a strong foundation
As insurers and financial institutions develop plans to migrate to IFRS 17, it is important that they assess their data infrastructure as well as analytical, modeling, data governance, and reporting capabilities. Preparation is a rigorous process, requiring firms to adopt new models for determining contract value estimates, risk adjustment, CSM, portfolio optimization and more. They must also be prepared to provide greater documentation on their financial and risk models and how they’re applied.

What components should be included in an end-to-end solution designed to ensure IFRS 17 compliance?

Consider the following checklist:

• A unified data platform and repository for risk and finance data
• End-to-end management of complex computations and accounting, as well as financial and management reporting
• Transparent, rules driven identification of distinct investment and risk components, contract boundary, and the identification of directly attributable costs
• Pre-built business event rules and methodologies for calculations such as contract value estimates, service margins, risk adjustment, CSM, and more – at a policy level
• Analytical capabilities that enable portfolio optimization by factoring mortality, lapses, acquisitions, costs, future cash flows, credit risk, and more
• Native capability for modeling that can be a shared utility across risk and finance areas – which is particularly important as IFRS 17 does not provide full guidance on how risk margin, discounts, and adjustments should be calculated
• Predefined reporting templates
• Ability to support both IFRS 9 and 17, as all institutions must implement both

IFRS 17 will play an important role in driving greater alignment between risk and finance across insurers and other financial institutions. The standard, and the data infrastructure needed to support it, will position financial institutions to more actively and accurately incorporate risk into their decision making, and to deliver actionable business and profitability insights. In addition, it helps firms to cultivate a transparent risk management culture, as well as promote pervasive intelligence across departments. Combined, these capabilities present a solid foundation for improved performance.

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Picking apart the challenges of IFRS 17
How might IFRS 17 affect insurance ratings?