Category: accounting

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Financial stability implications of IFRS 17 Insurance Contracts

This memorandum from the European Systemic Risk Board highlights discount rates as a key risk in IFRS 17.

IFRS 17 allows two methods (bottom-up and top-down) to calculate discount rates which, in turn, determine the ultimate amount of insurance contract liabilities. In practice, the bottom-up and top-down methods may result in different discount rates. Furthermore, IFRS 17 is going to be applied in an environment of low interest rates, with increased importance of unobservable components (expected and unexpected credit losses, as well as an illiquidity premium). Together with the level of discretion in the requirements of IFRS 17, the behavioural response of insurers may have consequences for financial stability, mainly as a result of large cross-sectoral heterogeneity in the computation of discount rates and ultimately in the valuation of insurance liabilities.

See also:

The significant weight of the unobservable component of discount rates under IFRS 17 may require close attention from audit firms, accounting enforcers and microprudential supervisors. Potential actions could include setting audit expectations, issuing guidelines on how to compute the unexpected components of the top-down and bottom-up methodologies, a benchmarking exercise across European insurers, and setting out expectations on adequate disclosures.

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In da house

An interesting set of questions here from Baroness Bowles of Berkhamsted about a possible conflict of interest in advice to the UK Endorsement Board.

Question[s] for Department for Business, Energy and Industrial Strategy Baroness Bowles of Berkhamsted Liberal Democrat, Life peer.

Asked 14 October 2021

Due for answer in 13 days (by 28 October 2021)

To ask Her Majesty’s Government why the UK Endorsement Board is not using in-house counsel to instruct barristers for public interest legal advice; and why they are instead using Katherine Coates.

To ask Her Majesty’s Government what assessment, if any, the UK Endorsement Board have made of any potential conflict of interest of instructing Martin Moore QC to work on the endorsement of accounting standards either (1) directly, or (2) indirectly.

To ask Her Majesty’s Government whether the UK Endorsement Board has sought the advice of Martin Moore QC in the course of seeking endorsement of for its accounting standards either (1) directly, or (2) indirectly through Michael Todd QC.

To ask Her Majesty’s Government whether they will place copies of the tender documentation of the UK Endorsement Board for the procurement of legal advice and legal opinions in the Library of the House.

What could all that be about?

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Letter to IASB

The UK Shareholders letter to the IASB is now published here, in response to the Board’s public consultation on its activities and its work plan for the next five years.

Naturally we argue that discount rates should loom large in the Board’s forthcoming work.

In the Appendix, we reject the Board’s argument that we should discount liabilities by more than the risk free rate, their thinking being that a liquid bond has an embedded option to sell the bond at market, an illiquid bond does not contain that option, ergo the illiquid bond should be cheaper.

Their thinking is utterly fallacious, for the reasons given in the Appendix. Perhaps I shouldn’t call it ‘thinking’. Wittgenstein “Thought can never be of anything illogical, since, if it were, we should have to think illogically” (Tractatus 3.03).

Other comment letters are listed here.

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Meanwhile back at t’mill

A technical paper here on the UKEB website suggests more trouble brewing around discount rates.

As usual it’s hard to tell, given the impenetrable language used by accountants, but I suspect the problem is the so-called Contractual Service Margin (CSM). This is a mechanism that weirdly takes away the effect of excess discount rates like Matching Adjustment (or rather, the statutory equivalent of Matching Adjustment), forcing a firm to release day one MA gains over time. How this practice differs from just discounting by riskfree is a mystery to me.

The paper says “Profit recognition will be significantly slower than under current practice, mainly due to the absence of gains on initial recognition (sometimes referred to as ‘day 1 gains’),” then continues, ominously:

Data on the likely transitional impact from this change across the industry is not available to us, but the expectation is for material reductions in equity. The scale of the impact will depend in part on the transition approach adopted …

Unfortunately the rest of the paragraph makes almost no sense.

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No it’s an error

Nom de Plume writes:

Just to make sure I have understood correctly, it is not that the independent expert has made an error, but that he used a number you don’t agree with i.e. if you didn’t subtract the £3bn transitional relief you would then get the 41% number.

