TAA n° 91 - First analysis of the adoption of IFRS 17 by Belgian insurance undertakings

Introduction

Insurers are required to apply ‘IFRS 17 Insurance Contracts’ for annual reporting periods beginning on or after 1 January 2023. Many insurance companies have decided to adopt ‘IFRS 9 Financial Instruments’ simultaneously with IFRS 17 to avoid accounting mismatches on their balance sheet. In our previous article (TAA nr 77) we had analysed the expected interaction between IFRS 17 and 9 to understand the reasons as to why this simultaneous adoption was preferred. In the earlier article we described how various combinations of measurements (amortized cost 1 , FVOCI 2 or FVPL 3 ) would lead to different ways in which volatility may be incurred in the Profit and Loss (P&L) or Other Comprehensive Income (OCI).

As a reminder, one major development under IFRS 17 is the shift towards a current value measurement (instead of acquisition value) of the insurance liabilities. Insurers then have the choice to attribute the effect (on the insurance liabilities) of changes in the discount rates to either the P&L or the OCI. Therefore we now observe the effect of using the OCI or P&L option for the insurance liabilities, in combination with different classifications and measurements for the assets (i.e. amortized cost, FVOCI or FVPL).

We will analyse the different accounting approaches that have been considered to manage volatility.

The hypothesis tested in this article assumes that volatility in P&L and OCI will be limited in case one of the following approaches is being applied:

1. The combination of an IFRS 9 business model that measures financial instruments on a FVOCI basis and the application of IFRS 17 GMM 4 liabilities with the OCI option enabled; and
2. The combination of an IFRS 9 business model that measures financial instruments on a FVPL basis and no application of the OCI option on the GMM liabilities.

In this article, our analysis is based on the year-end 2023 consolidated IFRS financial statements of our chosen population of relevant insurance groups to observe a matching OCI position between IFRS 17 and IFRS 9. Our chosen population consists of Belgian insurance companies that prepare IFRS consolidated financial statements in Belgium or are part of foreign group consolidated financial statements

As a starting point please find below the accounting approach relevant for this analysis as it has been observed on the Belgian market:

It is generally known that investors evaluate variability in results as negative for insurance companies. Variability in results has a unique significance when it comes to insurance companies because of the nature of their business, which inherently involves managing risk and uncertainty. We can evaluate this variability in different ways: (i) OCI,  (ii) P&L and (iii) Contractual Service Margin (CSM). These concepts are further explained in the sections below.

Below we will be investigating these different impacts.

1. Analysis of the impact of IFRS 17 and IFRS 9 on the OCI positions

In order to assess the matching in OCI, we calculate a ratio which expresses the relationship between the impact on OCI of IFRS 17 and IFRS 9, taking into account the volume, the latter by reference to shareholders’ equity.

Test hypothesis: We observe that there is a significant volatility in the OCI balances between periods. The volatility in this ratio is observed for most insurance groups in our population. In FY 2022, we saw mostly decreases in OCI, whereas OCI has picked up again during FY 2023. We have observed that movements in the OCI originate from financial effects (i.e. discounting) impacting the (re)insurance liabilities. We note that these financial effects in FY 2022 are driven by the rising interest rates. In FY 2023, the impact is much more limited resulting in a more stable ratio.

Achieving a transparent view of OCI under IFRS 17 and IFRS 9 is a challenging endeavour due to the inherent complexities and variabilities in accounting methodologies, as well as the presentation practices.  We observe the following main differences in methodologies applied between insurance groups making the comparison at the level of OCI difficult:

●   Valuation Methodologies: The Variable Fee Approach (VFA) and General Measurement Model (GMM) differ significantly in how OCI is treated. VFA, typically used for participating contracts, aligns changes in financial assumptions with the policyholders' share, often leading to smoother OCI. In contrast, GMM, used for non-participating contracts, can result in more volatile OCI due to direct recognition of changes in financial assumptions. This distinction is crucial in the Belgian market, where mainly insurers reporting to an international group entity predominantly use VFA for their participating contracts, resulting in relatively stable OCI figures compared to those using GMM which is mostly being used at Belgian level.

●   Transition Methodologies Applied: Transitioning to IFRS 17 involves retrospective application, modified retrospective, or fair value approaches. Each method impacts OCI differently, with retrospective application providing the most comparable historical data but also the most complexity. The fair value approach is particularly challenging due to the lack of observable information and limited market transaction data. Belgian insurers have shown a preference for the modified retrospective approach, balancing the need for comparability with practical implementation challenges. Within the accounting policy choices to be made at the moment of transition, the retrospective calculation of OCI was one of the decisions to be made. Some entities have calculated OCI retrospectively for a limited number of years, which will have an impact on the net OCI position also prospectively (i.e. results for KBC in FY 2022 are not in line with other insurance companies in our population). In this article, we will not analyse the transition methodology applied in the opening balance sheet instead we will focus on the impact on subsequent years.

