Insurance Risk and Finance Regulations

The marathon reform continues

Abstract

After fifteen years of being in the making, the new Solvency II regime is now effective and applies to all EU insurers’ risk and capital management. In parallel, the reform of the International Financial Reporting Standard (IFRS) on insurance contracts is approaching the end of its standard setting phase which started over eighteen years ago. Given the complexity of introducing this new IFRS it is unlikely that it will be mandatory for another four years’ time (i.e. from 1/1/2020).

With Solvency II European Insurers have just completed a long implementation journey on the risk side of their business and they are about to start operating in the context of new, regionally uniform and more transparent risk capital rules. However, this important milestone is only the mid-point of a marathon to usher new European insurance regulations on risk and finance. With the new IFRS on insurance (likely to be published as IFRS 17) impacting the earnings that insurers will report to investors, the need for implementation stamina and the ability to build on Solvency II may prove essential to successfully cross a finish line that may not be so close. In this article Francesco Nagari, Deloitte Global IFRS Insurance lead partner, discusses the underlying trends that are shaping these developments.

Why reform insurance risk and finance regulations in the EU?

Insurance contracts are an effective way to manage risks of individuals and companies. In addition, the combination of savings features with the core risk protection has made insurance contracts a popular choice to fund retirement needs. When the EU internal market is considered as one market, its insurance industry is the largest in the world, but for consumers and investors it is not easy to understand how solvency and profitability compare across that market and over time because it is not yet regulated in a uniform way.

The EU institutions decided to reform these two important segments of insurance regulation via a direct EU initiative that has now produced the Solvency II regime and by intensifying the EU support to the International Accounting Standard Board (IASB) as it worked to produce a new IFRS for insurance contracts. These combined reforms will undoubtedly represent a paradigm shift in EU insurers’ comparability and transparency of their solvency capital and profitability. These enhancements in turn will increase consumers’ trust in insurers’ ability to fulfil the insurance contracts they offer and reduce the cost of capital that insurers need to pay to attract new investors or to retain existing ones.

The financial crisis of 2008-09 and the Euro sovereign debt crisis that followed have contributed to reshape these strands of the EU reform agenda for the insurance sector. The impact has been both material and unprecedented: on one hand it made the whole reform a far more sensitive political and legislative issue, and on the other hand it caused substantial uncertainty over the end state of the European insurance regulations (see “Rethinking the response – A strategic approach to regulatory uncertainty in European insurance”, Deloitte LLP, September 2013). All the stakeholders involved in these reforms have contributed to the resolution of the key issues. A fundamental issue has been the degree to which, for insurance business, market variables should determine solvency requirements and reported profits where insurers are established to deal with market variables over the long term. The consequential delays on the implementation timeline of both Solvency II and the new IFRS for insurance contracts have been unavoidable, given the need to reach the appropriate level of consensus.

The regulatory marathon has nearly ended on the solvency capital/risk side with Solvency II “going live” on 1 January 2016. This means that the regulatory uncertainty is now effectively over and the new rules will start to play out their effects on the market. The IASB marathon to complete the new IFRS for insurance contract has yet to reach the equivalent target and Deloitte estimates that the finish line for the second strand of the reform will not be crossed before 1 January 2020, four years after the “go live” date for Solvency II.

Similarities and differences between Solvency II and the new IFRS on insurance contracts

The preamble of the Solvency II Directive makes an explicit statement that the valuation of assets and liabilities of an insurer under Solvency II must be developed in line with an economic risk-based approach that “provides incentives for insurance and reinsurance undertakings to properly measure and manage their risks”. It also makes it clear that this economic risk-based approach is one that must be in line with the international developments arising from the IASB work. Finally, it makes it clear that “valuation standards for supervisory purposes should be compatible with international accounting developments, to the extent possible, so as to limit the administrative burden on insurance or reinsurance undertakings”.

The area where this statement has found its most compelling application is in the valuation of insurance liabilities or technical provisions as defined in the Solvency II regulations 1. This is because, although Solvency II and the new IFRS for insurance contracts have different timelines and objectives, insurers will have to address many similar questions and issues when dealing with their implementation.

Having completed the implementation of Solvency II, the gained understanding of what these similarities and differences are should become the key ingredient to build the organisation’s stamina to cover the remaining distance in the implementation marathon of the combined regulations. The target that insurers must strive to achieve in the next four years is to organise the new implementation work for the new IFRS on insurance contracts in a beneficial and cost effective manner. The opportunity to use these unprecedented regulatory changes to integrate risk and finance data and metrics and take these two key business functions to the next level has never been greater.

As explained above, the gateway to achieve this goal is the measurement of the liability side of the balance sheet (see figure 1). It is useful to bear in mind that the two regulations serve different purposes: Solvency II is designed to protect EU policyholders and to ensure insurers have sufficient capital to withstand unexpected claims. By contrast, the new IFRS for insurance contracts (together with all the other relevant IFRSs) governs how an insurer reports its financial position and performance (profit or loss) to serve the general economic interests of current and potential investors in that insurer.

The key consequence of the two different approaches is that Solvency II has adopted a “current exit value” valuation philosophy that gives credit to the insurer for selling profitable business from the date it has sold it (equivalent to an accounting day 1 gain on sale). An exit value approach enables the solvency regulator to appreciate how much another insurer would need to be payed to take up the liability in the event of a regulatory action to protect the policyholders. The approach that the new IFRS will take will prohibit the recognition of such an accounting gain at the point of sale because it uses a “current fulfilment value” valuation philosophy aimed at reporting this expected profit as the contractual obligations are fulfilled. The expected profit will be a highly visible explicit component of the IFRS liability defined as the “contractual service margin”. It will be the first time that solvency and financial reporting regulations demand the explicit reporting of expected insurance profits and this is a significant increase in the transparency of the numbers published by risk and finance departments for external stakeholders.

