The credit ratings of Canadian non-life insurers reporting under IFRS will not be affected by the recent adoption of IFRS 17, Fitch Ratings says.
The adoption of IFRS 17 Insurance Contracts on Jan. 1, 2023 (starting with 1Q23 reporting) replaced IFRS 4, resulting in a fundamental accounting change for insurers. Most North American insurance companies report under U.S. GAAP and were thus not impacted by changes in IFRS.
The changes to IFRS 17 from IFRS 4 primarily reflect timing differences in reporting results, since cash flows are not impacted (see Insurers’ Finance Transformation and Priority of IFRS 17 Compliance).
As such, the new IFRS 17 accounting standard does not significantly affect insurers’ business models or risk structures and is unlikely to alter how management evaluates its operations.
Going forward, shareholders’ equity should become less volatile as liability values and asset values under IFRS 17 move more symmetrically in response to interest rates changes (see why European insurers said that it does not plan to use IFRS 17 yet).
Furthermore, as IFRS 17 introduces a fully market-consistent approach to liabilities, Fitch will no longer deduct unrealized capital gains and losses on bonds from the equity component in the financial leverage ratio calculation.
The cumulative effect of implementing IFRS 17 has varied considerably by company. For example, Fairfax Financial Holdings common equity increased by 16% (USD2.4 billion) at Dec. 31, 2022.
The increase primarily reflects USD4.7 billion of net claims reserves discounting due to the sizable increase in interest rates in 2022. Prior to IFRS 17, the company had limited reserve discounting (only standard tabular in workers’ compensation). Fairfax’s reserve discount benefit was partially offset by a risk adjustment margin of USD1.6 billion and other adjustments.
Conversely, Intact Financial Corporation’s common equity was restated upward by only 3% at Dec. 31, 2022, primarily due to the deferral of allocated acquisition costs that were previously expensed as incurred and a decrease in net claims liabilities reflecting the change in discount rate methodology and risk adjustment. Intact had used reserve discounting under IFRS4 and its reserves are lower in duration than Fairfax.
Under IFRS 17, insurance contract accounting brings major changes for the valuation of liabilities.
Insurance contract liabilities are calculated as the expected present value of future insurance cash flows with a provision for non-financial risk.
For non-life business, the principal measurement model used is the more simplified premium allocation approach (PAA), while life business primarily uses the more complex general measurement model.
Under the PAA, non-life claims are recognized at present value to reflect the time value of money using risk-free yield curves adjusted for an illiquidity premium. This discount is unwound over time through investment results until final settlement when the full value has been recognized in the income statement.
In addition, underwriting results include a risk adjustment margin for reserve uncertainty for the timing and amount of cash flows from non-financial risks to functionally offset to the claims discounting. Any future release of this risk adjustment reserve is recorded favorably in underwriting income as part of prior year reserve development.
Under IFRS 17, the income statements present an ‘insurance service result’, computed from a separate ‘net insurance result’ and ‘net reinsurance result’.
Gross and net written premiums are no longer presented and have been replaced by ‘insurance revenue’ within the ‘net insurance result’, which is similar to gross earned premium.
In addition, underwriting results include a risk adjustment margin for reserve uncertainty for the timing and amount of cash flows from non-financial risks to functionally offset to the claims discounting. Any future release of this risk adjustment reserve is recorded favorably in underwriting income as part of prior year reserve development.
As a result of this new IFRS 17 reporting, the combined ratio calculation will differ from that under GAAP. Fortunately, many companies will continue to report an undiscounted combined ratio as well as gross and net written premiums. This will facilitate comparability to insurers reporting under U.S. GAAP.
by Yana Keller
