When IFRS17 comes into effect for life insurers, there will be a material change in the liability valuation standards, and hence on the balance sheet. We take a look at how this can impact the value of a life insurance company, and how to manage these impacts.
IFRS17, which is the new accounting standard for valuing insurance liabilities, is targeted to come into effect for the financial year starting 2022. Insurance liabilities will change in value, and this change will be accounted for by an adjustment to equity on the balance sheet, rather than through profit & loss.
What does this mean for shareholder value?
At first glance, one may expect that a change in balance sheet equity translates into a direct change in shareholder value. However, nothing has changed in the business, so one may claim that there is no change in fundamental shareholder value. The reality is somewhere in between, and to a fair degree will depend on how the financial aspects of the transition are managed.
The once-off change in Liability/Equity can be viewed as having an offsetting change in future profits, but there is a time value aspect
There are offsets
IFRS17 requires that profits are to be released according to a pattern which is set at the point of sale of the product, and hence requires the valuation to be applied retrospectively for the existing liabilities. If a product has historically released profits quicker than what IFRS17 stipulates, those profits will need to be “recouped" and added back to the liability to be paid out at a later stage. This results in a larger liability now, but also larger future profits.
Conversely, if profits were withheld relative to what IFRS17 stipulates, this would require an immediate increase in equity now to effectively pay them out, rather than paying these profits out at a later stage.
So the change in liability (equity) could be viewed as having an offsetting change in future profits, albeit with a timing difference.
Capital, liquidity, funding and investment optimisation required to achieve value
The timing of profits has shifted, and this means that having the optimal capital and funding structures is required to manage the impact on value. Simply, one needs to obtain the right return on the balance sheet assets to achieve the expected value of future profits. This requires allocating assets accordingly, as well to manage any required funding and liquidity impacts.
A particular challenge to address is the fixed-rate aspect of reserving for future profits on specific classes of business, as required by IFRS17. The options range from doing very little compared to the status quo, and explaining the volatility to stakeholders, to an actively managed approach incorporating a top-down strategic volatility appetite and calculated targets, which optimises the return for residual P&L volatility. The difference in approaches here will drive the changes in value as well as profit volatility over time.
The financial aspects of product management will matter
From a pragmatic perspective, the product hasn’t changed, so one could argue there should not be much impact on fundamental value. However, with a change in accounting standards, the projected cash-flows and required returns of the products may change - and that means that they would require different asset allocations to match the accounting liability. Correctly managing the asset allocation will thus be required to achieve the targeted returns, and hence the targeted value.
With the shift to more market related rates in IFRS17, market volatility will have a more direct impact on liability values – therefore a fine tuned ALM approach, which incorporates product nuances such as cohort-specific features and funding requirements, is required to manage P&L and optimise returns. As this would be the bulk of the balance sheet related to such products, it stands to reason that the impact of this is quite material.
Net impacts can play a role
Even if there is a limited overall change in the net liability value, there may be offsetting impacts within the calculations or between products – in which case, these dynamics likely still play a role. For some product groups, the impact is likely to be moot, while for other product groups, such as for risk products, the impact could be more pronounced, depending on the current shape of the book.
New business will need to be managed in the same way
New business will be subject to similar dynamics, and could be managed as part of the overall program set up to handle the existing book. There are other features that will come to light, such as increased new business strain because of the inability to reserve for indirect costs, which will have an impact on the profit profile.
Overall, it is likely that profit emergence will be delayed relative to current accounting standards, and this is also just a shift in the time value of profits – with a clear strategy to manage this reserve of future profits, total shareholder value can be optimised.
Volatility of earnings needs to be considered
IFRS17 means companies will have less scope to counterbalance the impact of experience variances, and this is anticipated to result in increased profit volatility. Features such as the fixed-rate aspect of future profits, are also anticipated to increase reported P&L volatility.
Increased profit volatility typically means lower share value, but to the extent that it is easily explainable and clearly managed, one would anticipate a more limited impact. Hence having a well communicated strategy to manage overall profit volatility will assist with managing shareholder value.
This requires balance sheet optimisation and ALM, which is feasible, but not straightforward
Much of this boils down to optimising the balance sheet and having the right infrastructure in place to actively maintain the optimal allocation. In practice, there are a range of nuances to unpack, ranging from operational requirements, to product specific assumptions and features. One would need to consider aspects such as tax and associated transitional arrangements, availability of data based on current operations, funding sources and rates, investment strategy, and the fixed-rate aspect of future profits required by IFRS17.
Proactive management will add value
With the large amount of changes, business will need to consider the complexities in practically implementing the required changes, and the time frame required. With under three years to go before the financial impacts start to materialise, proactive management will be key to set up operations on time, and to have a transition plan in place.
Effectively handling these balance sheet and product management dynamics will allow insurers to make the right strategic & technical decisions, and assist them in communicating how they are managing the impact on value.
If you'd like to discuss any of the points raised in this article, or other related topics then please get in touch at michael@workworth.co.za
Disclaimer: This article has been prepared in good faith with sources believed to be reliable. It contains opinions, and in no way is this article to be construed as advice, a professional opinion, or guaranteed for accuracy. No liability accepted for any loss arising from any use hereof.
