IFRS 17 beyond implementation, towards commercial implications Chris Hancorn, PwC Hong Kong Jenny Jiang, Morgan Stanley Asia The Actuarial Society of Hong Kong 28
Agenda Overview: the changing financial reporting landscape What are the challenges and opportunities? IFRS 17: recap of the requirements What are others doing? Market reaction: the equity analyst s view What will the market reaction be? Implications: understanding and preparing for change What are the commercial implications? 2
Overview: the changing financial reporting landscape
Why is the IASB undertaking project on insurance contracts? IFRS 4 is an interim standard Existing policies make comparison across products, companies and jurisdictions difficult Insufficiently transparent information for users 4
The changing financial reporting landscape IFRS Standard 2015 2016 2017 2018 onwards Insurance contracts (IFRS 17) IASB re-deliberations Drafting and final standard Effective 1 January 2021 Financial instruments (IFRS 9) Effective 1 January 2018, with deferral option to 2021 Revenue (IFRS 15) Effective 1 January 2018 IAIS ICS Effective 1 January 2018 Hong Kong RBC QIS and publication of Pillar 1 consultation The insurance industry plays a vital role in the global economy; high-quality information to market participants on how insurers perform financially is therefore extremely important. Hans Hoogervorst, 18 May 2017 5
How are you feeling now? The Kubler-Ross model Denial Acceptance Anger Bargaining Depression Up to 2013 too many unanswered questions Exposure draft addressing many of the questions, but creating many more how far can we push this out? 2014-mid 2015 major progress with lobbying Continued concern about a number of issues with hope that they will be resolve during the drafting process Standard to be issued in May 2017 no way back from here? 6
IFRS 17: recap of the requirements
Overview of the measurement models General Model Premium Allocation Approach Variable Fee Approach Why is it needed? Default model for all insurance contracts To simplify the requirements for short term contracts with little variability To deal with participating business where the policyholder liability is linked to underlying items Types of contract Long-term and whole life insurance, protection business Certain annuities US style universal life Reinsurance written General insurance Short-term life and certain group contracts Unit-linked contracts* US variable annuities Equity index-linked contracts Continental European 90/10 contracts Certain general insurance contracts UK style with-profits contracts *Assuming significant insurance risk exists 8
General Model Default model for all insurance contracts. Based on discounted best estimate of future cash flows (in and out). Explicit margins: Contractual service margin to prevent gain on policy inception. Risk adjustment. Day 1 loss recognised in income statement. Cash flow approach for all liabilities: past claims (including IBNR) and future cover. Contractual service margin Risk adjustment Discounting Best estimate of future cash flows Unearned profits recognised over coverage period. Reflect compensation entity requires for uncertainty. Quantifies the value difference between certain and uncertain liability. Discounting future cash flows using top-down or bottom-up approach for discount rates to reflect characteristics of the liabilities. Best estimate cash flows explicit, unbiased and probability weighted estimate of fulfilment cash flows. Fulfilment cash flows Expired and unexpired risk Similar to market-consistent embedded value balance sheet, but with the addition of a contractual service margin 9
Financial statements under the General Model Changes in cash flows related to future services Update for current estimates relating to future coverage 6 2 Contractual service margin Risk adjustment Probability weighted discounted expected present value of cash flows Release of contractual service margin Release of risk adjustment relating to current period Interest on insurance liability at inception rate (unwind of discount rate) Changes in discount rates (update current market rates) Changes in cash flows related to past and current services 7 * 5 3 4 1 Income statement Other comprehensive income (equity) Balance sheet measurement *Accounting policy choice to separate finance component Flow to income or equity 10
