Discounts rated – Accounting and discount rates clash

While Solvency II ‘boxes in’ insurer discount rates, IFRS 17 sets them free – but the regulators aren’t happy

In many ways, the changes applied to the Solvency II discount rate – which is the basis of valuing all cashflows – symbolise the insurance regulatory standard’s transformation from its principles-based origins to the rigid rules-based standard that came into force on January 1, 2016. First came the extrapolation method for calculating long-dated cashflows in liquid markets, followed by the volatility and matching adjustment, resulting in a discount rate that – according to one leading consultant – leaves insurers ‘boxed in’ when it comes to valuing their liabilities. 

 

Solvency II versus IFRS 17 

The approach applied by the European Insurance and Occupational Pensions Authority (Eiopa) is so prescriptive, the regulator publishes a monthly set of interest rate structures to be applied to all insurers. These figures are based on the bond and swap rates of around 60 countries worldwide – including Liechtenstein, Taiwan and Colombia – according to the 130‑page report published by Eiopa in January 2018 on the technical standards to be applied for determining interest rate structures.

The difference between Eiopa and the International Accounting Standards Board’s (IASB’s) thinking on this results in substantial practical differences between the standards, according to Anthony Coughlan, director at PwC’s UK insurance practice. He highlights a number of points of divergence, such as the Solvency II volatility adjustment, which is not permissible under IFRS 17, and the approach to extrapolating the risk-free rate from a number of currencies. And it doesn’t stop there. 

“For annuity products – primarily in the UK and Spain – the Solvency II matching adjustment is a similar concept to an IFRS 17 top-down discount rate, but it would require revisions. The end result would be a significant difference between a Solvency II- and IFRS 17-compliant discount rate.”

Another key difference between Solvency II and IFRS 17 is that the latter specifically allows expected cashflows from the product itself. Therefore, for a firm selling an asset-based policy, such as a unit-linked product, the discount rate chosen under IFRS 17 would reflect the expected return on assets. But, for a product such as term insurance, the determinants of the discount rate would be metrics such as durations, currency and the liquidity of the assets supporting the product. 

 

Preventing figure massaging

Several people Risk.net spoke to reported that the net result of such a major disparity in the approach to the discount rate in Solvency II and IFRS 17 meant it could be possible for insurers to use the greater IFRS discount rate flexibility to massage their IFRS 17 figures.

“The opportunity to calibrate this in a different way is real,” says one. “But how many insurance companies in Europe will do that remains to be seen. There will be a discussion between those insurers and their auditors about whether a discount rate set under the prescriptive rules of Solvency II can also be valid for IFRS 17 and, if it is, whether the shareholders will actually like it.”

Regulators appear to be aware of this point. Eiopa, for example, sent a letter in November outlining its response to IASB’s decision to extend the implementation date. Despite welcoming the “paradigm shift” in accounting regulation that it said IFRS 17 represents, it went on to raise concerns over the differences in discount rates. 

The letter goes on to state: “IFRS 17’s principles on determining the applicable discount rate and risk adjustment may have exceeded the appropriate level of allowing for entity-specific inputs and consequently may give rise to significantly different and potentially incomparable results.” 

 

Setting the discount rate

This received a scathing response from Andrew Carpenter, IFRS policy specialist at the Association of British Insurers. He said that, while the IFRS 17 discount may result in different end numbers for different companies, that is because it is intended to inform investors, not regulators or policyholders. Moves by groups such as Eiopa to influence this are therefore a clear case of going beyond their mandate. 

“There have been calls from regulators for more prescription in setting the discount rate: both the European Securities and Markets Authority and Eiopa have raised this issue, among others, but we feel this is an example of regulators overreaching their responsibilities. Capital markets have their own dynamic,” says Carpenter.

Capital markets are also global and, according to sources familiar with IASB’s thinking, the body was conscious that it has a large number of member countries, and that the needs of all – not just European – members needed to be considered when setting out the discount rate, particularly given the market-driven nature of all other standards. That is the critical issue. 

According to the IFRS website, it serves as a standard-setter for more than 150 economies globally – in places as diverse as Timor-Leste, Gambia and Iran – and, as such, has met a very diverse range of needs. 

Crucially, of the 150 states IFRS says it provides accounting standards in, one exception is the US – the world’s largest insurance market. Meanwhile, Japanese insurers – the second largest market – have the option of using IFRS 17 or a Japanese version of Generally Accepted Accounting Principles (GAAP). 

In fact, the US Financial Accounting Standards Board is also overhauling its approach to accounting for insurance liabilities to roughly the same timeline as IFRS 17, meaning European insurers with US subsidiaries will have to overhaul two sets of [differing] accounting regimes at the same time.

 

Euro-centricity

However, William Gibbons, insurance asset-liability management specialist at PwC, is sanguine about the impact of these processes occurring at around the same time. US GAAP is different to IFRS already, and after the next round of changes it will be different in yet another way. 

“In the context of European insurers, the reality is there is a difference today between US GAAP and IFRS GAAP, and there will just be difference between them in the future. Insurers were hoping for a global standard but, sadly, won’t get that and instead it’s effectively more of a European standard. A number of Asian countries, including important markets like China, Korea and Hong Kong have already said they will adopt some form of IFRS 17 – but what exactly and when is not clear.”