IFRS 4 Phase II and Solvency II
Insurance regulation meets insurance accounting standards
By Thorsten Hein, Global Insurance Industry Consultant, SAS
In addition to Solvency II, which went live January 2016 in the European Union, another regulation will soon change the face of the insurance industry – IFRS 4 Phase II (which is planned to be renamed IFRS 17 Insurance Contracts in 2017), issued by the International Accounting Standards Board (IASB).
The objective of Phase II is to improve financial reporting by providing more transparent, comparable information about:
- The effect of the insurance contracts on financial performance.
- The way by which entities earn profits or incur losses, through underwriting services and investing premiums from customers.
- The nature and extent of risks that companies are exposed to as a result of issuing insurance contracts.
Phase II (starting in 2020) will introduce additional requirements regarding calculation and disclosure of various financial measures.
The goal is to ensure “high quality, understandable, enforceable and globally accepted financial reporting standards based upon clearly articulated principles” to improve transparency and comparability of insurers’ financial statements, regardless of sector, geography or products.
In a similar vein, Solvency II’s goal is to establish a common regulatory framework to maintain capital adequacy and risk management standards for those who operate in the EU. The aims of IFRS and Solvency II are to facilitate comparability and transparency from a regulatory and accounting perspective to external stakeholders, in contrast to the divergent practices and measures which currently characterize insurance reporting.
Clear and transparent communications will help stakeholders navigate their way through the changes to regulatory and statutory reporting, increase confidence, and help mitigate any adverse impacts on share prices and ratings.
Solvency II and IFRS 4 Phase II: Differences and similarities
For insurers trying to implement these changes, it’s important to understand the differences between these two regulatory frameworks:
- Solvency II will lead to competitiveness of the products in terms of their pricing and features offered by insurers with a focus on an enhanced level of policyholder protection and solvency capital requirements. IFRS 4, on the other hand, aims to apply uniform accounting standards for all types of insurance (and reinsurance) contracts and also to reduce the gap between standards followed in insurance. IFRS 4 reporting will also be more transparent due to stringent disclosure requirements.
- Solvency II specifies the risk-free rate as well as liquidity premium, but under IFRS 4, there is no such restriction on liquidity premium.
- Although the principles-based approach will be adopted in both regulations, Solvency II measures are more prescriptive and comprehensive as compared to IFRS 4.
- Profits are recognized immediately at the inception under Solvency II, while under IFRS 4 profits will be recognized over the life of the individual insurance contract.
- Unlike Solvency II, general overheads will not be allowed in cash flows under IFRS 4 Phase II.
There are similarities between the two frameworks that insurers will need to carefully consider when developing an approach for implementation of both the directives:
- Solvency II and IFRS 4 Phase II place emphasis on the insurer’s own assessment and management of risks facing the business. In both directives, there is a departure from the narrow and prescriptive rules and adoption of a broader and more risk- and principles-based approach to regulation.
- Asset and liabilities are likely to use a current valuation approach, which is expected to increase volatility on financial statements in comparison to current standards.
- A best-estimate basis is used in expected future cash flows. Discount rate used is the sum of risk-free rate and liquidity premium.
The synergy of a coordinated approach
For insurers it makes sense to take a coordinated approach for the implementation of both directives given the significant overlaps in the requirements. There is no requirement for consistency between regulatory and financial reporting, but there are significant overlaps in both the measurement and disclosure requirements between frameworks.
Performance management changes
Given the similarities in the regulations, insurers will need to improve their understanding of the differences between Solvency II and IFRS in order to effectively manage their business. For example, the primary focus for Solvency II is capital adequacy rather than profitability management. Your finance unit can help you negotiate this challenge by explaining the differences between the summarized margin approach from IFRS 4 Phase II and the profit-and-loss attribution under Solvency II.
Business planning and forecasting models will need to align with the new external reporting requirements and models for evaluating potential investments and acquisitions. Informing and educating external stakeholders, including analysts, will be a major challenge during the transition period. Clear and transparent communications will help stakeholders navigate their way through the changes to regulatory and statutory reporting, improve confidence, and help mitigate any adverse impacts on share prices and ratings.
Minimizing the impact on systems and data
Both frameworks require insurers to invest in data quality, control and management. The content and structure of data captured from business units to support group statutory and regulatory reporting will change significantly. This will require major changes to group financial consolidation and reporting systems.
In addition, changes to the primary financial statements and disclosures will affect the general ledger and chart of accounts at the group and business unit levels. You will also need to consider solutions for supporting parallel reporting of IFRS 4 Phase I and Phase II results during the transitional period and provide Solvency II, local GAAP and local regulatory reporting (as required) on an ongoing basis.
The data requirements for IFRS 4 Phase II are similar to Solvency II and address many of the potential data gaps of Phase I (e.g., data to model future premiums, participation benefits, options and guarantees). Solvency II also requires insurers to invest in data quality, control and management; however, there are differences in the detail (e.g., the definition of a portfolio, contract boundaries and unbundling). A key challenge will be to ensure that these different types of data are available and that systems have the flexibility to accommodate differences in the inputs to cash flows between the two frameworks.
Process and governance considerations
Under IFRS 4 Phase II, accounting policies will need to be standardized and you will need to ensure that the compliance processes are auditable. IFRS 4 Phase II has raised the benchmarks in terms of governance and quality of documentation required to facilitate a smooth audit sign off. But insurers will also need to conform to the governance and control framework in Solvency II in terms of policies, assumptions and calculation methods.
Reporting and disclosure differences
Insurers will need to take care when planning a common approach to reporting and regulatory disclosure standards for both sets of requirements. Despite similarities between IFRS 4 Phase II and Solvency II, there will be challenges in implementation. You may need to consider different approaches when reporting the organization risk profile (i.e., IFRS 4 versus Solvency II). Detecting those differences will require a mature understanding of the insurance business as well as accounting, reporting and disclosures for a smooth implementation.
The challenges ahead
Although the details (identification of contracts, approach to calculations, reported measures, responsibilities, etc.) are different, the basic requirements regarding data, structures, auditability and traceability of processes and supporting systems are similar. Both regulations require the implementation of an end-to-end approach using an integrated framework. An integrated approach will also be needed to best support the reconciliation between external, management and regulatory reporting for both IFRS 4 Phase II and Solvency II.
Unfortunately, organizations that have not yet implemented Solvency II, can’t benefit from any of these synergies. And IFRS 4 Phase II will likely pose even greater implementation challenges.
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To learn more about Solvency II and its effect on the insurance industry, download our paper: Solvency II compliance and beyond: The essential steps for insurance firms.