Insurance revenue Consistently with IFRS 15 (Revenue from contracts with customers), insurance revenue represents the recognition of services provided to the customer. In IFRS 17, it therefore represents all the components of the liabilities that represent insurance services delivered: Expected insurance claims and expenses Risk adjustment fulfilled CSM released Acquisition costs allocated during period 17
Income statement presentation & drivers Prescribed income statement presentation 20XX 20XX Summary of key profit drivers Insurance revenue 1 X X Incurred claims and expenses 1 (X) (X) Underwriting result X X Investment income X X Insurance finance income or expenses (X) (X) Net interest and investment income X X Insurance service result X X Gains and losses on financial assets at FVOCI X X Effect of discount rate changes on insurance liability (optional) Total comprehensive income X X 1 Deposit elements excluded from revenue and claims Experience variances implicitly reflected within revenue and claims Fee income (for unbundled or investment contracts) would also be in P&L (X) (X) Release of the CSM Experience variances Onerous contracts Release of the risk adjustment Investment margin Indirect and corporate expenses 12
Groups and portfolios A portfolio: insurance contracts subject to similar risks and managed together Entity divides each portfolio of contracts into groups based on profitability and initial recognition date. Portfolio 1 Whole-life insurance Portfolio 2 Annuities Portfolio 3 Car insurance Group A Group B Group C Group D Group Group AA Group BB Group CC Minimum requirement 19
Grouping detailed requirements 1. Objective Profitable vs onerous contracts No CSM at the end of coverage period 2. Aggregation requirements* Top-down approach: Start at portfolio level (similar risks, managed together) 3 groups at inception **: Onerous; Profitable with no significant risk of becoming onerous; and Other profitable contracts Risk of contracts becoming onerous: Internal reporting Sensitivity of fulfilment cash flows Requires that a group shall not include contracts issued more than one year apart Effect of regulation Some laws or regulations prevent insurers from pricing for certain risk indicators (eg gender) *Exception for the level of aggregation on transition. **There may be no contracts in one or two of the indicated profit groups. If a law or regulation specifically constrains - insurer's practical ability to set a different price or level of benefits for policyholders with different characteristics, - then ignore that characteristic for grouping (eg male or female drivers) 20
Coverage units How do they work? An example Assuming : $1,000 CSM at end of year 1 after all adjustments but before release to PL Reporting periods Insured amount, in thousands Year 1 Year 2 Year 3 Reporting and coverage periods, in thousands Current Future 0-1 1-2 2-3 Total, in thousands Contract 1 100 100 100 100 300 Contract 2 150 150 150-300 Total 250 250 100 600 Coverage units In units 250 350 600 In % 42% 58% 100% CSM amortisation, $ $420 $580 $1,000 Adjustment to Amortisation to P&L for Year 1 CSM at start of Year 2 21
Transition under the General Model Approach Full retrospective Have to apply where not impracticable Requires day 1 data and assumptions and full history to date of transition Implementation considerations Simplified approach Retrospective with prescribed simplifications (e.g. certain interactions with contracts already terminated ignored) Risk of unintended consequences due to prescribed simplifications Not clear that it is simpler than full retrospective Fair value Comparison of fulfilment value to fair value Wide experience of fair value assessments from acquisition accounting Different views on the size of the CSM and hence future profits Given data requirements, may end up here? Data collection Materiality One off calculation Risk of double transition Recycle/lost profits Resourcing When to start? Which approach to use? 16
Variable Fee Approach (some par contracts) Eligibility requirements 1. Participates in a clearly identified pool of underlying items 2. Pay policyholder substantial share of the returns 3. Substantial proportion of the cash flows vary with the underlying items All other participating contracts are defined as indirect and use the BBA with some adjustments. Key measurement differences between the VFA and BBA Topic Building Block Approach Variable Fee Approach Changes in amounts supporting insurer s share (variable fee) Changes in options and guarantees Not directly relevant, but likely to be recognized in P&L / OCI Recognised in CSM (non financial) or P&L / OCI (accounting option) Release of CSM to P&L Passage of time based on coverage units Inception rates to unlock and accrete interest Posted to CSM and recognised over the contract s lifetime Posted to CSM, but permitted to put in P&L where there is risk mitigation to avoid an accounting mismatch Passage of time based on coverage units potential uncertainty over application (e.g. open WP funds)? Current rates (implicitly) to unlock and accrete 17
