“Are We Ready for the Next Crisis?”

We took a dive back into the archives all the way to 2018, when Chair of the IASB Hans Hoogervorst delivered a speech at the annual conference on regulatory developments organised by the American Institute of Certified Public Accountants. Mr Hoogervorst described the Board’s own response to the global financial crisis at the times. His comments are equally relevant today as the world battles the novel Covid-19 and the financial implications it has had on our accounting. Here is an excerpt from his speech titled: “Are We Ready for the Next Crisis” where he speaks on IFRS 17’s contribution to financial stability. 

IFRS 17’s contribution to financial stability 

Let me now turn to insurance. Given the long-term nature of the insurance liability, the insurance industry is much less prone to sudden liquidity crises than the banks. Nevertheless, with their vast holdings of financial assets, insurance companies are not immune to systemic risk. Moreover, the business model of insurance companies is under pressure by the current low interest rate environment. 

In its Financial Stability Report of 2017, the International Monetary Fund (IMF) warned that, in their search for yield, insurers have taken on more credit risk and more liquidity risk. It noted that the share of lower-grade bonds held by insurance companies has gone up significantly. The IMF also noted that the industry ‘suffers from opaque and heterogeneous financial disclosures and deficiencies in the accounting and regulatory regimes’. 

This is of course exactly the reason why the IASB issued IFRS 17, the new Standard for insurance contracts. 

I firmly believe that IFRS 17 brings a very important contribution to financial stability in the insurance industry. 

First, the insurance liability, including the costs of options and guarantees, will be properly measured and regularly updated, giving much better information. The build-up of unsustainable equity positions will become visible sooner. The FASB has made similar changes to its insurance standards, replacing historical cost measurement with current measurement. 

Second, IFRS 17 ends up-front profit taking. Revenue will only be recognised as the service is provided. Clearly, this is more prudent than current practice in some parts of the world, where profits on long-term contracts like annuities can be taken upfront. 

Moreover, IFRS 17 will result in much better information about profitability trends by making an end to unfettered averaging of different generations of contracts. Current accounting standards give much leeway for insurance companies to mix the profitability of different generations of contracts. Old, profitable contracts can be mixed with less profitable, newer contracts to smoothen the income statement. Old contracts can even contribute to current earnings long after they have expired! 

Clearly, this practice makes it much harder for investors to discern earnings trends. It also creates room for imprudent dividend distribution even when the performance of an insurance company is worsening. IFRS 17 will instead require insurers to clearly distinguish between different vintages of insurance contracts. If profits start declining, it will be visible much earlier. 

In Closing 

I have come to the end of my contribution. I have sketched the enormous risks in the global economy. I am not sure whether the financial system as a whole is ready for the next financial crisis. What I am sure of is that the recent improvements in our accounting standards will provide much more transparency that will help investors and regulators identify risks at a much earlier stage. That is the best contribution that accounting can give to financial stability and we believe that IFRS 9 and 17 are big improvements in this respect. 

Source: ifrs.org 

To view our related Courses – IFRS Training material on the standards discussed above, follow the links before: 

> COVID-19 & IFRS | COVID Impact on Financial Statements | IFRS Training 

> IFRS 17 Insurance Contracts Updated | 2020 | 2021 | IFRS Training 

> IFRS 9 Financial Instruments Updated 2020 2021 | IFRS Training 

> IFRS Masterclass Updated | 2020 | 2021 | IFRS Training