The Perfect Storm Part 1 – IFRS reporting under SAM

A client recently mentioned that they were concerned about the implication that the adoption of Solvency Assessment and Management (SAM) would have on insurance accounting under current IFRS4.

The apparent concern was that measurement of policyholder liabilities for IFRS reporting would change to follow SAM automatically.

Let me start out by saying this is categorically not the case. The adoption of SAM should not change IFRS measurement of insurance liabilities. In this post I’ll cover some of the technical details and common misconceptions of IFRS4 to demonstrate why this conclusion is so clear.

What does IFRS4 Phase 1 actually say about liability measurement for insurance contracts

Not much actually. When IFRS4 was created, the IASB couldn’t agree on a measurement and instead issued a partial standard covering primarily:

  • definitions of insurance
  • comprehensive disclosure requirements
  • a limited number of specific prohibitions
  • rules on what changes in accounting policy would be allowed
  • rules for acquisition accounting (as per IFRS3) for insurance contracts

I’m not going to cover all of these in detail. Some, like acquisition accounting, will be covered in a separate post. There are also a few other points that I don’t view as critical to the coming changes, although some might view the treatment of discretionary participation feature (DPF or “with profits”) business as pretty fundamental too.

So what is specifically not allowed under IFRS4 currently?

  • Insurers can’t hold liabilities for contracts that are not in existence at the balance sheet date (paragraph 14).
  • Insurers may not offset reinsurance balances versus direct policyholder balances (paragraph 14)
  • Liabilities must be not less than the current estimate of the amount required to meet all contractual cash flows (paragraph 15)
  • Additional excessive prudence, over and above what was in place on adoption of IFRS4. “Excessive prudence” isn’t well defined though. (paragraph 26)

So how are insurers supposed to measure liabilities under IFRS4 Phase 2?

This is a little complicated and a lot important. Let’s build this up piece at a time.

An “accounting policy” governs the measurement of insurance liabilities. Even if they’re calculated by actuaries, if they’re part of the financials they need an accounting policy.

From IAS 8:

“Accounting Policies are the specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial statements.”

Now IFRS4 talks about changing accounting policies while it doesn’t specify accounting policies itself.

Paragraph 22 (back to IFRS4 here) states:

“An insurer may only change its accounting policy for insurance contracts if, and only if, the changes make the financial statements more relevant to the economic decision making needs of users and no less reliable, or more reliable and no less relevant to those needs….”

This is very much in line with IAS8, although IFRS4 exemptions insurers from some of the specific principles in IAS8. (paragraph 13)

Since IFRS4 doesn’t provide measurement policies, insurers are free to adopt their own within pretty broad reason. I would argue that paragraphs 8 to 10 of IAS8 should still be given thought even if they strictly don’t need to be complied with, but that’s an opinion and I definitely no of differing views here.

So this is what it boils down to:

  1. For any accounting policies that already exist, insurers may only change them if the changes are for the better. Any policies that are in not in line with the few prohibitions (outlined earlier) must be changed, but otherwise it’s business as usual.
  2. For new contacts where no existing accounting policies exist, the insurer must choose sensible accounting policies that don’t breach the restrictions of IFRS4.
  3. It does not say used the regulatory basis
  4. It does not say follow market practice (although for new policies there is merit here)
  5. Accounting policies cannot be defined by reference to an external document.

That last point is important. IAS8 describes what accounting policies are and none of that allows reference to an external document. There are practical reasons for this too. If the external document changes, the insurer would automatically have a change in measurement of balances without a change in accounting policy since the policy would still reference the same document.

Another approach would be to reference a specific version of the document. Disclosure requirements actually require the disclosure of the specific policies in the AFS in any case.

Conclusion

No part of IFRS4 or IAS8 allows the definition of accounting policies as “current regulation” or through reference to an external document.

Outlining the principles, but also describing why they were chosen or from where they were derived is arguably fine since it’s just providing more information.

The introduction of SAM will therefore not change IFRS reporting for insurers. The introduction of Solvency II in Europe won’t change IFRS reporting in Europe either.

Post Script – Why all the confusion?

The point about accounting policies under IFRS4 and changes in accounting policies are commonly confused. The reason for this is simple.

Very few insurers adequately disclose their implied accounting policies in their financial statements. The policies are “implied” by actual practice rather than explicitly documented or disclosed. This muddies the water of changes in estimation techniques, changes in estimates and changes in accounting policies.

Good practice, good governance and good financial reporting all require insurers to codify their measurement approaches in accounting policies that are approved, disclosed and applied consistently.