- ALM & Regulatory Capital Strategist
United Kingdom, Professional
Change
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From 1 January 2023, new accounting standards set out in the International Financial Reporting Standards (IFRS) on Insurance Contracts and Financial Instruments1 (IFRS 17 and 9, respectively) will affect every sector of the insurance industry and will significantly impact long-term contracts, notably for life and health insurance. In particular, the changes will influence how insurers’ investment teams and actuaries manage assets and liabilities and allocate to fixed income, equity and hedging strategies.
In the first of three articles on the new requirements, New IFRS financial reporting standards: a game changer for insurers?, we assessed the implications of the new accounting standards for managing insurance investment portfolios and balance sheets. Our second article, New IFRS reporting standards: how should insurers implement the changes?, outlined the implementation approach that insurers should consider to create value for shareholders and mutual members. Our final article focuses on the investment implications of the changes to the accounting rules and explores potential multi-asset investment solutions.
Three investment strategy considerations
The new IFRS regulations have implications for insurers’ investment strategies in three key areas: asset and liability management, hedging and equity investments.
Asset and liability management (ALM)
- Valuation methods: the General Measurement Model (GMM) in IFRS 17 is based on market-observed discount rates. As such, changes in interest rates can increase or decrease the level of reserves in a portfolio. Insurers typically allocate most of their portfolio to interest-rate-sensitive assets, primarily bonds. Under these new rules, the volatility in an insurer’s capital position from the impact of interest-rate changes on the bond portfolio can be offset by the symmetric change in the valuation of technical provisions.
Some insurers may be comfortable with the interest-rate risk arising from their portfolio’s net exposure to assets and liabilities, while others may not. In both cases, understanding and quantifying this exposure is key to managing the risk.
- Profit recognition: both IFRS 17 and IFRS 9 let changes in the value of technical provisions flow through the income statement, other comprehensive income (OCI) or a combination of both.
For most insurers, using a profit recognition method for the assets backing a specific insurance portfolio that is consistent with the method used for the value of technical provisions is helpful because it minimises volatility on the income statement.
To achieve consistency between the profit recognition of assets and liabilities, insurers will generally need to manage their own accounting policy. This ability to provide consistency is particularly useful when profit recognition flows through the income statement, as stakeholders can be sensitive to volatile results. However, to ensure consistency between profit recognition of assets and technical provisions through OCI, the investments used to back insurance portfolios must meet certain characteristics regarding cash-flow generation, as set out in the Solely Payment of Principal and Interest test (SPPI) in IFRS 9.
Hedging
Some insurers use hedging instruments to adjust the interest-rate and currency exposure relating to the assets in their portfolio, technical provisions or the joint asset and liability exposure. Accounting rules can influence insurers’ choice of hedging techniques. In extreme cases, insurers may choose not to hedge economic risks due to the accounting volatility that hedging can introduce into the income statement.
The changes IFRS 9 and 17 introduce to valuation and profit recognition may help to remove some of the accounting volatility arising from hedges in the existing standards. Insurers should assess the likely impact of the new standards on their hedges and consider amending existing hedges or introducing new hedging techniques as required.
Equity investments
- Profit recognition: under the existing standards, changes in the value of equity investments can flow through the income statement or OCI, depending on the insurer’s investment policy. Equity investments with value changes that flow through OCI, once sold, generate a gain or a loss that is “recycled” through the income statement.
The revised IFRS 9 keeps changes in equity values flowing through the income statement or OCI. However, it removes the gain or loss “recycling” option. As such, insurers choosing the OCI option will not be able to book gains or losses through the income statement.
- Investments through funds: under the existing standards, changes in value and profit recognition of funds are treated in a similar way to equities, regardless of whether they qualify as “puttable instruments”2. However, under the new standards, investment funds that qualify as puttable instruments are no longer eligible for changes in value to flow through OCI. Instead, these changes must be booked through the income statement.
- Investment and ALM implications: although neither of the changes above alters economic performance or the risks of equity investments, not being able to show gains from equity disposals may make equity investments less appealing. It may also encourage insurers to focus on forms of accounting value extraction that are different from price gains, most notably dividend income.
Insurers investing in funds that are “puttable instruments” or opting to recognise changes in equity values through the income statement may find these choices too volatile. Instead, they may adjust equity exposure to attain risk levels palatable for their shareholders and other stakeholders.
The possibility of avoiding accounting volatility in the income statement by using the OCI option has often made insurers disinterested in exploring the links between equities, investment through funds and technical provisions. However, with the changes that IFRS 9 and 17 involve, some insurers may opt for a more holistic approach to balance-sheet management and include equities and funds as part of the asset/liability management process.
Implications for investment and balance-sheet management
The way in which insurers should respond to the IFRS changes will vary significantly by type of business, jurisdiction, initial balance-sheet structure and risk appetite. However, these general observations should apply in most cases and across both public and private markets:
For fixed income investments:
- Consider using instruments with a suitable interest- and credit-risk profile in order to seek a compelling reward for the risks taken and to avoid becoming forced sellers during volatile periods.
- Where non-domestic currency strategies are applied, assess the likely impact of any currency or interest-rate hedges and evaluate the possibility of tailoring the portfolio profile and hedges to the technical provisions and other liabilities.
For equities and funds, insurers with limited tolerance for income volatility may wish to:
- Focus on sectors and regions with lower price volatility and higher income-generation capacity.
- Focus on sectors that display a stronger relationship with the variables driving liabilities.
- Consider implementing hedges that reduce the potential downside of equity or fund exposures.
Next steps
For more information on the implications of the changes to the IFRS accounting regulations or to discuss any insurance-related issues, please contact Wellington’s insurance team.
1 A list of the countries covered by the new IFRS requirements is available at: https://www.ifrs.org/use-around-the-world/use-of-ifrs-standards-by-jurisdiction/ | 2 Funds in which holders may receive a pro-rata share of net assets in the event of liquidation qualify as puttable financial instruments.
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