A second key difference is the general approach taken to the scope of liabilities within each set of valuation rules. Solvency II focuses on the liabilities that are subject to insurance regulatory authorisation while the new IFRS for insurance contracts ignores the regulatory dimension and instead scopes in liabilities based on the presence of a significant transfer of insurance risk to the insurer.

There are three other main differences that arise from the fact that both regulations adopt the “building blocks approach” to value insurance liabilities but with different methodologies in the areas of undiscounted probability-weighted cash flows projections (block 1), discount rate (block 2) and risk margin (block 3).

These three differences are against the backdrop of extensive similarities in each of the three areas. For example both Solvency II and the new IFRS will require a current estimate for expected cash flows inclusive of the effects from embedded options and guarantees. Both regimes also demand the use of market interest rates to determine a current discount rate term structure. Finally both Solvency II and the new IFRS will require an explicit liability to provide for the risk of the uncertainty of the expected cash flows which is defined as the risk margin in Solvency II and as the risk adjustment in IFRS.

IFRS vs Solvency II

Figure 1 – Comparing the new IFRS to Solvency II valuation of insurance liabilities. Five broad categories – the devil is in the detail, as always!!

Block 1: a different approach to general expenses and future premiums

Solvency II takes a different view to the new IFRS when it comes to general overheads requiring that the estimated probability-weighted cash flows calculations include all of these expenses, irrespective of whether those are attributable to the fulfilment of the obligations arising from the portfolio of insurance contracts. The IFRS principle instead would only require the expenses attributable to the fulfilment of those obligations to be included. An example of expenses that would not be included under IFRS are those incurred for product development and training. These costs are recognised in profit or loss when incurred under IFRS but they would reduce the “day 1 gain” under Solvency II.

Both IFRS and Solvency II require the inclusion of future premiums from cancellable and renewable contracts when they fall within the “contract boundary”. This is a point in time in the future of an existing contract when substantive rights for the policyholder or the insurer no longer exist and, effectively, a new contract begins. Both IFRS and Solvency II require the boundary to be determined in substance and not based on legal form. However, they adopt a different logic to achieve this result, which may produce, in a small number of cases, a lower amount of future premiums in the Solvency II calculations. In this instance, the effect of the greater prudence on the contract boundary under Solvency II would reduce the “day 1 gain” compared to what would have been if the IFRS basis had been used, all other things being equal.

Block 2: two ways to address the illiquidity conundrum

Reflecting the illiquidity of insurance cash flows has been a major conundrum for both the IASB and Solvency II regulators and it was central to the debate on the impact of market variables that followed the financial crises of the past few years.

Though in different ways, both regimes reflect illiquidity risk. The new IFRS reflects illiquidity as a component of the IFRS current discount rate. The illiquidity premium could be estimated either directly, as an additional spread to the risk-free rate curve (bottom up approach), or indirectly by removing spreads that do not relate to the insurance cash flows (e.g. credit risk) and assuming the residual is the illiquidity premium (top down approach).

The Solvency II approach is the key output of a major political agreement and is more complex because it takes into account both conditions at each insurer and market data published by the European Insurance and Occupational Pension Authority (EIOPA). This approach results in two alternative ways to calculate the spread for illiquidity: the volatility adjustment and the matching adjustment. Given the restrictions on these methods, Deloitte has found that the Solvency II discount rate term structure tends to be lower than the equivalent under IFRS in a number of instances. All other things being equal this difference would also reduce the Solvency II “day 1 gain” compared to what it would be if the IFRS discount rate had been used.

Block 3: IFRS principles vs. Solvency II prescriptive rules

The explicit liability for the uncertainty surrounding the estimate of probability-weighted cash flows is common to both sets of rules. However, Solvency II imposes a single way to calculate the risk margin, which is the cost of capital approach, while IFRS allows the insurer to choose based on the risk characteristics of the in-force business. Solvency II requires the calculation to be made by reference to a hypothetical insurer (exit value scenario) while the IFRS calculation measures the entity own risk aversion against the uncertainty of fulfilling its obligations (fulfilment value scenario). Both calculations allow diversification benefits to be taken into account. Finally, Solvency II imposes a cost of capital rate of 6%. No such imposition exists in IFRS and it is reasonable to anticipate that this liability component would be higher under Solvency II if the IFRS risk adjustment is expected to be closer to the economic capital calculations that insurers have published lately.

What are insurers doing at this stage?

EU insurers have been particularly busy with the implementation of Solvency II for at least the last five years and the costs for the whole market have been substantial (at least 4 billion Euros according to the European Commission).

The additional delay on the IFRS reform has allowed them to limit their efforts on that front thus far. However, the largest insurers have in the last two years started to invest in IFRS business and financial impact assessments, training programmes and system evaluations to ensure that the material investment made in the implementation of Solvency II is future-proof when the new models and systems used in risk and finance departments are tested against the upcoming IFRS requirements.

2016 is the right time for the whole EU market to take similar detailed planning steps to ensure that the implementation of the new insurance risk and finance regulations will be complete when the finishing line is in sight.

Footnotes

  • 1 A comprehensive analysis of the similarities and differences between the insurance liability valuation rules of IFRS and Solvency II can be found in chapter 4 of “The Solvency II Handbook”, 2014, Risk Books.

Author’s note

The author wishes to acknowledge the invaluable support in preparing this article of Sarah Curmi – Insurance Leader and Ian Coppini – Director at Deloitte Malta.

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