Accounting standards set out in the International Financial Reporting Standards (IFRS) on Insurance Contracts and Financial Instruments (IFRS 9 and IFRS 17) are affecting every sector of the insurance industry. Given this, we conducted a short IFRS 9 survey earlier in the year with insurance companies around the world to better understand the progress that is being made to comply with the regulation, the challenges firms are facing, and the most popular analytical approaches being used. This blog summarizes the major findings.

About IFRS

Many lessons were learned from the 2007-2008 financial crisis, including the need to better understand an organization’s expected credit losses (ECLs). In response, the International Accounting Standards Board (IASB) put in place measures to address perceived deficiencies in the accounting for financial instruments.

• IFRS 9 became effective for annual periods beginning on or after January 1, 2018, with a January 1, 2022 deadline for compliance. It specifies how an entity should classify and measure financial assets and liabilities, as well as some contracts to buy or sell non-financial items.
• IFRS 17 became effective January 1, 2023 for listed insurance companies in the EU. It requires a company to measure insurance contracts using updated estimates and assumptions that reflect the timing of cash flows and any uncertainties relating to insurance contracts.

In June 2020, the IASB published an amendment to extend the temporary exemption from applying IFRS 9 until annual periods beginning before January 1, 2023. This amendment maintains the alignment of the effective dates of IFRS 9 and IFRS 17, enabling many insurance companies to adopt the standards simultaneously to avoid accounting mismatches on their balance sheet.

IFRS 9 contains three main components for each asset (investment): classification and measurements, impairment, and hedge accounting. Of the three, it is expected that the greatest challenge will come from the handling of the impairment of financial assets. This is calculated on an expected, rather than incurred, loss basis. ECL is a forward-looking measure and is influenced by a variety of factors, including the credit rating of an issuer and macroeconomic conditions. Having an inadequate approach for calculating ECL could create an allowance that is too high, impacting deployment of capital to other revenue-generating functions. Alternatively, it could create an allowance that is too low, exposing a firm to unexpected losses in a downturn. This makes it essential to get the calculation right.

Sixty Percent of Survey Respondents Have Proceeded to Implement IFRS 9

Of the 40 survey responses received, 60% have proceeded with implementing IFRS 9. Others have used the temporary exemption to adopt the standard simultaneously with IFRS 17. To be prepared, however, several respondents with temporary extensions have taken steps to implement IFRS 9 and are currently in the design phase. Of all respondents (both those proceeding to implement and those with a temporary exemption), 45%¹ said they expect to be ready for full IFRS 9 reporting in the next three to six months, while 34% said they would be ready in six months to a year.

Implementation Challenges Exist

The new impairment model based on ECLs is significantly different from the previous incurred loss model. As shown in Figure 1, of 20 responses, 45% said the number one reported challenge was having an appropriate methodological approach for calculating the ECLs, and 40% pointed out forecasting data and implementation costs.

Multiple Approaches Are Being Used

The estimation of probabilities of default (PDs) (a view on the probability that a bond issuer will not pay when due) is particularly challenging given the need to have a point-in-time (PiT) view of default risk, which is forward looking until a bond matures. Matters are further complicated by data scarcity, as asset classes to which insurers are typically exposed are considered low-default portfolios, where the number of historical defaults is very low or non-existent.

When asked how they have calculated, or are planning to calculate, the PDs for IFRS 9 purposes:

Loss given default (LGD) estimation (a view on post-default recovery prospects) is considered more difficult than the estimation of PDs. Many institutions struggle with developing sound methodologies, and often settle on the use of average historical losses as indicators of future expected losses. This simplified approach is not well suited for IFRS 9 purposes since averages, by definition, are not PiT nor supported by empirical evidence.

Finally, when asked how they have estimated, or are planning to estimate, lifetime PDs for IFRS 9:

Several Indicators Will be Used to Identify a Significant Credit Deterioration

An important element in the calculation of the ECL is the assessment of whether there has been a significant increase in credit risk since initial recognition. If this has happened, an entity is required to recognize lifetime ECLs rather than just the 12-month ECL. The switch assumes there is a heightened PD throughout an asset’s whole lifetime, instead of only within the next 12 months.

When asked what indicators they have used, or plan to use, to identify a significant credit deterioration:

Some System Changes Will Be Necessary

IFRS 9 is more than a simple change in accounting practices and may require adjustments to data management systems and internal controls.

When asked what disclosure items will require additional effort and changes to systems and data of financial entities:

• 70% said quantitative and qualitative information needed for ECLs.
• 20% said credit risk concentrations to assess credit risk exposure.

Getting it Right

Insurance companies must consider analytical tools for IFRS 9 that are robust, efficient, and transparent. An incomplete approach to new accounting standards could negatively impact the P&L and expose companies to the risk of lengthy discussions with auditors.

Click here for more information on our suite of IFRS 9 solutions to help you comply with credit impairment requirements.

¹ A subset of the 40 respondents completed each question.