The Next Great Upheaval in Financial Reporting for the Insurance Business
By Lucy L. Chan and Arnel F. de Jesus
First Published in Business World 5/6/2013)
In July 2010, the International Accounting Standards Board (IASB) issued an Exposure Draft (ED) on Phase 2 of International Financial Reporting Standard (IFRS) 4, Insurance Contracts, which detailed several significant changes to the way insurers measure insurance contracts. The ED required them to apply current market assessment when they measure their liabilities. The comment period for the ED ended on 20 November 2010 and the IASB has since conducted re-deliberations and has reached tentative conclusions on key topics.
Given the expected requirements under the proposed Phase 2 of IFRS 4 and the current state of the Philippine insurance industry, a Financial Reporting upheaval may just be brewing and we pose these questions: How large are the changes? What will be required of the local insurance industry to be prepared for them?
As prescribed in the Insurance Code, insurance companies in the Philippines are currently using a maximum of 6% discount rate for statutory reserves. Since the Insurance Code was issued way back in 1974, many industry players view the 6% maximum discount rate as outdated and believe that they should not confine themselves to the 6% maximum rate. Further, only mortality rate, premiums and benefits are considered in the cash flows for actuarial liability.
Under the ED, insurers should set their reserves composed of the discounted current estimate of future cash flows, plus a risk adjustment, and residual margin. This is known as the “building block approach.” Current estimate of future cash flows will not just comprise benefits and premiums, but will also include expenses and acquisition costs. These cash flows are then probability-weighted, incorporating not only mortality but also other factors such as lapsation and disability. These cash flows are discounted at the risk-free discount rate, adjusted for a liquidity margin.
The risk adjustment is the compensation the insurer requires for bearing the uncertainty inherent in the cash flows that arise as the insurer fulfills the insurance contract. This component reflects management’s level of risk aversion and their willingness to accept the risk of favorable or unfavorable cash flow outcomes compared to expectations. The residual margin, which is the difference between the discounted expected cash inflows, outflows and the risk adjustment, will be determined at inception and adjusted each period for changes in expected cash flows.
As described above, the building block approach requires detailed data analysis and management judgment to arrive at a reasonable and understandable value for the insurance contract liabilities. Developing an industry consensus on the calculation of a risk-free discount rate plus liquidity margin, capturing new data to support cash flow projections, and developing a company policy and approach to calculate the risk adjustment and residual margin will prove to be challenging new areas.
The new standard will have a significant impact not only on financial reporting but also on other areas of the insurance business, such as changes in the systems, data storage, policies, processes and controls, and governance. These obviously require significant investments in infrastructure, mostly to be incurred for systems and data. Some insurance companies may even have to replace their current systems, including the actuarial software, so that they can handle the demands of the proposed standards in terms of data manipulation and analysis. Regardless of the underlying systems, significant investment in actuarial modeling and analytical capability is likely to be required.
Data governance will become more important than ever. Insurers will need to adopt additional processes and controls to improve quality of both internal- and market-sourced data. With reliable base data, the modeling and analysis will require not only actuarial expertise, but also management judgment on future expectations. For many products, companies will need to run literally thousands of scenarios to determine the probability-weighted cash flows and test the sensitivity of assumptions. These assumptions, together with the additional processes and controls, should be documented to provide clarity and transparency on the insurance company’s approach to their adoption of the new standard.
Lastly, considering all the factors discussed earlier, implementation of IFRS 4 Phase 2 would affect the overall operations of an insurance company, and changes in governance will be necessary. Management should expect dramatic revisions in their procedures and policies, and some products will potentially no longer be commercially attractive.
Even though the IFRS 4 is still pending, many international companies are already performing high-level impact assessments given the significance of the changes. Insurance companies are encouraged to identify the areas where significant changes are expected, evaluate the cost and benefit of investing to cope with the changes, such as data management, actuarial modeling and reporting systems, assessing the resources needed and developing training programs. In particular, the potential profit impact and volatility under the proposed standard are key concerns of many boards and management teams. The preparation can be done in conjunction with the other significant players in the industry, including the actuarial community and accounting firms.
With sufficient preparation, insurers will be more equipped to weather the coming changes. They will be in a better position to make an initial assessment on how the new standard will impact their financial position and results of operations, including changes that can affect their business operations, and reducing the risk of being overwhelmed by the additional complexity.
Lucy L. Chan and Arnel F. de Jesus are Partners of SGV & Co.
This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.