Interaction With IFRS 9 And IFRS 15 IFRS 17 Insurance .

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EFRAG TEG meeting27 September 2018Paper 07-03EFRAG Secretariat: Insurance teamThis paper has been prepared by the EFRAG Secretariat for discussion at a public meeting of EFRAGTEG. The paper forms part of an early stage of the development of a potential EFRAG position.Consequently, the paper does not represent the official views of EFRAG or any individual member of theEFRAG Board or EFRAG TEG. The paper is made available to enable the public to follow the discussionsin the meeting. Tentative decisions are made in public and reported in the EFRAG Update. EFRAGpositions, as approved by the EFRAG Board, are published as comment letters, discussion or positionpapers, or in any other form considered appropriate in the circumstances.IFRS 17 Insurance ContractsInteraction with IFRS 9 and IFRS 15Objective1The objective of this paper is to highlight the interaction of IFRS 17 InsuranceContracts with:(a)IFRS 9 Financial Instruments (Part A); and(b)IFRS 15 Revenue from Contracts with Customers (Part B).Introduction2IFRS 17 is effective from 1 January 2021. An insurer can choose to apply IFRS 17before that date but only if it also applies IFRS 9.3The paper considers components of IFRS 9 and IFRS 15 that are relevant to theendorsement of IFRS 17. Where relevant, findings from the case studies and theuser outreach are integrated in the paper. Additional information from the extensivecase study is included in Appendix I.4This paper is based on the following as the most likely scenarios:(a)entities have deferred IFRS 9 and will implement IFRS 9 together withIFRS 17.(b)Unless stated otherwise, the discussion regards the General Model and thePremium Allocation Approach (PAA) as having the same outcome, as eitherthere is no material difference between the two or the insurance contractsliability matures in the short-term.EFRAG TEG meeting 27 September 2018Paper 07-03, Page 1 of 21

IFRS 17: Interaction with IFRS 9 and IFRS 15A - INTERACTION OF IFRS 17 WITH IFRS 95This part comprises:(a)Overview;(b)Measurement;(c)Asset liability management; and(d)Transition.Overview6As a result of applying IFRS 9, financial assets are measured at either amortisedcost or fair value. When financial assets are measured at fair value, gains and lossesare recognised either in profit or loss (fair value through profit or loss), or in othercomprehensive income (fair value through other comprehensive income (OCI)).7IFRS 17 requires insurers to discount their insurance contract liabilities using acurrent interest rate and the effect of changes in that interest rate can be reportedin profit or loss. Thus, the income and expenses reported in profit or loss, as a resultof changes in current interest rates, are expected to offset, to the extent theinsurance liabilities are economically matched with the relating assets, the volatilityin profit or loss that may arise from financial assets accounted for at fair valuethrough profit or loss.8IFRS 9 allows all entities, including insurers to elect to measure financial assets atfair value through profit or loss where this addresses an accounting mismatch. Thisis important as insurers typically seek to minimise accounting mismatches1.Measurement9Generally, measurement possibilities of financial assets and insurance liabilitiescould be illustrated as follows:Financial assets (in accordance withIFRS 9) Amortised cost (if it passes boththe business model and the SPPItest) FVPL 10Insurance liabilities (in accordancewith IFRS 17)Fulfilment valueFVOCI (with recycling – debt measurement)instruments)(acurrentvalueFVOCI (without recycling – equityinstruments)When applying IFRS 17, changes that relate to future insurance coverage arerecognised by adjusting the contractual service margin (CSM)2 and changes thatrelate to past insurance coverage will be recognised in profit or loss. As a result,upon recognition in profit or loss, measuring assets backing insurance contracts atfair value and measuring insurance obligations using current estimates consistentwith relevant market information reduces accounting mismatches.Defined as differences arising if the values of assets and liabilities respond differently to changesin economic conditions.12This will be recognised in profit or loss only over time.EFRAG TEG meeting 27 September 2018Paper 07-03, Page 2 of 21

