“IFRS 17 and IFRS 9 are the new accounting standards for insurance contracts and financial instruments, respectively, that are effective since 1 January 2023 for the insurance industry. These standards introduce significant changes in the measurement, presentation, and disclosure of the financial and risk position and financial and risk performance of insurers. They also have implications for the key performance indicators (KPIs) and key risk indicators (KRIs) that insurers use to monitor and manage their business activities. In this article, I will briefly describe the main features of IFRS 17 and IFRS 9, and suggest some possible KPIs and KRIs that insurers may adopt or adapt under the new standards.
IFRS 17 introduces a new “by default” insurance contracts liability measurement model, called the building block approach (BBA), which aims to provide more transparent and consistent information about the profitability and risk of the in-force insurance contracts.
The BBA consists of four components: (1) Expected present value of the cash flows: These are the present value of the unbiased and probability-weighted estimates of future cash inflows and outflows from premiums, claims, benefits, and directly attributable expenses, within the contractual boundaries. (2) Risk adjustment: This is an adjustment to reflect the compensation that the insurer requires for bearing the uncertainty and variability of the expected present value of the cash flows, which is determined by the insurer using either a confidence level approach or a cost of capital approach. (3) Discount rates: These are the rates that reflect the characteristics of the insurance contracts (such as the timing, currency, and liquidity of the cash flows), which are used to discount the expected cash flows and risk adjustment. (4) Contractual service margin (CSM), the remainder balance, which reflects the unearned profit that the insurer expects to earn from providing insurance coverage in the future, being released according to the underlying risk pattern. Indeed, the recognition of unearned profit using CSM is allocated to profit or loss over the coverage period on a systematic basis reflecting the pattern of the services provided. This may result in a more faithful representation of the profitability of insurance contracts over their lifetime, but also a deferred recognition of profit compared to previous standards.
The sum of the expected present value of cash flows and expected present value of the risk adjustment are the fulfilment cash flows of the in-force insurance contracts.
Adjustment experience is one of the components of the insurance service result under the BBA. Adjustment experience arises every time the fulfilment cash flows differ from either the actual cash flows incurred or expected to be incurred. Adjustment experience related to past services is immediately recognised against profit or loss. Adjustment experience related to future services adjust the CSM and can arise from various sources, such as premiums, claims, expenses, options and guarantees, risk adjustment, and discount rates.
The treatment of changes in estimates depend on whether they relate to past or future services. Changes in estimates that relate to past services are adjusted against CSM if it is positive, or recognized immediately in profit or loss if it is negative. Changes in estimates that relate to future services are adjusted against CSM if it is positive or negative. This may result in more timely recognition of losses from adverse changes in estimates, but also more asymmetry and complexity in accounting for changes in estimates.
KPIs are measurable values that show how well an insurer is achieving its goals and objectives. KPIs can help an insurance company monitor its solvency, performance and efficiency, identify areas of strength and weakness, and improve its decision-making and strategy. The BBA will outdate most of the traditional and common KPIs that lingered around for decades in the insurance industry.
Eventually some new KPIs that will emerge in the insurance industry are: (i) CSM generated by unit coverage sold by business line and cohort; (ii) Breakdown of the CSM components by business line and cohort; (iii) CSM release pattern vs. actual pattern of the services provided, by business line and cohort; (iv) Root analysis of recognised onerous contracts by business line and cohort; (v) Contractual boundaries monitoring by business line and cohort; (vi) Root analysis of negative adjustment experiences; (vii) Reconciliation between the starting and ending reporting balances of the components of the insurance contract liability by business line and cohort; (viii) Breakdown of the YTD insurance revenue components and comparison with the expected values by business line and cohort; (ix) Breakdown of the YTD insurance service expenses by business line and cohorts, and comparison with the budget and/or expected values (particularly changes that relate to past and future services); (x) Breakdown of the reinsurance result by business line and cohorts with enough granularity (expenses, incurred claims recovery, other incurred directly attributable insurance service expenses, effect of changes in the reinsurer non-performance risk, changes in the fulfilment cash flows that do not adjust the CSM for the group of underlying insurance contracts, and changes relating to past services); (xi) Breakdown of the insurance finance income or expenses, particularly the effect of the time value of money and changes in the time value of money, and the effect of financial risk and changes in financial risk.
Monitoring per line of service and cohort of gross written premium, average gross premium, revenue per policyholder, average cost per claim, average time to settle a claim, customer retention rate, general opex, and many other traditional KPIs will obviously continue to make sense.
