Interesting times lie ahead for insurers, who are readying for more transparency under a new accounting standard while preparing for a heavy flow of potential pandemic-related claims.
At a glance
- Accounting standards within the insurance industry have had to evolve constantly given the complex nature of revenue in the sector and the fact that insurance contracts are valued differently across different jurisdictions.
- IFRS 17 Insurance Contracts – a new accounting standard effective from January 2023 – is expected to ease the process of measuring liabilities consistently.
- Under IFRS 17, insurers will be required to provide more detail to investors about the risks in their contract portfolio and how they are provisioning for each risk.
By Prue Moodie
Years of low returns from their fixed-income portfolios, significant losses from catastrophe insurance and competition from agile new entrants to the sector – the past few years have been challenging and disruptive for insurers.
Hot on the heels of all the turbulence, the sector is now bracing itself for potentially astronomical business interruption payouts as a result of the ongoing pandemic.
It is also making preparations for the implementation of IFRS 17 Insurance Contracts, an International financial reporting standard issued by the International Accounting Standards Board in May 2017, which is set to replace IFRS 4 on accounting for insurance contracts and has an effective date of January 2023.
IFRS 17 is about 20 years in the making and is unusual in that it is directed at a specific industry. It is needed because of the knotty nature of revenue in the insurance sector. Insurance contracts are considered liabilities until their term ends, so premiums are not “revenue” in the sense of immediately bookable income.
“Insurers in different jurisdictions differ in how they’ve valued insurance contracts,” says David Pacey, Grant Thornton New Zealand’s national technical partner.
“One of the key considerations of IFRS 17 was to find a way not to under-report liabilities, and to measure them consistently.”
Role of insurance
The role of insurance, according to a paper from international insurance think tank the Geneva Association, is to “alleviate people’s fear of sudden misfortune by reducing loss through services and/or financial compensation”.
“By extension”, the paper continues, insurance “contributes to the social protection of citizens by enhancing their financial security and peace of mind”. There has always existed a tension between this social contract and the stringent capital adequacy demands that apply to the insurance industry.
The strength of the sector rests on a delicate balance between insurers’ assets – investment assets and reinsurance contracts – and contract liabilities. Underwriting, or risk assessment of contracts, is designed to maintain the balance.
Over the past several years, increased risks from extreme weather events have become a major consideration for insurers.
However, while natural disasters can be factored into risk models, “social inflation”, on the other hand – industry jargon for the litigation and court payouts that push up insurers’ costs over and above general economic inflation – is harder to predict.
Business interruption concerns
Recent court findings on business interruption insurance related to the COVID-19 pandemic offer plenty of examples of the challenges posed to insurers by social inflation.
In December 2020, the New South Wales Court of Appeal found that policies that referred to Australia’s repealed Quarantine Act 1908 did not block COVID-19 business interruption claims. Insurance company IAG subsequently set aside A$1.15 billion as a provision specifically for business interruption payouts.
Australia-based international insurer QBE, meanwhile, was specifically targeted by a UK court ruling, which found that claims on QBE’s business interruption policies could extend beyond the 25-mile radius of the policyholder’s business.
By January 2021, QBE had set aside US$785 million (A$1 billion) for multi-year, multi-jurisdiction COVID-19-related payouts.
By mid-March 2021, a string of Australian class actions were awaiting the outcomes of two cases the Insurance Council of Australia (ICA) had mounted to test the law with regard to business interruption insurance.
Among its arguments, the ICA said premiums for business interruption insurance policies did not reflect the cost of cover for pandemics when they were written, reserves had not been established for claims and reinsurance was generally not available for pandemic cover.
In its February 2021 report focusing on Asia-Pacific insurance markets, ratings agency S&P Global suggests that general insurers are likely to sustain only moderate COVID-19 impacts.
The sector has solid capital adequacy and prudent investment portfolios in place, the report says. Life insurers could be harder hit, mainly due to the effect of market volatility on investment earnings and mental health claims on life insurance.
“We continue to have a stable outlook on the Australian property and casualty [general insurance] sector,” says Craig Bennett, director, financial services group at S&P Global Ratings.
“A small number of insurers have set aside sizeable provisions against potential business interruption claims, although the impact of these has been lessened by raising equity, or equity-like funding.”
Bennett notes that the effectiveness of reinsurance would depend on the nature of cover bought, and that some insurers have an aggregate cover protection that could be activated and used.