IFRS 17: Interaction with IFRS 9 and IFRS 1511Both IFRS 9 and IFRS 17 include options to reduce accounting mismatches.Whereas IFRS 9 allows entities to elect to measure financial assets at fair valuethrough profit or loss where this addresses an accounting mismatch, IFRS 17 allowsentities to make an accounting policy choice between:(a)including insurance finance income or expense for the period in profit or loss;or(b)disaggregating finance income or expense between profit or loss and OCI.Evidence from case studies and economic study12Under the extensive case study, respondents were asked to identify the relatedassets of the portfolios included and how these are accounted for today and underIFRS 17/IFRS 9. Some respondents indicated the measurement bases they areusing (see paragraph 19 of Appendix I).13Half of the respondents did not know whether IFRS 17 would result in a change ininvestment strategy. The remaining respondents had split views about the issue.14Respondents to the simplified case study were divided as to whether IFRS 17 wouldaffect their current investment strategy. It was noted that economically risks areunchanged by the introduction of IFRS 17, but the accounting would make theserisks more visible than today. For those that expected an impact, it was due to thedesire to reduce capital requirements under Solvency II as well as any volatility inprofit or loss for accounting purposes.15In the economic study commissioned by EFRAG it has also been noted that:(a)Although there is considerable discussion about insurers moving away fromdebt securities towards new asset classes and/or equity, the aggregate datafrom EIOPA on the investments of EU insurers do not show a significantmovement out of the debt securities at the EU wide level.(b)The majority of stakeholders interviewed (i.e. supervisory authorities, insurersand external investors) agree that IFRS 17 alone will not impact the assetallocation of insurance undertakings, as this activity is more driven by riskmanagement and/or asset/liability management.(c)However, industry stakeholders expressed the view that the combined effectof applying IFRS 17 and IFRS 9 may have an impact on asset allocation.EFRAG Secretariat analysis16Based on the assets identified in the case studies there will be few changes in thebalance sheet structurally and from an accounting perspective3 under IFRS 17 andIFRS 9. However, for the income statement the EFRAG Secretariat assesses that,when measuring the insurance liability in a way that is consistent with observablemarket information:(a)For financial assets at fair value through profit or loss, the income andexpenses reported in profit or loss under IFRS 17 as a result of changes incurrent interest rates are expected to offset, at least to some extent, thevolatility in profit or loss that may arise from financial assets accounted for atfair value through profit or loss under IFRS 9.(b)For financial assets at amortised cost, the insurer can elect the fair valueoption under IFRS 9 in order to reduce accounting mismatches.(c)For financial assets at fair value through OCI, the insurer can either:However, some respondents indicated that complex bonds and equity-like instruments may beclassified and measured differently under IFRS 9.3EFRAG TEG meeting 27 September 2018Paper 07-03, Page 3 of 21

IFRS 17: Interaction with IFRS 9 and IFRS 15(i)elect the fair value option under IFRS 9 in order to reduce accountingmismatches; or(ii)elect the option under IFRS 17 to disaggregate financial income orexpense between profit or loss and OCI.17Given the few responses, the EFRAG Secretariat has little evidence of equityinstruments that were carried at cost4 and the only available evidence points tobonds being classified as Available-for-Sale (AFS) under IAS 39 FinancialInstruments: Recognition and Measurement. From the economic studycommissioned by EFRAG the EFRAG Secretariat notes that although a significantshift in investments in bonds is not expected, the measurement category mightchange due to the SPPI test under IFRS 9. As noted in paragraph 19 of Appendix I,some respondents to the extensive case study noted that they are currentlyclassifying assets as AFS under IAS 39. For further discussion on equity instrumentscarried at FVOCI under IFRS 9, refer to paragraphs 39-42 and 57-60 below.18In summary, the EFRAG Secretariat notes that although IFRS 17 in itself is notexpected to change the investment strategy of insurers, the combined applicationof IFRS 17 and IFRS 9 might have such an impact.Asset liability management19The degree to which matching insurance liabilities and assets backing thoseliabilities can be successfully matched depends on a number of factors:(a)The use of a dedicated fund of assets or a general fund of assets;(b)The existence of economic mismatches between the assets and the liabilities;and(c)The existence of accounting mismatches between the assets and theliabilities.The use of a dedicated fund or a general fund of assets20Some insurers invest in a dedicated fund where a direct link exist between theassets and the liabilities whilst others make use of a general fund where there is nodirect link between the assets backing the liabilities.Evidence from case studies21The case studies showed:(a)In the extensive case study that, of the nineteen portfolios5, eleven werefunded through a general fund of assets, while eight were funded through ageneral fund of assets.(b)in the simplified case study that half of the respondents held assets that backspecific liabilities whilst the other half generally held assets in a general fund.EFRAG Secretariat analysis22The EFRAG Secretariat notes that one of the conditions for applying the VariableFee Approach (VFA) is that the contractual terms should specify that thepolicyholder participates in a share of a clearly identified pool of underlying items.Consequently, the EFRAG Secretariat envisages that a dedicated fund of assetswill be more prevalent for portfolios accounted for under the VFA than the GeneralModel. Therefore, EFRAG Secretariat acknowledges that using a dedicated fund ofassets allows the insurer to align the characteristics of the assets more closely to4Although one respondent commented that illiquid investments may be measured at cost.5For life insurance portfolios where sufficient information was received.EFRAG TEG meeting 27 September 2018Paper 07-03, Page 4 of 21