IFRS 17 also introduces an insurance contract liability measurement model specifically to those insurers who have participating business, called variable fee approach (VFA). The main difference between BBA and VFA under IFRS 17 is that under VFA, the CSM is updated for both financial and non-financial changes in estimates, while under BBA, the CSM is only updated for non-financial changes in estimates. Hence, the whole range of suggested KPIs above can also be applied to under the VFA.
KRIs are metrics used to provide an early signal of increasing risk exposures and measure the potential or actual impact of risks. Hence, KRIs help insurers to monitor and manage their risks proactively, by identifying the root causes of risk events, setting thresholds and triggers for risk mitigation actions, and providing real-time actionable intelligence to the risk manager and the wider decision-makers.
Both BBA and VFA are more than accounting frameworks as in a sense they are also probable maximum loss models and as such there are a number of KRIs that may be drawn upon them as well (e.g., modified duration gap between the insurance contracts liability and respective backing assets, confidence level driven simulations, correlation effects analysis, etc.).
Lastly, IFRS 17 introduces the premium allocation approach (PAA), which is a simplified measurement model for insurance contracts. It is intended for insurance contracts of short duration (i.e., one year or less contract boundary) or in cases where the results under the PAA would not materially differ from applying the general measurement model, i.e., the BBA. Under the PAA, the liability for remaining coverage (LRC) is measured based on unearned premiums, adjusted for any acquisition costs and onerous contracts, widely similar to the previous standard. The liability for incurred claims (LIC) is measured consistently with the BBA. Hence, most of the traditional KPIs will continue to be sensible under PAA in what regards the LRC. Eventually the aforesaid suggested KPIs in what regards the LIC under the BBA will make sense as well under the PAA.
IFRS 9 is the accounting standard that covers the classification, measurement, impairment, and hedge accounting of financial instruments. IFRS 9 has the following main features: (1) Classification and measurement: IFRS 9 introduces a principle-based approach for the classification and measurement of financial assets and liabilities, based on the business model and the cash flow characteristics of the instruments. Financial assets are classified into three categories: amortised cost, fair value through other comprehensive income (FVOCI), and fair value through profit or loss (FVTPL). Financial liabilities are generally measured at amortised cost, except for some liabilities that are designated at FVTPL or that arise from derivatives. IFRS 9 also eliminates the bifurcation of embedded derivatives for financial assets, and simplifies the requirements for the fair value option and the reclassification of financial instruments. (2) Impairment: IFRS 9 introduces a new expected credit loss (ECL) model for the impairment of financial assets, which requires entities to recognise ECLs at all times, not only when there is objective evidence of impairment. The ECL model applies a three-stage approach, based on the change in credit quality of a financial asset since initial recognition. In stage 1, a financial asset is performing and an entity recognises a loss allowance equal to 12-month ECLs. In stage 2, a financial asset has experienced a significant increase in credit risk and an entity recognises a loss allowance equal to lifetime ECLs. In stage 3, a financial asset is credit-impaired and an entity recognises a loss allowance equal to lifetime ECLs and interest revenue on a net basis. (3) Hedge accounting: IFRS 9 introduces a new general hedge accounting model that aligns hedge accounting more closely with risk management activities. The new model allows more hedging strategies to qualify for hedge accounting, such as hedging groups of items or net positions, and hedging non-financial risk components. The new model also introduces more flexible hedge effectiveness requirements, such as the use of qualitative or quantitative methods, and the elimination of the 80-125% bright line test. The new model also enhances the disclosure requirements for hedge accounting, such as the effect of hedging on the statement of financial position and the statement of profit or loss.
There are a number of new KPIs and KRIs that shall be introduced stemming from IFRS 9, foremost around the ECL and stage monitoring. Following what banks have done back in 2018 will help insurers not inventing the wheel.
Finally, but not certainly the least, IFRS 17 together with IFRS 9 will improve the enterprise risk management (ERM) practices of insurers, as it will require them to adopt a more holistic and forward-looking approach to managing their risks and opportunities, hence fully aligning the insurance financial reporting with the Solvency II regulatory framework. For example, a better alignment of the modified duration of the assets backing technical liabilities with those of the liabilities under the asset-liability management (ALM) in place, alongside optimizing their investment credit risk-adjusted returns under IFRS 9. IFRS 17 and IFRS 9 will also enable an easier comparison of the risk-adjusted return on allocated capital (RAROC) with the weighted average cost of capital (WACC), being now clear whether or not the insurer is adding value to the shareholders.
I am fully confident that insurers have the courage and the vision to embrace the challenges and opportunities of this new world!”