●   IFIE 6 Approach: The diversity in accounting policy permitted by IFRS 17 of insurance finance income and expenses (IFIE), adds another layer of complexity. Entities must carefully consider these choices and their impact on OCI, as different policies can lead to significant variations in reported figures. For example, Athora has opted to recognize all insurance finance income and expenses in P&L, while others split these amounts between P&L and OCI, leading to different OCI outcomes. The Insurance Financial Income and Expense (IFIE) approach assesses the financial impact of IFRS 17 on insurers. This approach highlights the challenges in achieving transparency in OCI due to varying interpretations and implementations across entities. In Belgium, the IFIE approach has revealed significant differences in how insurers interpret the standard, leading to diverse OCI outcomes.

●   Risk Adjustment (RA): The risk adjustment refers to the compensation an insurer requires for bearing the uncertainty about the amount and timing of cash flows arising from non-financial risks. It reflects the level of risk the insurer is exposed to and their confidence in meeting future obligations. Different risk adjustment methodologies lead to varying degrees of OCI volatility. Disaggregating financial risk for the risk adjustment can significantly impact OCI by isolating market-driven changes, such as interest rate fluctuations, from operational performance. Disaggregating financial risk for the risk adjustment helps to isolate the impact of financial market movements, such as changes in discount rates, from the core insurance operations. Consequently, this disaggregation can lead to more volatile OCI figures, reflecting the sensitivity of the financial risk component to market conditions, while the non-financial risk component impacts the P&L through the Risk adjustment release. This method provides a clearer view of the underlying performance of the insurance contracts by distinguishing between financial market effects and operational results.

●   Discount Rates: Changes in discount rates directly impact the measurement of insurance liabilities and, consequently, OCI. Entities may use different discount rate methodologies, leading to significant differences in OCI volatility. In Belgium, insurers have adopted a range of discount rate approaches, from market-consistent rates to more stable, internally derived rates, further complicating OCI comparability.

Besides the methodological differences, also the presentation of the financial information shows important differences:

●   Disclosure: The presentation of OCI under IFRS 17 and IFRS 9 does not necessarily make a transparent disclosure of the above methodological choices, impeding comparison.

●   Granularity: Beyond the minimal required presentation, we observe that some groups are providing detailed breakdowns of the OCI components as immediate clarifications to the changes in the comprehensive income statement, where others leave it to the reader to distil such information from the disclosure tables. 

●   Groups: Group entities often do not report country-specific details, further complicating the transparency of OCI positions. For example, while Allianz SE provides a consolidated view of its OCI, it does not break down the figures by country, making it difficult to assess the impact of local market conditions on OCI. Similarly, AXA SA's financial statements offer a global perspective without detailing the contributions from individual countries. This practice obscures the underlying drivers of OCI volatility and makes it difficult to assess the impact of local market conditions on the group's overall OCI. The recent European Securities and Markets Authority (ESMA) report highlights that insurers across the EEA exhibit significant variability in their OCI reporting practices. For instance, Vienna Insurance Group AG (which is not part of our sample of insurance companies) provides separate disclosures of liquidity premiums per country, whereas other insurers like Talanx AG focus on group-level adjustments without country-specific details. This inconsistency in reporting practices underscores the challenges in achieving a transparent and comparable view of OCI positions across different jurisdictions.

2. Analysis of the impact of IFRS 17 and IFRS 9 on P&L

When it comes to measuring P&L impacts, for KPIs that existed previously but have been modified under IFRS 17/9 (i.e. the variables in the KPI are changing but not the formula of the KPI itself), a good example would be the Return on Equity which is analysed below.

Return on Equity (ROE)

ROE is a standard profitability metric, calculated as:

It indicates how effectively a company or group is using its shareholders' equity to generate profits. In the context of IFRS 17 however, both net result and shareholders' equity are affected by how insurance contracts are accounted for, leading to some adjustments in how ROE is interpreted. Here is how each part is affected:

1. Net Result under IFRS 17

The net result for an insurer under IFRS 17 is influenced by several factors, including:

●        CSM release: A key driver of profitability is the release of the CSM over the coverage period. As the insurer provides services under its insurance contracts, it gradually recognizes the unearned profit stored in the CSM, which flows into the income statement as profit.

