In July 2020, Milliman professionals published the research report “Reinsurance as a capital management tool for life insurers,” written by consultants Eamon Comerford, Paul Fulcher, Rik van Beers, and myself.
Capital management is an increasingly important topic for insurers as they look to find ways to manage their risks and the related capital requirements and to optimise their solvency balance sheets. Reinsurance is one of the key capital management tools available to insurers. The paper investigates common reinsurance strategies, along with new developments and innovative strategies that could be implemented by companies. This blog post is one of a series being released in relation to this research. Each blog post will give an overview of a certain section of the Milliman report.
Reinsurance and IFRS
The new International Financial Reporting Standards (IFRS) accounting standard for insurance contracts, IFRS 17, is expected to have an effective date of 1 January 2023. This will change the accounting treatment of reinsurance contracts under IFRS reporting. IFRS 17 requires a reinsurance contract to be accounted for separately from the underlying insurance contract, which hasn’t previously been the case under IFRS 4.
Both insurance contracts and reinsurance contracts held will have a separate contractual service margin (CSM) on the balance sheet, which is a mechanism to spread profit over the lifetime of the contract.
The separate accounting treatment of reinsurance and insurance contracts will mean that there may be earnings volatility due to mismatches between the accounting treatment of the contracts.
Accounting mismatches may occur in a number of areas:
- The underlying insurance contracts and reinsurance contracts may have different terms, which may lead to different measurement models being used to value them. If the coverage period of a reinsurance contract is one year or less, it may also be possible to model the reinsurance contract under the premium allocation approach. A mismatch will occur if the underlying insurance contracts are modelled using the general measurement model.
- Differences in contract boundaries can occur between reinsurance contracts and the underlying insurance contracts. Reinsurance contracts often have cancellation clauses where contracts can be cancelled prematurely, leading to instability in financial results.
- Aggregation of contracts into units of accounts may also differ between insurance and reinsurance contracts. Insurance contracts may only be aggregated into cohorts that are incepted no more than one year apart, whilst reinsurance contracts may cover many years of insurance contracts.
- Coverage units used to allocate the CSM over an accounting period may differ between the underlying insurance contracts and the reinsurance contracts, which may result in differences in the timing of profit and loss recognition.
- The CSM of the reinsurance contract can be both positive and negative, but the CSM for an insurance contract must be positive or floored at zero. Losses from onerous groups of insurance contracts are recognised immediately in the profit and loss (P&L) statement. Onerous reinsurance contracts can have a negative CSM which is spread over the lifetime of the reinsurance contract. This can lead to an accounting mismatch between the reinsurance contracts and the reinsured portfolio.
- Inception dates of reinsurance and reinsured portfolios often differ as reinsurance is taken out after insurance contracts have been written. This will lead to different locked-in rates being used to value contracts, leading to a mismatch in finance income and expenses.
- The separate presentation of insurance and reinsurance contracts can lead to balance sheet accounting challenges. The risk adjustment is the compensation that an entity requires for bearing the uncertainty about the amount and timing of nonfinancial risks. The risk adjustment of the reinsurance contract is not netted against the risk adjustment of the underlying insurance portfolio. This leads to the question of how to allocate diversification benefits to the reinsurance contract.
As a result of changes in financial reporting impacts, including possible additional earnings volatility, some insurers may require some elements of reinsurance treaties to be commuted or rewritten (where possible) to remove some of this earnings volatility. This will affect both internal and external reinsurance contracts and will depend on the reinsurance treaty terms.
As insurers develop familiarity with IFRS 17 reporting requirements, their appetite for reinsurance solutions
Insurers taking out new reinsurance contracts for capital relief should also consider the impact on financial reporting in addition to capital optimisation.
Milliman research paper
The full research paper can be found on Milliman’s website here. At the same site, you can also find an executive summary version that notes some of the key highlights of the research and acts as a guide to the full paper.