Why the VFA model matters Profit emergence: Participating endowment Base scenario IFRS 4 Profit IFRS 17 Volatile economic scenario Time IFRS 17: Base Profit IFRS 17: VFA IFRS 17: BBA Time 18
Premium Allocation Approach Current IFRS/GAAP BBA PAA Expired risk Unexpired risk UPR less DAC Undiscounted reserves for past claims (including IBNR) Contractual Service Margin Risk adjustment Discounting Best estimate of fulfilment cash flows Risk adjustment Discounting Best estimate of fulfilment cash flows Unearned premiums (less acquisition costs) Risk adjustment Discounting* Best estimate of fulfilment cash flows Eligibility Different models for same product types Mismatches with reinsurance Underwriting vs accident year basis *Discounting is optional if the claim liability cash flows are expected to be paid or received in one year or less. 19
Market reaction: the equity analyst s view
Prefer Stable, Predictable, Sensible Disclosure EV has been a popular valuation basis in Asia Y-Y % Earnings EV Free surplus 300 250 200 150 100 50 0-50 -100 FY11 FY12 FY13 FY14 FY15 FY16 Source: Morgan Stanley Research; aggregate of listed Chinese insurers 21
IFRS 17: More Complexity / Volatility or Less Example: IFRS earnings can be volatile and deviate from underlying trends Y-Y % 250 200 PRC GAAP earnings 231 Operating earnings 150 100 50 57 27 36 38 36 98 0-50 -100-49 FY12 FY13 FY14 FY15 Source: Morgan Stanley Research; Company data. 22
IFRS 17: Can it Provide Additional Insight? Source of earnings is the most powerful disclosure for investors % 100 90 80 70 60 50 40 30 20 10 0 37 63 Source: Morgan Stanley Research; Company data. Underwriting 78 22 Investment 31 69 AIA A PICC B Ping CAn 23
IFRS 17: Can it Provide Additional Insight? Chinese insurers start to disclose residual margin to help crystalize its future earnings Rmb bn Others Long-term protection 45 40 38.2 35 30 25 20 15 13.4 10 5 0 FY11 FY12 FY13 FY14 FY15 FY16 Balance of residual margin: 331 455 Source: Morgan Stanley Research; Company data. 24
IFRS 17: Will it Impact Strategy? Case 1: UL sales shrank when China initially adopted IFRS principles in 2011 Y-Y % 120 100 80 60 40 72 82 39 95 55 20 0-20 -40-27 6.5-8.3 3.2 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 Source: Morgan Stanley Research; CIRC. 25
IFRS 17: Will it Impact Strategy? Case 2: Maintaining IFRS based payout can lead to capital shortage Rmb mn Dividends (LHS) Solvency ratio (RHS) % 25,000 350 20,000 15,000 10,000 5,000 150% min requirement 300 250 200 150 100 50 0 0 FY08 FY09 FY10 Source: Morgan Stanley Research; Company data. FY11 FY12 FY13 FY14 26
Final thoughts A step forward to help investors track expected earnings but still not sufficient to perform true source of earnings analysis. Volatility and complexity could increase cost of capital if the results are not well understood by investors. Supplementary disclosures might continue to help guide the market. Need to keep an eye out for unintended consequences on product strategy, asset allocation and dividend policy. 27
Implications: understanding and preparing for change
Implementation status of key players IFRS Major insurers positions (source: PwC analysis) Get organized Understand the impact and plan the project Transition to the new standard Number of entities 8 5 2 2 1 2 Significant activities not yet underway Initial gap analysis / sizing Technical gap analysis Systems + data gap analysis Solution design Build and test Deploy Key observations Capacity Finance and actuarial resources will be kept busy by other existing projects during 2017 and beyond, e.g. RBC implementation. IT complexity Significant lead times required to implement an automated solution by the 2021 expected go-live date. Need to focus on designing the end-state solution, but don t overlook transition. One-off tools may be required. Early identification of the potential impacts of IFRS 17 allows improved management of the interactions with other projects. IFRS 17 creates opportunity to optimise the operating models for the finance, actuarial and potentially risk functions. Limitations in IFRS capability and insight can exist, particularly in Asia where financial reporting can be less advanced. Some clients are already locking up third-party support for the long term due to concerns over resource shortages. 29
