Insurers reporting under International Financial Reporting Standards (IFRSs) continue to face a steady flow of new standards and interpretations. The IASB decided that the mandatory effective date of IFRS 9 will be for annual periods beginning on or after 1 January 2018. The mandatory effective date of IFRS 9 will not depend on the completion of the new insurance contracts standard which could potentially mean that insurers would need to assess their classification and measurement under IFRS 9 twice. Mr Lee Yin Toa of EY describes the impact for insurers in the implementation of new measurement requirements for assets under IFRS 9.
Financial instruments: Classification and measurement
This first part of IFRS 9 Financial Instruments prescribes, among other things, the conditions under which a financial asset may be measured at amortised cost.
Two tests need to be met for amortised cost measurement: the business model test and the contractual cash flow characteristics of the asset test.
Business model test
The business model assessment refers to how an insurer manages its financial assets in order to generate cash flows.
For example, there are business models within which financial assets are neither managed solely to realise fair value changes from movements in market rates nor are they held only to collect contractual cash flows. As such, these business models are a hybrid of the two.
Prior to IFRS 9, insurers generally classified financial assets held within such business models as available for sale (AFS). It may be a challenge to apply the new approach under IFRS 9 to businesses that may not be managed on a fair value basis, but where a significant number of assets are sold before maturity.
For example, the insurer might sell an asset in order to buy another asset with a similar maturity and risk but a higher yield (a process known as “switching”), and the insurer may be prepared to incur losses in the process of switching, so as to lock in a higher long-term yield rather than “to realise fair value gains”.
Other factors that need to be considered include the frequency, the volume, the value of sales, the reasons for sales, how business performance is reported, how employees are remunerated, etc.
As insurers start to implement IFRS 9, we expect that some level of consensus will emerge as to the extent of sales that is considered consistent with amortised cost accounting.
For Asia Pacific, the availability of long-dated high grade corporate and government bonds is generally more limited than in Europe and Americas. This could lead to more frequent sales to roll over investment assets to better manage the duration matching with the corresponding life insurance liabilities. Market practice would evolve to provide consensus what an acceptable range could be for Asian insurers.
Contractual cash flow characteristics of the asset test
The contractual cash flow characteristics of the asset test requires an insurer to test if the contractual cash flows that are solely payments of principal and interest on the principal amount outstanding are consistent with a basic lending arrangement. Complexity will arise if the asset has early termination clause, extendible terms, embedded call or put options, etc.
The introduction of a fair value through other comprehensive income (FVOCI) measurement category for certain debt instruments under IFRS 9 is of particular significance for many insurers in respect of their liquidity buffer portfolios held to fund unexpected cash outflows arising from stressed scenarios.
This FVOCI category is designed to capture portfolios of plain vanilla loans or debt securities that are managed within a hold and sell business model.
This FVOCI category is similar to the current available-for-sale category but could be more restricted. This means that only some but not all of the current available-for-sale category could be reclassified to FVOCI upon adoption of IFRS 9. In addition, if IFRS 4 phase II would be effective after 2018, there could two separate classification exercises with 2018 being focused on maximising the amortized cost category and after 2018, on optimising the matching between FVOCI and changes in insurance liabilities’ revaluation reserves also reflected within OCI.
Financial instruments: Impairment
This second part of IFRS 9 Financial Instruments prescribes that impairment of financial assets should be based on an expected loss approach which recognises impairment losses that are expected to occur over the life of the asset, rather than the incurred loss approach as currently required.
When financial instruments are initially recognised, an insurer would provide a credit loss allowance of 12-month expected losses. Subsequently, 12-month expected losses are replaced by lifetime expected losses if the credit risk has increased significantly since initial recognition (the lifetime expected credit losses criterion). The credit losses allowance or provision will revert to 12-month expected losses if the credit quality subsequently improves and the lifetime expected credit losses criterion is no longer met.
IFRS 9 does not define “default” or prescribe the specific approaches used to estimate expected credit losses. As these are judgmental areas, complexity will arise if the insurers have invested in illiquid assets.
In a sustained low interest rate environment, illiquid assets are becoming more and more attractive yield enhancing investments, providing insurers with predictable and stable cash flows over the long term. To comply with IFRS 9, insurers may need to review existing illiquid asset valuation models, credit due diligence performed and capital model framework.
Financial instruments: Hedge accounting
This third part of IFRS 9 Financial Instruments prescribes hedge accounting requirements. The new general hedge accounting model is a more principle-based approach. There will be clearer links between an insurer’s risk management strategy and the impact of hedging on financial statements.
IFRS 9 requires the fair value changes of certain financial assets to be recognised in other comprehensive income rather than net income. This is meant to avoid an accounting mismatch and would result in part of the volatility as a result of duration mismatches between insurance liabilities and assets backing those liabilities to be presented in other comprehensive income rather than net income.
However, when taking the accounting effects of risk management actions such as the use of derivatives to reduce the exposure to interest rate risk, volatility may be back in net income because IFRS 9 requires derivatives to be marked to market through net income unless hedge accounting is applied.
Hedge accounting may not always be possible and comes with additional processes and systems. As a result, the question arises: will insurers see a trade-off between their IFRS accounting and risk management strategies? Clearly the IFRS changes to reduce volatility will have an operational impact, as accounting is becoming even more complex.
Next step forward
Insurers resolving to push ahead with preparations may also have the opportunity to gain “reputational” advantages.
With the accounting changes providing more information and changing the presentation of financial information, insurers will need to manage the message to stakeholders carefully, helping them to appreciate the pure accounting changes and impacts, and distinguishing these from any underlying genuine changes in business performance and value.
The earlier insurers assess the likely impact on reported results and capital requirements, the greater the potential for optimising that impact – even potentially improving their reported results and capital positions under the new reporting requirements.
Mr Lee Yin Toa is Partner, Financial Accounting Advisory Services/Capital Markets at EY.