If that is the case, why not say you don’t agree with the idea of transitional relief rather than call it a serious error.

No, it’s an error.  Transitional relief is another form of fake asset, just like Matching Adjustment. If you take away the £7bn odd Matching adjustment ‘benefit’ from Rothesay’s book, their available capital amounts to pretty much zero. Clearly you can’t say that to policyholders, or they would object in their thousands. So Rothesay assumed that they would get back some of the lost MA in the form of transitional relief, i.e. having lost one fake asset the PRA would give some of it back in the form of another fake asset.

I can see no reason why that would happen, and in any case, as I pointed out in the previous post, TMTP is even more fake than MA, because you have to pay it back over 10 years. As well as the value of the fake asset, you have to include the present value of a series of fake cashflows over the amortising period. Thus zero minus zero equals zero, by my arithmetic.

 

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Just makes no sense

There was an RMS announcement yesterday for the sale of a portfolio of equity release mortgages from Just Group to Rothesay Life. The sale was hinted at in the Interim results released last week.

The announcement is confused partly because the sale is the first of two tranches, with the numbers referring sometimes to the total amount, sometimes to the amount in the first tranche. As far as I can make sense of it, the total imputed value of the loans being transferred is £475m, and the total amount paid by Rothesay is £334m (see also their announcement here), resulting in a theoretical loss of £141m for both tranches. Just Group say that the loss will be only £125m, but they also refer to ‘IFRS value’ as being different from the imputed value.

The stated reason for the loss is “the insurance liabilities impact due to the lower investment yield on the replacement bonds” which does make a kind of sense.

Welcome back to the weird world of Matching Adjustment accounting.

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Shareholders’ association slams UK’s IFRS 17 discount rate paper

Interesting article here on the horrible UKEB paper that I mentioned earlier this week. I am quoted extensively.  Behind a paywall, but the main points are

  • the paper conflicts entirely with the points raised in the UKEB’s priorities list, published last week, and fails to reflect concerns raised by Sharon Bowles among others.
  • The paper says that absolute precision (in the ‘measuring’ the illiquidity spread to be used in discount rates) is not necessary, whereas the UKEB’s priority list says that discount rates often have a material impact on accounts.
  • The paper concedes that estimating the illiquidity spread is a matter of judgment, but that is OK because “such judgements and estimates are integral to insurance business and insurers have extensive relevant experience”. The article quotes Hoogervorst (ex chair IASB) highlighting discount rates as one of the inconsistencies IFRS 17 was aiming to correct.

The paper was beyond even the usual joke expected of accounting standards bureaucrats.

 

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More nonsense

I reported earlier on the official list of priorities for the UK Endorsement Board to consider. They have now published the paper that the Board will consider on 20 July next week.

Warning: the paper is truly awful, and was the main reason I stepped down from the Technical Advisory Group in February. Note the inconsistency between the Priority List, which eerily reflects the concerns I raised while on the Group, and the relaxed and unconcerned nature of the paper itself. Left hand meet right hand etc.

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Does IFRS 17 require the use of discount rates that are too high?

Well obviously, but interesting that the question is now on the official list of priorities for the UK Endorsement Board to consider.

Their summary is interesting.

  • Some stakeholders have raised concerns that the requirements in IFRS 17 regarding the determination of discount rates will lead to excessive subjectivity (whether in respect of illiquidity premiums or the elimination of market and credit risk). Further, does IFRS 17 require the use of discount rates that are too high because they are in excess of risk-free rates?
  • This is a pervasive aspect of IFRS 17, often with a material impact on the accounts
  • An area of significant entity-level judgement
  • Requirements have attracted controversy and are a primary focus for certain stakeholders
  • Use of rates in excess of risk-free has (indirectly) been referred to in parliamentary debate
  • Users of accounts consider this an area of potential concern due to the subjectivity and the scope for variety in rates applied

My emphasis. I discussed the ‘parliamentary debate’ issue here.