IFRS 17: Interaction with IFRS 9 and IFRS 15the portfolio of insurance liabilities that it supports, thereby limiting the degree ofmismatches. In contrast, when relying on a general fund of assets, the assets insuch a general fund support several portfolios of insurance liabilities each withdifferent characteristics. In such a case, it is there will be more mismatches betweenthe assets and the insurance liabilities.Economic mismatches23Insurance entities typically seek to match the characteristics of their assets with theirliabilities to minimise economic mismatches6 between the two. Economic matchingdepends on several factors (for example, the availability of assets of sufficientduration, the uncertainty as to when pay-outs on insurance contracts will berequired, and the insurer’s desire to generate higher returns).Evidence from the case studies24From the extensive case study respondents provided information on the followingeconomic mismatches:(a)Currency mismatches;(b)Eurozone mismatches7; and(c)Duration mismatches.25For three portfolios currency mismatches were quantified. For one portfolio, backedby a dedicated fund, the mismatch was small. The two other portfolios backed by ageneral fund showed much bigger differences, however no conclusions can bedrawn as information on the size of the general fund compared to the tested portfoliowas not received.26For 13 portfolios Eurozone mismatches were reported, and for only three of these,quantitative information was provided.27As an illustration of the potential effect of eurozone mismatches, consider thefollowing market interest rates:Euro Member StateFranceGermanyItalySpainInterest on 30-year government bonds81.63%1.10%3.52%2.58%28Many of these Eurozone mismatches were significant. In particular, respondentsused qualifications such as “most”, “majority” or “mainly” to indicate whether theirassets were held in the same jurisdiction as the corresponding liabilities.29The portfolios that were backed by a general fund of assets showed a significantaverage duration mismatch of 20%. In contrast, portfolios that were backed by adedicated fund of assets showed a much smaller average duration mismatch of 4%.30Based on whether the portfolios were accounted for in accordance with the GeneralModel or the VFA, no other particular trend information could be derived.Defined as differences arising if the values of assets and liabilities respond differently to changesin economic conditions.6Eurozone mismatches refers to mismatches that arise when assets and liabilities are held in thesame currency, but the jurisdictions of the assets held and liabilities issued differ (such as assetsheld and insurance contracts issued in differing countries of the Eurozone).78As at 11 September 2018.EFRAG TEG meeting 27 September 2018Paper 07-03, Page 5 of 21

IFRS 17: Interaction with IFRS 9 and IFRS 15EFRAG Secretariat analysis31The EFRAG Secretariat observed in paragraph 22 that economic mismatches aremore prevalent in cases where portfolios are backed by a general fund as opposedto a dedicated fund. As a clear link between insurance liabilities and underlyingassets is not needed under the General Model, it is more difficult to align thecharacteristics of the assets and the insurance liabilities in order to mitigate volatility.For the Eurozone mismatches, the EFRAG Secretariat obtained evidence that thereis significant variability.32Although the VFA could be applied in cases where entities do not hold theunderlying assets, the EFRAG Secretariat is of the view that in such cases anothereconomic mismatch arises as changes in assumptions of the IFRS 17 liability willbe recognised in profit or loss over time without the recognition of similar changesin assets.33Consequently, the EFRAG Secretariat is of the view that the mismatches identifiedabove do not arise solely from the application of IFRS 17 and IFRS 9 but areeconomic in nature.Accounting mismatches34When applying IFRS 17 and IFRS 9 together, accounting mismatches could arisefrom insurance liabilities measured at a risk-adjusted present value while assetsbacking the liabilities are measured differently. The EFRAG Secretariat assessesthat accounting mismatches can arise in some of the following instances:VFA - Scope35Some insurance contracts have returns based on the fair value of specifiedunderlying items, such as bonds. The insurer and its policyholders share thosereturns, which are affected by market-driven changes in the fair value of the bonds.36The VFA enables insurers to recognise some changes in insurance contractliabilities due to changes in returns by adjusting the CSM, rather than in profit orloss. Absent such an approach, the General Model will have to be applied wheresuch unearned returns would have to be recognised within profit or loss.Evidence from case studies37In its extensive case study, the EFRAG Secretariat noted the following product linesand how they were expected to be accounted for carried under the differentapproaches.General ModelAnnuitiesNon-lifeProtectionReinsurance ceded andheldSavings/ProtectionUnit linkedIndirect participationOtherVFAAnnuitiesSavings / ProtectionUnit linkedOtherPAAMotorOtherEFRAG Secretariat analysis38In conclusion, entities that qualify and apply the VFA and manage their assets andliabilities together in order to reduce economic mismatches can reduce mismatchessignificantly. However remaining mismatches are still present when the GeneralModel are to be applied.EFRAG TEG meeting 27 September 2018Paper 07-03, Page 6 of 21

