COME Jan 1, 2021, insurance and takaful companies will have to apply a new accounting standard, known as International Financial Reporting Standard 17 (IFRS 17), which will ultimately change the way they recognise revenue and profits from insurance contracts.
IFRS 17, or MFRS 17 as the Malaysian equivalent is known, represents the most significant change to insurance accounting requirements in 20 years.
“It demands a complete overhaul of insurers’ financial statements. It affects mainly life insurers because theirs are long-term contracts. For general insurers, the financial impact is much less although their disclosure requirements are also increased,” EY’s Asia-Pacific IFRS 17 implementation leader Martyn van Wensveen tells The Edge during a joint interview with Brandon Bruce Sta Maria, EY Malaysia’s insurance leader.
It’s an impactful change for insurers as it will affect many areas, from actuarial models, accounting systems, product design and financial statements to taxation and operations.
It would mean insurers having to make fundamental changes, especially to their systems, which is expected to be time-consuming and costly.
This, in turn, raises questions on whether MFRS 17 may eventually lead to insurance products becoming more costly for the end-consumer, and whether it has the potential to spur further consolidation in the industry when combined with other challenges the industry is going through.
But what is MFRS 17? In a nutshell, it requires that the revenue (primarily premiums) and profit earned from the insurance contract be recognised over the period that the insurer provides coverage. Insurers do so by amortising unearned profits on a straight-line basis over the lifetime of a contract.
“It requires you to basically calculate how the revenue from the contract is spread over time, and to take your profit over the same time period. So, the general effect of IFRS 17 is that it spreads the revenue as well as the profit over the lifespan of a contract ... as opposed to the current practice of taking most of the profit on Day 1. This is reasonable and is in line with what all other industries [with long-term service contracts] are already doing,” Sta Maria explains.
It, however, raises certain challenges for the insurance companies. For one, it will have an impact on their profit statement, especially in the first year of implementation.
“The challenge from a company’s point of view is that, at the end of the day, if the underlying economics don’t change — that is, the risk is the same and the premium is the same — it should, after the, say, 20 or 30-year lifespan of the contract, generate the same profit. (But) management and investors generally prefer profit now rather than later. So, the question is if the market will recognise that the economic fundamentals of the business have not changed, and so the valuation of the company should also remain the same,” van Wensveen points out.
MFRS 17 also impacts companies in other ways.
“There are a lot of practical implications. For example, typically, the marketing budget that insurers have for new products is often dependent on the anticipated first-year revenues generated by that product. If the first-year revenues are now going to be half or less than what it was before [because of this new accounting standard], does the insurer now have to halve its marketing budget even though the profit is still the same over time?” van Wensveen says.
“Another example — management used to be primarily rewarded on the basis of written premiums. But under the new standard, premiums will be less relevant as a performance metric and will replaced by this new concept of profit-over-time, which is called contract service margin. So, management’s remuneration contracts will now have to be changed too,” he adds.
MFRS 17 will also see insurers having to unbundle the “investment” components from certain insurance contracts. This is because some insurance contracts come bundled with investment components.
“In order to correctly measure the cash flows related to the insurance contract, distinct investment components, embedded derivatives and other distinct performance obligations within the insurance contract will need to be separated. These components will need to be considered for measurement under different standards, such as IFRS 9 or IFRS 15. For life insurers in particular, this will take quite a bit of effort and while it is not expected to alter the definition of insurance contracts at the product level, certain contracts at the individual policy level may fail the test now under MFRS 17. The accounting considerations moving forward will no doubt become more complex,” Sta Maria says.
Though complex, MFRS 17 is nevertheless seen as a positive development for the industry. It will make things more transparent and easier for the investor to compare an insurer’s performance with another, regardless of their jurisdiction.
Currently, there is no one standard for insurance contracts that the industry follows. “If the insurer now has to split the contract in an underwriting and investment component, the investor can very easily see in the financial statements which are the companies that are making most of their profit from the investment margin as opposed to being good underwriters. As an investor, I might not want to invest in an insurance company that makes most of its profit on investments because there are other companies out there that are much better at that,” remarks van Wensveen.
According to Malaysian Accounting Standards Board (MASB) chairman Mohamad Raslan Abdul Rahman, MFRS 17 will “help investors and others better understand insurers’ risk exposure, profitability and financial position”.
What is clear is that actuaries — or the people within insurance firms that compile and analyse statistics and use them to calculate insurance risk and premiums — are expected to become increasingly important to insurers.
The cost of compliance with MFRS 17 is significant, resulting in smaller companies potentially struggling with it. Half the compliance cost is expected to comprise investment in systems, says van Wensveen.
“There are about 4,500 insurance companies in the world that have to follow this new standard; of those, 500 are listed companies that have even more onerous reporting requirements. The top 10 global life insurance companies, combined, are expected to spend in excess of US$2 billion on this new standard. The general consensus in Malaysia is that for the smaller life insurance companies, the minimum spend will be between RM5 million and RM10 million, whereas the larger listed companies are expected to be spending up to RM40 million. So, it’s a very expensive and very impactful change indeed,” he adds.
Will insurance products then become more expensive for the consumer? “For new products that an insurer issues, that could potentially happen as they may factor additional costs into the equation. But then again, that strategy may be counter-productive as it could make the insurer less competitive, so it remains to be seen whether they’ll do that or not,” says Sta Maria.
He believes Bank Negara Malaysia, which wants to see the insurance penetration rate in the country raised, will keep a watchful eye on that. “I’m sure Bank Negara will not allow arbitrary increases in price without appropriate justification or support,” he opines.
Are the insurers ready?
The International Accounting Standards Board issued the IFRS 17 standard on May 24, 2017, while the MASB issued the local standard a few months later on Aug 15.
At this point, it leaves insurers in Malaysia roughly 2½ years to get ready for MFRS 17.
“It seems like a long window, but it’s really not because companies only have until end-2019 to design, build, test and implement all their system changes, as the transition adjustment and opening balance must be calculated effective Jan 1, 2020, in order to derive the first-year comparatives. Furthermore, insurers will also need to adapt to a series of other accounting standard changes — MFRS 9 (financial instruments) and MFRS 15 (revenue recognition from non-insurance contracts), which are effective from this year and MFRS 16 (leases), effective Jan 1, 2019.”
“Starting implementation programmes early can help insurers seize new MFRS 17 market opportunities, aside from having enough time to redesign their products and reshape their business model and financial performance to be more MFRS 17 resilient, without unknown surprises,” van Wensveen says.
It is understood that Bank Negara has been closely tracking the industry’s preparation for MFRS 17, requesting regular implementation plan updates and preparing for testing later this year.