Companies implementing International Financial Reporting Standard (IFRS) 17 are required to disclose the impact on the balance sheet of transitioning to IFRS 17 in their first sets 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 companies to provide at least one year’s comparative information in their first sets of accounts. Therefore, for a company applying IFRS 17 from 1 January 2023, the Transition Date is 1 January 2022. As this transition date has now passed, companies should be well underway with their transition calculations. Some companies are aiming to finalise their transition results around the middle of this year, and it is expected that listed insurers will give indications of the likely impacts of transition to IFRS 17 to the market later in the year. This article discusses some of the practical issues companies are finding with the transition calculations.

The first issue with transition calculations is deciding on which method to use. IFRS 17 requires that the Full Retrospective Approach (FRA), i.e., the approach assuming that IFRS 17 had always applied, should be used unless it is impracticable to do so. If it is impracticable to use the FRA, then there is a choice between the Modified Retrospective Approach (MRA) and the Fair Value Approach (FVA).

Full retrospective approach

Some life insurers have found it impracticable to use the FRA for annual cohorts of business older than a couple of years. The main issue companies have had is finding the required data, at the required granularity, to be able to calculate the current contractual service margin (CSM) as if IFRS 17 had been in force from initial recognition of each contract.

In order to do this, companies will need to have the expected cash flows from the date of initial recognition for each contract—this will require historical datafiles, historical assumption sets including discount rates and possibly also historical models, which may have since been updated and are no longer available.

The granularity of the data needed may also pose a problem—the calculation of CSM will be needed at the unit-of-account level (i.e., by portfolio, profitability and annual cohort), which may not be easily available from historical information, as this level of granularity would not typically have been needed prior to IFRS 17.

The issue of hindsight is another challenge. The FRA is considered to be impracticable if it is not possible to calculate past estimates without the use of hindsight, i.e., the estimates must be based on historical circumstances and shouldn’t take into account changes in management intent or policies since then.

Modified retrospective approach

If a company decides to use the MRA there are simplifications which can help to alleviate some of the issues with the FRA, but this method still has its practical challenges.

There is a simplification to estimate the expected cash flows at initial recognition. For this simplification, however, all of the actual cash flows which have occurred from initial recognition to the transition date are needed, and this data may not be readily available, particularly at the unit-of-account level (i.e., grouping by portfolio, profitability and annual cohort).

There is a simplification for the grouping of contracts, where contracts issued more than one year apart can be grouped together, but they are still subject to grouping by portfolio and profitability. However, this may lead to a challenge with the discount rates to use. For example, if all business sold between 2007 and 2021 was grouped together, a decision would need to be made on which inception discount rates to use for the group—discount rates at 2007, at 2021 or maybe at the midpoint? These rates may vary significantly and have a big impact on the result.

The simplifications which can be used for the MRA are prescribed by IFRS 17 and many companies feel they are too restrictive. For example, some companies may have enough data to make an estimate of the CSM which would be in line with the FRA, but this is not permitted if simplifications not specified by the MRA are used.

Another issue companies are struggling with for both the FRA and MRA is obtaining information for historical coverage units. Often even if historical finance cash flows are available they won’t include historical policy counts or sums assured, which may be used to calculate coverage units. The projection of coverage units can have a big impact on the CSM at transition.

Fair value approach

Under the FVA, the CSM at the transition date is calculated as the difference between the fair value, calculated in accordance with IFRS 13, and the IFRS 17 fulfilment cash flows calculated at the transition date (i.e., the sum of the IFRS 17 Best Estimate Liability and Risk Adjustment).

The practical challenge in using the FVA is in deciding on the areas of judgement in the method to be used. A direct or an indirect method may be used, though in practice most companies will use an indirect method.

• A direct method involves using available market transaction data and taking the price and/or value implied by these market transactions to determine directly the implied fair value of the liabilities. For example, an active market for annuity business could be used if it exists.
• An indirect method involves using a standard valuation technique to determine a proxy fair value, or an estimate of the price at which an orderly transaction might take place.

Judgement will be needed to select the technique to use for an indirect method. Some options include: Solvency II Technical Provisions with an adjustment, IFRS 17 fulfilment cash flows with an adjustment or an Embedded Value approach. An important decision with any method is the approach to use for the allowance for risk—possible options include a cost of capital approach, and a confidence level approach. Within these options, decisions are needed on the cost of capital rate, and which risks to include—for example, whether to include market risk in the allowance for risk.

Judgement will also be required in areas of the fair value calculation such as the level of expenses to include (under FVA expenses may be based on an average market level of expenses rather than the entity’s own expenses), the contract boundaries to apply (under FVA there is scope to take a more economic approach to contract boundaries compared to Solvency II and IFRS 17) and the level of discount rates to use.

The decisions made in calculating the fair value will have consequences for the future calculation of IFRS 17 results. For example, if future premiums are included in the fair value, and hence in the CSM of existing business, then they shouldn’t be treated as new business, with a new CSM, in the IFRS 17 results. Careful consideration is needed in the areas of judgement applied.

Conclusion and other considerations

In conclusion, there are practical challenges with each of the methods which can be used for the transition calculations. The FRA must be used unless it is impracticable to do so. If the FRA is deemed impracticable, the company must be able to evidence why it is impracticable. If a company is choosing between the MRA and FVA, as well as considering the practical challenges with each, the company should also consider the level of the resulting CSM and impact on equity at transition. The FVA may be simpler to apply than the MRA, but both approaches can lead to different answers. For example, the FVA can lead to a lower CSM, and in some cases, where the FRA or MRA would give a negative opening CSM (i.e., loss component), the FVA can give a positive opening CSM. All of this needs to be weighed up as a company decides on which approach to adopt.

Companies are likely to be busy with finalising their transition calculations over the coming months—this will involve engagement with key stakeholders to ensure they understand the outcome and impact on opening equity and future profits and to ensure the approaches used are aligned with market practice.

More details on each of the transition approaches can be found in the following Milliman research paper:

• Transition to IFRS 17

More details on the FVA, and FVA versus MRA for recent new business, can be found in the following papers:

• IFRS 17: Fair Value Approach to Transition
• IFRS 17: Fair Value Approach to Transition: Options and Market Review
• Transition: MRA or FVA for Recent New Business?

To discuss how Milliman can help with your transition calculations or any aspect of your IFRS 17 project please contact your usual Milliman consultant or Andrew Kay or Gillian Tucker.

More information on Milliman insights, products and services related to IFRS 17 can be found at: https://www.milliman.com/en/insurance/ifrs-17