IFRS 17: Interaction with IFRS 9 and IFRS 15Equity instruments at fair value through OCI without recycling39IFRS 9 allows for equity instruments to be carried at fair value through OCI.However, the amount in OCI will never be recycled in profit or loss apart fromdividends received. If these instruments back insurance liabilities an accountingmismatch can arise as over time the changes in the insurance liabilities will berecognised in profit or loss whereas the changes to any equity instruments backingthose liabilities will never be recycled through profit or loss.Evidence from case studies40Respondents in the extensive case study indicated their proposed accounting forequity instruments in paragraph 19 of Appendix I.41As part of evidence received, concerns have been raised by insurers that in the caseof contracts with participation features, the share of profit of the shareholder isrecognised in profit or loss over the total contract term, while for equity instrumentsat FVOCI the investment income will never be recognised in profit or loss. The lackof recycling is therefore perceived to create an accounting mismatch with themeasurement of insurance liabilities.EFRAG Secretariat analysis42The EFRAG Secretariat notes that the share of profit for the shareholders will berecognised in P&L over the period via the release of CSM to profit or loss.43Furthermore, the option to measure equity instruments at fair value through OCI isan option and not a requirement under IFRS 9. However, the EFRAG Secretariatnotes that the reason for exercising this choice is to mitigate the volatility of the effectof strategic investments within the income statement. Nonetheless, the EFRAGSecretariat is of the view that if those assets are backing insurance liabilities, entitiescould choose to measure such instruments at fair value through profit or loss asopposed to OCI to reduce any perceived opportunity for an accounting mismatchthat could arise.Risk mitigation option in IFRS 17 and hedge accounting44The concerns relate to the risk mitigation option in IFRS 17 only deals with contractsunder the VFA and derivatives as hedging instruments.45As with other industries, accounting mismatches may arise where a hedginginstrument and hedged item are not measured consistently.Evidence from case studies46Respondents indicated that derivatives are not the only method of hedging, otherhedging instruments include mortality bonds or investments in special funds, buthow these are accounted for were not discussed.47The EFRAG Secretariat notes that hedge accounting under IFRS 9 could be usedas a measure to mitigate risk. However, when respondents to the extensive casestudy were asked if they intend to apply hedge accounting almost all respondentsindicated that they do not intend to apply hedge accounting due to the followingreasons:(a)When derivatives are part of the underlying items, the change in the fair valueof the derivatives will offset (partly or fully) the cost of the guarantees, leadingto reduced changes in the fulfilment cash flows. This offset is not perfect, i.e.some mismatches still remain depending on the methods used;(b)Currently, hedging (including economic hedging) is applied on a macro basis,i.e. derivatives backing VFA contracts are not allocated to the same backingassets of insurance-portfolios since IFRS 4 does not require such granularity.EFRAG TEG meeting 27 September 2018Paper 07-03, Page 7 of 21

IFRS 17: Interaction with IFRS 9 and IFRS 15(c)The vast majority of assets backing insurance contracts (including hedgingderivatives) are held at FVPL with fair value movements going through theincome statement are matched against movements i

(a) IFRS 9 Financial Instruments (Part A); and (b) IFRS 15 Revenue from Contracts with Customers (Part B). Introduction 2 IFRS 17 is effective from 1 January 2021. An insurer can choose to apply IFRS 17 before that date but only if it also applies IFRS 9. 3 The paper considers components of IFRS 9 and IFRS 15 that are relevant to the

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