EY reports: Insurers in for major changes in 2021

After a very long journey, (approximately 20 years) the International Accounting Standards Board (IASB) issued IFRS 17 ‘Insurance Contracts’. Come 1 January 2021 insurance companies will have to apply the new standard, which will ultimately change the way they recognise revenue and profits from insurance contracts. In Sri Lanka, the exposure draft of IFRS 17 has been issued by CA Sri Lanka, and the standard is yet to be issued. The overall objective is to provide a more useful and consistent accounting model for insurance contracts among entities.

“IFRS 17 demands a complete overhaul for many life insurance companies due to the long term nature of the contracts. For general insurers, the financial impact is comparatively less, although their disclosure requirements have increased,” says EY Sri Lanka Country Managing Partner Ruwan Fernando. “It’s an impactful change for insurers as it will affect many areas, from actuarial models, accounting systems, product design and financial statements to taxation and operations,” adds Ruwan.

But what is IFRS 17? To simply answer this question, the standard will require companies to recognise the revenue (primarily premiums) and profit earned from the insurance contract to be recognised over the period that the insurer provides the service. In other words, the profit arising from the insurance contract will be released in a systematic way to the Income Statement over the life of the contract. 

“This is reasonable and is in line with what all other industries with long-term service contracts are already doing in terms of financial reporting,” EY Partner Hiranthi Fonseka explains. However, the first time adoption of the standard will have certain challenges, including impact to revenue and profit. 

IFRS 17 will also see insurers having to unbundle the “investment” components from certain insurance contracts. This is because some insurance contracts come bundled with investment components. In order to correctly measure the cash flows related to the insurance contract, distinct investment components embed derivatives and other distinct performance obligations within the insurance contract will need to be separated. 

“IFRS 17 will make things more transparent, and with time easier for investors to compare performance of insurance companies,” says EY Assurance Leader Manil Jayesinghe. For example, if companies are more prone to issue contracts with investment components, the new measurement and disclosure requirements will take these into consideration when preparing financial statements, ensuring comparability which is a fundamental requirement in financial reporting, he adds.

Taking a look at the Liability side of the Insurance Contract, it will consist of Liability for remaining coverage (LRC) and Liability for incurred claims (LIC). LRC will reflect the amount that the insurer expects to hold for events that has not yet incurred, whilst LIC will reflect the amounts the insurer expects to pay for incidents that are already incurred. In estimating both LRC and LIC, an insurer will be required to forecast future cashflows based on historical data, along with risk estimates and discount rates. Given the complexity and variety of insurance contracts that are available in the market, there are three measurement models available in order to give flexibility to the preparers of financial statements. 

The General Model or the default model is the Building Block Model (BBA) where the liability consists of, estimates of future cashflows, adjustment for the time value of money (i.e. discounting) and the financial risks related to the future cash flows, risk adjustment for non-financial risks, and contractual service margin. A simpler measurement model is available where the contract term is one year or less. The third measurement model is Variable fee approach and is applicable for direct participating contracts. 

Although the effective date is 2021, insurers must start the journey to implement now. The design and execution of the new standard should not be underestimated. Companies will need to carry out Impact assessments in order to plan implementation steps, and design a road map for compliance on the due date and be ready to understand and explain the financial impact to its stakeholders.