We take a look at managing the pool of assets backing future profits, and what challenges and opportunities lie ahead with IFRS17 coming into effect. We find that there is opportunity to optimise returns and manage profit volatility, as well as a strong case for centrally managing these funds with guidance from top-down trade-off framework.
Assets backing the profits are usually aligned to assets backing the product
To date, accounting regulations have been conducive to managing the assets backing future profits as part of the product management. This largely means that the assets held for future profits are invested in line with those of the product.
For investment-type products, this was, and remains optimal
For investment products, where fees are a percentage of the assets, it is natural to manage the future profit as part of product’s assets. Doing so has allowed actuaries to optimise the value of having a reserve for future profits e.g. actuarial funding, which uses some of the future profits to provide liquidity thereby reducing the total cost of providing services. For these products, continuing to manage the funds as a percentage of assets is very appropriate, and also consistent with IFRS17.
For other lines of business, managing these assets as part of the product’s funds is no longer appropriate
For other, more typical life products, the embedded profit is often managed via actuarially calculated loadings in various forms. There is some flexibility in how these profits are managed and released, which has allowed products to appropriately buffer experience and other impacts.
With IFRS17, there is limited flexibility in how the profit reserve is calculated: the reserve for profits (called the Contractual Service Margin) is to be a function of the coverage units, and a fixed interest rate set at outset - this reserve may be released in a manner which is different to the amount of assets, or return on the assets backing the product.
Asset strategy of products and profits is separated
The shift to IFRS17 disentangles the behaviour of future profits from the product's asset management, or market related asset returns - and such is the nature of IFRS17: profits are seen as set upfront and earned over the period according to a pattern set at outset.
Assets backing these profit reserves therefore need to be managed differently, to appropriately meet the requirements of this reserve.
The financial nature of future profits introduces a mismatch, causing profit volatility
Because IFRS17 requires the future profits to be discounted at set rates that are never changed, there is no natural matching market instrument. This specific aspect has been contested more than once, but the IASB has been firm in requiring this (for a variety of valid reasons).
Controlling the mismatch across the company
The consequence is that actual asset returns, relative to the set hurdle rates used to discount future profits, will cause profit volatility. For different products, and for different vintages, the hurdles are different, and so is the appropriate asset allocation. A decentralised approach may have different products optimising over the mismatch in varying ways, leading to a range of results at company level.
Instead, managing this basket of hurdles centrally will allow the company to control the total mismatch, as well as allow tactical calls on the appropriate trade-offs within the company’s context.
The financial nature of the profit reserve is fairly homogeneous
Furthermore, the reserve for future profits are largely just projected cash-flows discounted at various fixed rates, meaning that they have the nature of fixed cash flows with set hurdles. It is thus fairly natural to them group these flows together to manage them under a single strategy, or internal capability which can optimise over the mismatch.
Not consistent with solvency VIF treatment
There is a mismatch between the treatment of the future profits in IFRS and solvency calculations - hence any asset portfolio set to introduce sensitivities to manage IFRS P&L volatility must be considered in light of the solvency position it could introduce, and the corresponding impact on dividends. This trade-off can only be managed centrally, further supporting a consolidated view of the managing profit reserve’s assets.
A centrally controlled fund
Collating the above, a centrally controlled approach is needed to effectively manage the volatility introduced by the mismatch.
There's potential upside
By centrally controlling funds, one naturally consolidates liquidity, and can take a holistic value-based view of allocating that capital. In addition, there will be some natural profit volatility that will be expected, as all insurers will be exposed to these effects. By allocating this volatility strategically, one could optimise returns and target better expected long-term returns.
It's not easy, and there are management decisions to be made
There is no silver bullet to managing the mismatch, and as such, there are decisions and trade-offs to be made. Getting a management level handle on these trade-offs is not easy, but highly beneficial. One of the more tricky aspects is getting a pragmatic handle on the nature of the mismatch, which is a result of a portfolio of varying hurdles and compounded historical profit reserves, experience variances and basis changes. This is a prerequisite to being able to make the correct decisions and applying a strategic view.
The path forward
With less than three years to go before the financial impact starts to manifest, companies would do well to consider how they are addressing this issue. A framework that provides a firm grip on the essential trade-offs at a top-level, with a set of parameters to practically allow the business take action, will be essential for stakeholders to be able to make trade-offs on varying fronts.
The data and operational requirements to manage this in practice are significant, and would need to be considered when finding a practical solution.
This suggests an early start is required, with a high level framework constructed to allow management to make clear strategic decisions, and for those decisions to then filter into the complexities and set the appropriate operational parameters to be implemented. Doing so early enough will allow companies to unlock some of the upside, and limit downside.
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.
