In this article from InsuranceERM, RGA’s Paul Sauvé explores four areas related to the challenges of volatility and speed of profits under IFRS 17: onerous contracts, investment products, volatility of biometric results, and remote risk reinsurance.
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Two years on from the introduction of the insurance contract accounting standard, the market is beginning to understand how reinsurance can be used to manage issues around volatility and speed of profits.
Life insurers have now been reporting IFRS 17 results for several years and explaining those results to shareholders, analysts and other stakeholders. This ongoing communication exercise follows an extensive implementation effort. In parallel, reinsurers have been developing IFRS 17 reinsurance solutions to address challenges created by the new standards. RGA first wrote about this topic in 2021 prior to IFRS 17 implementation and, in working with clients over the past three years, acquired new insights to update this perspective.
One of the areas examined in 2021 – the cost and complexity of implementation – has naturally drifted into the background as life insurers have built new accounting systems and put new models into practice. The remaining two original topics – volatility of earnings and slow pattern of earnings emergence – remain key focus areas. Continued engagements with insurers on these topics suggest that some foreseen IFRS 17 effects have presented greater stakeholder communication challenges than anticipated.
The four areas explored in this update – onerous contracts, investment products, volatility of biometric results, and remote risk reinsurance – relate to those two persisting areas of focus, which often merge into the single IFRS 17 theme of pattern of earnings emergence.
Long before IFRS 17 took effect, insurers identified the conspicuous treatment of onerous contracts as a source of annoyance and gave reinsurers high hopes for remedying these situations with reinsurance. Since those early days, RGA has had numerous discussions with clients around the world on this topic. Somewhat surprisingly, none of these engagements have yet led to new “onerous contracts reinsurance.” RGA has examined in detail how this transpired.
At the highest level, the story is simple and uniform. Regardless of the country or the insurance product, insurers generally have followed this series of steps to address potentially onerous contracts in their portfolios:
Not all insurers have found their peace with this situation. Many are still working on refinements in the first two steps. Some of those who have exhausted the possibilities of those two avenues have arrived at satisfactory explanations for the remaining onerous disclosures in the third step.
Surprisingly, those insurers who seem to have the most difficulty at that third step are bancassurers – insurers with a single (bank) shareholder. This is counterintuitive, as one would expect such a shareholder to be more sophisticated and thereby more receptive to complicated explanations than the average small investor. One plausible explanation is that banks are innately averse to anything complicated or sub-optimal due to their culture, histories, or bank stakeholder expectations; another hypothesis is that widely distributed investors simply do not have the power necessary to demand satisfying explanations.
A notable dimension of this challenge is that onerous policies are commonly the smallest policies. Given global trends and national pushes towards broader insurance inclusion, it is unfortunate to see these smaller policies stigmatized with the “onerous” label, leading insurers to make them more expensive. Some argue this treatment is fundamentally at odds with the mutuality principle underpinning insurance and even unpatriotic in the face of national initiatives.
RGA does have reinsurance solutions for onerous contracts, but clients have thus far opted to use the three levers noted above. To be clear, RGA and others certainly reinsure onerous contracts in the normal course of business, so the prior comment applies to very focused cases with onerous disclosures being the sole problem to be solved, in the absence of other drivers of reinsurance.
Prior to the implementation of IFRS 17, a disproportionate share of the late modifications to the new standard, such as the Risk Mitigation Option (RMO) for reinsurance and the Variable Fee Approach (VFA), related to insurance policies that were largely investments or savings products. Such contracts are the predominant form of insurance in many countries, but the early foundations of IFRS 17 were seemingly written with a focus on “risk insurance” that paid uncertain outcomes in rarer events, as opposed to these other products with more predictable payment patterns. RGA and others wrote at length about facets of this several years ago (search for “bow wave effect” or “double deferral of spreads”).
Despite the flurry of activity to better accommodate these products in the lead up to IFRS 17, RGA remains surprised by the ongoing depth and complexity of deliberations in this subject area as we engage with clients around the world to discuss how reinsurance of these products can help their financial metrics, including IFRS results. This includes the multiple ways in which the effects of reinsuring these products can be brought into IFRS accounting, such as:
Though having a free choice among all these routes is uncommon, understanding when they are available and how to navigate among them is essential (and a skill RGA has honed over the last few years).
Optimizing the pattern of earnings emergence for the insurer is a common objective, and the potential levers involved extend to discount rate methodologies, coverage units, and Other Comprehensive Income (“OCI”) categorizations where reinsurance arrangements can have significant impacts. These considerations can be pivotal to reinsurance transactions, and the effects can be both material and unexpected for insurers. Presumably the initial wide range of options noted above will narrow in the coming years as accountants and auditors converge on a tighter set of norms, but each still has merit under different circumstances.
Some parts of the world are seeing an upswing in reinsurance of investment-focused insurance products, and IFRS is naturally one of the relevant financial bases when considering such transactions. Interestingly, this class of underlying business lends itself more to IFRS 17 optimization via reinsurance than does classic risk insurance. This is due to unique differences in the underlying business relative to IFRS 17 principles, leading to reinsurance essentially being able to increase total insurer profits.
