Modest slowdown in premium growth distinguishes second-quarter financial results for MPL specialty insurers
We look at the financial results for medical professional liability (MPL) insurers for the second quarter of 2022.
Under IFRS 17 the liabilities for your insurance business comprise the Best Estimate of Liabilities (BEL), Risk Adjustment (RA) and the Contractual Service Margin (CSM). For companies reporting under Solvency II, the IFRS 17 BEL will most likely be similar to the Solvency II BEL, although with possible differences in assumptions (discussed in section 6 below). The RA is a concept similar to the Solvency II Risk Margin, though the calculation technique used may be different (this is discussed further in section 7 below). The CSM, however, is a completely new concept, which would not have been seen or used before. There may also be differences in asset valuations arising from the implementation of IFRS 9, and the impact of asset and liability valuation differences could result in a new level of IFRS equity.
The CSM represents the profits not yet earned for each group of contracts (contracts are grouped by portfolio, profitability and cohort—see section 5 below for more details).
It is calculated at contract inception as the difference between the fulfilment cash flows and present value of premium, so that on day 1 the profit is zero. The future profits are then spread over the future lifetime of the contracts as the CSM is released through the P&L (the value of the CSM before it is released to P&L can change due to for example new contracts being added to the group, interest accretion and absorption of changes in fulfilment cash flows relating to future service).
The amount of CSM released to the P&L each period is determined based on the coverage units in the period. The coverage units are determined for each contract by considering the quantity of the benefits provided under a contract and its expected coverage period.
The CSM cannot be negative for gross of reinsurance business, meaning an insurer will have to recognise losses immediately in its P&L. In addition, a loss component will need to be established and tracked—the tracking of this will bring additional challenges.
The models or systems used to calculate the CSM can be complex, and therefore require rigorous testing and validation.
The Statement of Financial Performance will include the new presentation of P&L and Other Comprehensive Income (OCI). Companies can make an accounting choice on whether to disaggregate the impact of market movements and include them in OCI instead of the P&L—this may reduce volatility in reported profit or loss and allows insurers to manage the volatility across P&L and OCI.
The new P&L will have a completely different format—there is nothing comparable in other reporting regimes (e.g., Solvency II). It will require input from multiple stakeholders (actuarial as well as finance teams), will require consistency between all sources (e.g., actual versus expected cash flows) and will need to ensure any approximations and adjustments used in the balance sheet also work for the P&L.
Figure 2 illustrates how changes in the value of the insurance contract liabilities flow to the CSM, P&L and OCI.
An Analysis of Change (AoC) is used to determine these flows to the CSM, P&L and OCI. So for IFRS 17, the AoC is more than just a way of validating the balance sheet, it defines the reported profit in a reporting period. Therefore a robust and efficient process is required to produce the AoC.
The importance of the AoC means that the BEL model needs to produce meaningful cash flows over one year (or even shorter for interim reporting). This can expose model limitations that are appropriate in terms of discounted value (especially at low yields) but are not reliable in terms of cash flow timing. For example, assumptions regarding the payment of outstanding claims may be appropriate for calculating the BEL cash flows but may not be accurate enough to achieve meaningful actual versus expected comparisons.
In addition, any out-of-model adjustments need to explicitly consider the supporting cash flows and careful consideration is required when reflecting adjustments in the AoC (and ultimately the current year’s profit).
The key decisions and considerations needed prior to implementation are:
We discuss each of these in turn in the following sections.
IFRS 17 applies to insurance and reinsurance contracts issued, reinsurance contracts held and investment contracts with discretionary participation features.
An insurance contract is defined in IFRS 17 as “A contract under which one party (the issuer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder.” Companies will need to consider all of their business and determine which contracts, if any, fall into this definition, and therefore are in scope for IFRS 17.
An insurance contract might contain components that would be within the scope of another standard if they were separate contracts. These components need to be identified.
There are three measurement approaches which can be used for valuing your insurance liabilities. The choice of approach depends on the type of insurance contracts being considered:
Under IFRS 17, the CSM and hence profits are calculated at an aggregated ”group” level (unit of account). Contracts are required to be grouped in the following way:
This grouping will need to be tracked and maintained, which could require significant data and/or model developments. This level of granularity can also make it more difficult to analyse results.
A similar approach to the Solvency II BEL may be used to calculate the best estimate cash flows for IFRS 17, where the assumptions used are current best estimate. However, there may be some differences in the definition of the assumptions:
The RA for nonfinancial risk reflects the compensation an entity requires for bearing the uncertainty about the amount and timing of the cash flows that arises from nonfinancial risk as the entity fulfils insurance contracts. IFRS 17 does not specify a method or confidence level for calculating the RA. Each company must decide which risks are in scope and the confidence level, which should be based on the company’s own view of risk.
Some possible methods that can be used to calculate the RA include the value-at-risk, conditional tail expectation and cost of capital methods. The value-at-risk method will be familiar to companies that already adhere to a shock-based capital framework such as Solvency II. This is an approach similar to the Solvency Capital Requirement (SCR) calculations. However, in the Solvency II standard formula, the SCR is calibrated at a 99.5% confidence level over a one-year time horizon. Therefore, companies may need to recalibrate these shocks for a lower confidence level and multiyear time horizon under IFRS 17. Alternatively, companies may decide to use a cost of capital method to leverage the Solvency II Risk Margin calculations.
Confidence level equivalents will need to be disclosed if an alternative technique is used, which may be a challenge as it is rare for companies to determine the distribution of outcomes. This may need the use of updated actuarial models to achieve.
The choice of RA method will have an effect on how future profits will flow to the P&L—a lower or higher RA will lead to a higher or lower CSM. These impacts should be considered when choosing the method and confidence level to calculate RA.
The RA is released in the P&L each period as the risk exposure runs off.
Companies implementing IFRS 17 are required to disclose the impact on the balance sheet of transitioning to IFRS 17 in their first set of financial statements. The impact is calculated at the ”Transition Date,” which is “the beginning of the annual reporting period immediately preceding the date of initial application.” This is to enable the company to provide at least one year’s comparative information in its first set of accounts. Therefore, for a company applying IFRS 17 from 1 January 2023, the Transition Date is 1 January 2022.
The Full Retrospective Approach (FRA), i.e., an approach assuming that IFRS 17 had always applied, should be used unless it is impracticable to do so. This will require a full history to the date of transition for data and assumptions.
If the FRA is impracticable, companies can choose to either use the Modified Retrospective Approach (MRA) or the Fair Value Approach (FVA). The MRA allows for simplifications to the FRA to address data limitations, but it still has many practical challenges for implementation. For example, information on the actual historical cash flows from initial recognition are required—while using the actual historical cash flows does simplify things the data may not be readily available, particularly at the unit-of-account level (i.e., grouping by portfolio, profitability and annual cohort) The FVA may be simpler to apply than the MRA as it is a prospective calculation. This approach involves determining the CSM at the Transition Date as the difference between the fair value of the insurance contract at that date and the fulfilment cash flows measured at that date. However, the FVA can lead to a lower CSM. The practicalities, along with the resulting CSM, will need to be weighed up as a company decides on which approach to adopt.
Further details on the practical challenges with each of the transition approaches can be found in the following article: IFRS 17: Transition practical issues.
IFRS 17 will bring a lot of change—there are new ways of reporting results, completely new concepts and many modelling challenges. A lot of work is required to get ready for implementation and companies are likely to be busy over the coming months getting their models and systems ready for the implementation date of 1 January 2023.
More information on Milliman insights, products and services related to IFRS 17 can be found at: https://www.milliman.com/en/insurance/ifrs-17