Market ambition? Path A Strategic Path Benefits Operational Efficiency Strategic Redefinition A Some firms are taking this opportunity to transform their finance function - re-defining finance, actuarial and risk functions, establishing the operating model, tools and capabilities to support the business use the new metrics that are emerging. Compliance Implementation Time and Costs B Path B Compliance Path Some firms may seek to address the requirements in a lower cost compliance manner, either through workaround solutions or by increasing resources. 30
Some key requirements that need to be agreed at an early stage in the project Measurement model Discount rates Risk adjustment Transition approach General Model Top down / bottom up? Methodology to calibrate Fully retrospective Variable Fee Approach Where to perform the CSM calculation Premium Allocation Approach Grouping Risk free rate Illiquidity premium Ultimate forward rate Impact of changes to P&L or OCI Unit of account/diversification Mechanism to implement PADs? Confidence level disclosure Data availability by groups Modified retrospective vs fair value Stochastic modelling for options and guarantees 31
Strategic implications: business Business Product design Generating value Operating model We need to change our product design to include more explicit participating mechanisms to ensure our products qualify for the VFA model The guarantees on my variable annuity portfolio are going to severely damage my balance sheet - I need to find a solution, quickly. We need to rethink our actuarial and finance operating model to get a joined up view of the balance sheet and income statement What does minimum compliance look like, and will we have any capacity to deliver any more than that? Acquisitions & disposals Transition is going to cause significant problems for our Korean business. It doesn t make sense to stay in this market we are looking for a buyer 32
Strategic implications: investment Investment Investment strategy We need to investigate the duration gap under IFRS 17. I am concerned about market consistent discount rates and the impact of contract boundaries. Hedging strategy The CSM under the VFA helps address accounting volatility concerns do I still need hedging assets? Volatility management The BBA is going to create volatility in my P&L for protection business because the CSM is not unlocked for changes in discount rates. 33
Strategic implications: market reporting Market reporting How do we design portfolios and groups to maximise value and minimise volatility? Explaining value At transition I need to decided whether I want higher day 1 equity, or higher ongoing profits which is more suitable to my business model? Suite of reporting bases Stakeholder understanding Does IFRS 17, and its volatility smoothing options such as the use of OCI, remove the need for a separate operating profit definition? Profit emergence under IFRS 17 is going to be completely different from what I currently report I need to help my investors understand and buy into the new emergence pattern. 34
Recap Overview: the changing financial reporting landscape What are the challenges and opportunities? IFRS 17: recap of the requirements What are others doing? Market reaction: the equity analyst s view What will the market reaction be? Implications: understanding and preparing for change What are the commercial implications? 35
Questions Comments The views expressed in this presentation are those of invited contributors and not necessarily those of the ASHK or the contributors employers. The ASHK or the contributors employers do not endorse any of the views stated, nor any claims or representations made in this presentation and accept no responsibility or liability to any person for loss or damage suffered as a consequence of their placing reliance upon any view, claim or representation made in this presentation. The information and expressions of opinion contained in this presentation are not intended to be a comprehensive study, nor to provide actuarial advice or advice of any nature and should not be treated as a substitute for specific advice concerning individual situations. On no account may any part of this presentation be reproduced without the written permission of the ASHK. 36