With risk re/insurance, assumptions around mortality or disability claim rates do not generally vary enough between insurer and reinsurer to create material extra margins, partly because IFRS 17 effectively leaves more discretion for the insurer in setting these assumptions than in setting discount rates. With investment insurance products, on the other hand, expected profits are overwhelmingly tied to expected investment returns, which can vary significantly between insurer and reinsurer based on respective investment capabilities and tolerances and which are effectively governed by IFRS for the insurer. Reinsurance can thereby sometimes make the proverbial pie bigger for investment insurance products, which certainly helps pay for reshaping it and potentially makes the underlying product more competitive.
IFRS 17 appeared ideally designed for risk insurance. Not long after their initial IFRS 17 reporting, however, insurers started approaching RGA with tales of unexpected volatility in IFRS results due to volatility in “real” insurance claims experience. With the benefit of hindsight, the root of their surprise (and RGA’s) was the false assumption that the Contractual Service Margin (CSM) was akin to a Deferred Profit Liability (DPL), and that it was adjusted over time based on actual experience, within bounds. Given the many ways in which the CSM is adjusted at the end of each period, this was a tempting extrapolation for many accountants and actuaries. Reports following implementation made clear that this association was not entirely appropriate.
In reevaluating IFRS 17 texts in detail, RGA found the culprit in §44, which defines the progression of the CSM and includes an item (§44c) that captures changes in future expected claims and puts this into the future CSM. The intent of the International Accounting Standards Board (IASB) on this point appears clear: the CSM is not a deferred profit liability. This reflects the IASB’s strict adherence to the “services” mantra underlying IFRS 17. Regardless of the total amount of claims paid in a period, the insurer has provided the same total “service” to all policyholders, and the appropriate release from CSM into current income to match those services does not change.
Life insurers can therefore face unexpected IFRS 17 experience gains or losses in a given period. Multiple RGA clients find these results conspicuous and unfortunate to explain.
For now, this drives many hopeful reinsurance discussions. As a US-domiciled reinsurer, RGA has the advantage of being subject to US GAAP, which offers a more actuarially intuitive treatment of such experience gains and losses. Nevertheless, in all those IFRS 17 discussions, remote risk reinsurance remains a recurring challenge.
Insurers weigh the costs and benefits of reinsurance transactions in the context of the numerous financial bases (IFRS, statutory, tax, and required capital bases) and metrics (return on capital, new business margin, solvency ratio, or other KPIs) to which they are ultimately subject. IFRS 17 has introduced potential new benefits of reinsurance, such as modifying the pattern of IFRS 17 earnings emergence. In navigating these increasingly complicated constraints and implementing reinsurance solutions, RGA has found IFRS 17 surprisingly immune to some cheaper forms of reinsurance.
Two frequently used examples of such coverage are catastrophe reinsurance and financial reinsurance, which traditionally deal with financial or other bases fundamentally different from IFRS.
Catastrophe risk reinsurance generally addresses an insurer’s fundamental risk management concerns and sometimes also capital management. Financial reinsurance often addresses capital management and extremely conservative statutory accounting bases. That such reinsurance might not materially impact IFRS is therefore plausible, but which core workings of IFRS 17 cause this?
Cheaper forms of reinsurance, including catastrophe and financial reinsurance, cover only significantly adverse results or “tail risk.” IFRS 17, on the other hand, is primarily concerned with best-estimate scenarios and mean outcomes and only modestly concerned with adverse results, mostly via the Risk Adjustment (RA). IFRS 17’s RA invariably covers less remote events than either of the reinsurance types in question, and insurers have significant discretion in setting the RA level. IFRS prevents the effectiveness of remote risk reinsurance because the mean benefit of such reinsurance is minimal.
Digging deeper into IFRS 17 reveals a series of paragraphs and corresponding supporting texts that cause reinsurance with invariant total cashflows (not distinguishing between claims and experience refunds as they are both payments in the same direction) in the relevant scenarios to be unhelpful for remote risk reinsurance. The hard-won and much-lauded §66A, which can allow the use of reinsurance to defer underlying losses, does not come into play. Curious students of IFRS and reinsurance can trace the path from the IASB Transition Resource Group’s AP03 Appendix B and IFRS 17’s Basis for Conclusions §346 back through to IFRS 17 §86A and §66A.
This situation means that reinsurance relevant to IFRS 17 results will be mostly at-the-money, full-risk reinsurance. Potential exceptions may emerge. One of RGA’s reinsurance solutions for onerous contracts, for example, is a relatively inexpensive solution where a key challenge is the required IFRS 17 interpretations by the insurer.
While new IFRS reinsurance solutions may yet be discovered, existing solutions – more likely full-risk solutions – will continue to play a central role in the IFRS 17 world.
At RGA, we work with clients around the world to develop reinsurance solutions that address regulatory requirements and free up capital to drive business growth. We know firsthand that the right arrangement can create a win-win for all involved. Learn how we can create a win for you.