Across the rest of the Asia-Pacific, pandemic-related losses have been generally manageable, according to the S&P Global Ratings report.
Pandemics under IFRS 17
The risk of greater-than-anticipated payouts related to COVID-19 is a good example of how IFRS 17 reporting might change the information that insurers include in their financial statements.
“The broad purpose of IFRS 17 is to improve the level of disclosure for insurers,” says Bennett. “At the moment, there’s some opacity – they can choose when to disclose their risks.”
After IFRS 17’s introduction, insurance companies will be expected to provide more detail to investors about the risks in their contract portfolio, says Julian Nikakis, insurance analyst with S&P Global Ratings. They’ll also be expected to provide much more detail about how they are provisioning for each risk, he says.
Another standout from IFRS 17 is that onerous contracts – those that pay out more than the premium value – will have to be accounted for in more detail. There will be an upside as well as a downside to this exercise, says Anne Driver, Deloitte Australia’s IFRS 17 general insurance leader.
“As soon as you start to test for loss-making businesses at a more granular level, there’s a good chance you’ll find more losses that have to be recognised earlier,” she says. “But that’s good for improving business practices.
“If you’re an insurer, your business is about managing your portfolio of insurance risks. Anything that drives you to be more efficient in the identification of a loss-making business and addressing that is a positive thing.
"The broad purpose of IFRS 17 is to improve the level of disclosure for insurers. At the moment, there's some opacity - they can choose when to disclose their risks. Craig Bennett, S&P Global Ratings
“I’m trying to find good news stories in IFRS 17,” says Driver. “One of the problems is, how do you derive any value from the costs that you’re going to have to incur?”
Brendan Counsell, Actuaries Institute IFRS 17 Task Force member and EY partner, agrees that the cost of implementing IFRS 17 is likely to be considerable and that the value to insurers is uncertain.
“One question is, will IFRS 17 provide a good picture of the underlying economics of the business?” he asks.
Counsell uses the example of a reinsurance contract.
“The reason an insurer buys reinsurance is to offset risk. Under IFRS 17, you’ll have to calculate the reinsurance separately from the underlying contract, which is quite different to the approach today, where we are used to viewing the results net of reinsurance.
“Preparers and users will need to adjust to the new way of presenting these contracts and understand how the underlying economics are represented.”
In the above example, Counsell says the insurer might go back to the reinsurer and renegotiate the contract in order to get a better accounting outcome. “You’d hope an accounting standard wouldn’t drive behaviours and business practices, but it could happen,” he says.
On the clearly positive side of the IFRS 17 ledger, Counsell says the new standard may shine the spotlight on the work of the finance team.
“The finance team will need to educate senior management and boards about the implications of the new accounting method. And there may be more representation from finance during presentations to rating agencies, prudential regulators and investors.
“For a year or two, the finance people are likely to have the best understanding of the standards and its implications for the business.”
However, “there will be real-world consequences of IFRS 17”, Counsell warns. “Senior management may need to revisit some of the pricing or product terms of their insurance contracts. It could change capital allocation.”
Another real-world consequence of IFRS 17 could be an impact on dividends.
Reassessment of liabilities could change assumptions about future expected profits, in which case lower levels of shareholders’ equity would require cuts to dividend payments.
“There could be a reduction in dividend payments, particularly regarding life insurers, where there is either higher volatility of earnings or a lower level of restated opening equity,” Bennett says.
Bennett doesn’t expect any material changes to the ratings that S&P Global Ratings assigns in response to the extra disclosures in IFRS 17.
It is less certain what ratings agencies and investors will make of the final hit from COVID-19.
However, many insurers will be banking on their ability to raise premiums in order to shore up the challenges to their finances over the next few years.
CPA Library resource:
International GAAP 2020: generally accepted accounting practice under international financial reporting standards. Read now.
Insurers' outlook: winds of change
- Higher-than-expected payouts on business interruption policies
- Ongoing risk of natural disasters
- Turbulence in financial markets
- More competition from smaller players and disruptors
- Flow-on costs from reinsurers due to COVID-19-related claims
- IFRS 17 implementation costs and potential effect on dividends
- Stronger equity markets in early 2021
- Prospect of higher interest rates in the medium to long term
- A “hard” premium market, which makes it easier to raise premiums
- Good customer loyalty
- IFRS 17 implementation benefits possibly leading to a review of unprofitable business lines and improvements in data analytics