●        Experience adjustments: Differences between actual and expected claims and other cash flows may result in experience adjustments. Depending on whether these are recurring or not, they can affect net result positively or negatively.

●        Discount rate changes: Changes in the discount rates used to value insurance liabilities can introduce volatility into profit depending on the OCI option taken, which impacts net result. However, insurers might exclude these when reporting their own interpretation of adjusted net result.

●        Risk adjustment: The release of the risk adjustment for non-financial risk (a measure of uncertainty about the amount and timing of future cash flows) also affects net result.

Thus, net result under IFRS 17 will often include various elements related to how profits from insurance contracts are recognized, adjusted for changes in assumptions and discount rates, and can differ significantly from previous accounting standards.

2. Shareholders' Equity under IFRS 17

Shareholders’ equity under IFRS 17 is also impacted by the new standard, mainly byOCI. IFRS 17 allows insurance companies to use OCI to separate market-driven changes (e.g. changes in interest rates) from operating profit. This smoothens the volatility in reported P&L  and contributes the equity base used for ROE calculations.

Analysis of ROE in the insurance market:

Test hypothesis: The basis point difference between 2023 and 2022 demonstrates that the large international insurance groups have a stable ROE ratio (the difference is below 500 bps) and smaller insurance companies have more volatility in their ROE. It is clearly understood that the volatility of the return is originating from its underlying performance of the insurance business which is reflected in the IFRS 17 elements described above. Also, the fair value nature and complexity of the IFRS 17 standard itself combined with a difficult implementation (e.g. long implementation timelines and significant budgets) makes it difficult to properly manage results.   

3. Analysis of the impact of IFRS 17 and IFRS 9 on CSM

Finally, we are focusing on the new KPIs that have been introduced entirely as a result of IFRS 17/9.

For this section, several items deserve attention, starting from the most basic one, being the CSM. The CSM in itself is a key concept of IFRS 17, representing as a liability the unearned profit for a group of insurance contracts, which is recognized over the coverage period as the insurer provides services. It is initially measured based on estimates of future cash flows, discount rates, and risk adjustments for non-financial risk.

During the implementation of IFRS 17, it was often speculated upon how insurance groups and the readers of their financial reports would look at the CSM. Being a liability by definition, but by nature acting as a hybrid between liability and equity, there was a lot of curiosity about how it would be treated. Benchmarking the first reports of the insurance groups, it can be concluded that the CSM’s role of pseudo-equity has been assimilated in the market. There is a clear objective to keep the CSM position stable, and entities make significant efforts to explain any instability. Several entities even spend several pages to disclose a 'Normalized or organic CSM' to demonstrate underlying stability, adjusting for abnormal or non-recurring impacts

Using IFRS 17 as a reference, normalized CSM refers to an adjustment to the CSM that accounts for abnormal or non-recurring impacts. It is not a formal term defined by IFRS 17 itself but rather a concept used by some insurers to explain or analyse the movement in the CSM.

The term normalized CSM comes into play in performance reporting and management discussions when insurers adjust the CSM to remove certain abnormal or non-recurring items to reflect a more consistent view of ongoing profitability. These adjustments can include:

●        Non-recurring events: These may include one-off changes in assumptions, significant external events, or large acquisitions or divestments.

●        Experience adjustments: Large, unexpected experience variances (e.g., an unusually high number of claims due to a rare event) might be normalized out to show the underlying performance without such volatility.

●        Discount rate changes: IFRS 17 requires insurers to adjust the CSM for changes in discount rates, but for internal or management reporting, insurers might normalize the CSM to exclude the impact of such market-driven changes.

●        Impact of transition: When transitioning to IFRS 17 from previous standards, some insurers may present a "normalized" view that removes the one-time effects of transition adjustments.

●        Translation of foreign operations: For multinational insurers, the CSM for contracts issued in foreign currencies needs to be translated into the reporting currency. Foreign exchange rate changes can lead to variations in the reported CSM value.

The normalization process allows stakeholders (such as management, analysts, and investors) to compare the insurer's underlying performance over time without the distortion of unusual or non-recurring items. This is helpful for assessing the core profitability and management performance since it reflects how well the insurer is performing on its core operations, excluding factors outside management's control.

Analysis of normalized CSM in the insurance market (amounts in EUR million):

Test hypothesis: Based on our analysis of the normalized CSM, we notice that significant variability remains and almost no normalization is happening. When looking in detail, we see that the New Business CSM and CSM Release is stable over time but the impact of estimates change is causing variability. These changes in estimates are related to assumption updates that impact future cashflows for example changes to policyholder behaviour. It will be important to keep on observing whether this variability remains over time.