The future of Management Information and Key Performance Indicators under IFRS17

Olive Gaughan, Director of Life Actuarial Services, shares her thoughts on the future of MI and KPI under IFRS17

Insurance entities produce a myriad of information for different users internally and externally. The metrics within internal Management Information (MI) along with the Key Performance Indicators (KPIs) that are monitored by analysts and investors, provide insight into the entity's profitability, risk profile, solvency position, & value. Internal MI packs tend to focus on the year to date, on performance against plan, and trends over time. Investors turn to financial ratios to help analyse a company's fundamentals. They focus on KPIs and disclosures, which they primarily source from insurers' financial statements and solvency reports (SFCRs). 

This latter set of stakeholders has been a primary catalyst for IFRS17, as they considered that the existing reporting by Insurance companies had issues such as lack of consistency with other industries (re. revenue recognition), & lack of transparency. Now, IFRS17 is changing the face of the financial statements and the contents of the disclosures. These changes will impact the KPI, and it is in the interests of the industry that they quickly come to understand these and, where possible, replace old metrics with the new. The alternative – having yet another suite of metrics which must then be reconciled to the current metrics – is a situation that we must aim to avoid and is surely not what was envisaged by IFRS17.

The more commonly used metrics fall into five categories: Liquidity, Solvency, Activity/Efficiency, Profitability and Market Prospects. In this article I will consider the extent to which these are likely to change, or be replaced, due to IFRS17.

Liquidity ratios 

Liquidity Ratios reflect a company's ability to meet its short-term obligations. They focus on cash, cash net of expenses, current assets and current liabilities. These elements will all be available in the new financial statements, while no additional "liquidity" metric has been created. Therefore, this category of metric will remain unchanged due to IFRS17.

Solvency ratios

Solvency Ratios indicate a company's resilience and ability to meet its obligations under a severe stress scenario. Many solvency regimes are now risk-based and quite prescriptive, such as Solvency II. The calculations are independent of the Financial Reporting regime, and so they are not expected to change or be replaced when IFRS17 becomes effective. There may be some second-order impacts – e.g. if IFRS17 results in a change in reinsurance strategy – but there will be no direct impact on the Solvency metrics. IFRS17 introduces a new risk metric, the Risk Adjustment, along with disclosure of the confidence interval chosen. This may lead to some analysis relative to the Risk Margin in solvency II.

Activity or efficiency ratios

Activity or Efficiency Ratios indicate the level of productivity of a business. Metrics include Gross Written Premium (GWP), Annual Premium Equivalent (APE) and the Expense Ratio. We do not expect much change here, but there will be some challenges as a number of the components of these metrics will not be immediately visible in the Financial Statements. For example, GWP will no longer be a line item in the P&L. It should still be available in the disclosures, however, meaning that a little extra effort may be required to produce the metric.  

Profitability metrics

Profitability metrics include IFRS Profit, Underwriting Profit, Operating Profit, ROE, ROA, ROC, the Claims Ratio and the Combined ratio. We expect that this category will undergo significant change and consider that there are at least three types of change possible.

The first is a shift in the value of metrics.

Fundamentally, no existing insurance product is going to change. The future cash flows are going to be the same; therefore, the overall profit is the same. IFRS 17 does not change any of that. However, the timing of recognition of profits will change and could change very substantially. This will affect the profits in an individual year – and hence will result in a change in the value of any metrics that use profit in an individual reporting year.   

Transition adds a further layer of complexity, as, depending on the approach taken, there will be a shift between Shareholder Equity and Future profits. Some companies will see a hit to equity, offset by higher subsequent profits (remember – there is no change to overall profits), while others may see an increase in equity, offset by lower profits thereafter. Metrics that use equity in the denominator, therefore, also be impacted. 

Companies will need to think about the initial step change and the trend thereafter. This will be a bigger issue for companies with big back books, such as life companies, though it will vary depending on the product mix and the approach to transition.

The second is a change in the component of a ratio.

The Claims Ratio and the Combined Ratio are key profitability metrics for non-life insurers.  

The combined ratio [(Claims + Expenses)/ Premiums] is a very useful ratio that tells us what proportion of premium is used to cover Claims and Expenses, and hence, what remains as profit. It is widely used in non-life insurance. As GWP will no longer be readily available as a line item in the P&L, perhaps the industry might consider Insurance Contract Revenue as an alternative? i.e. What proportion of insurance revenue is used to cover claims and expenses? This could be a sensible approach to take, either as a replacement for GWP in the Combined metric, or as a new metric.

The third is a suite of new metrics that IFRS17 will introduce. 

These will be based on the new profitability information in the P&L and new information produced by the accounting systems.  

We expect that Insurance Service Result will give a very clear view of operational margins, or underwriting profits, i.e. those that relate to the true nature of the business written; while non-operational items (incl. other operating expenses and investment income on shareholder assets) will be separately identifiable. We expect that analysts will be very interested in the Insurance Service Result and will expect a good degree of stability within it. It is, therefore, likely that Management MI will include this metric going forward.  

We also expect that internal New Business MI will include information on onerous contracts at the level of aggregation required by IFRS17 for calculation, rather than at the portfolio level which can be used for the disclosures to the financial statements. This will give shine a spotlight on loss-making contracts, thereby facilitating management's review of whether or not these are within appetite and aligned with strategy, or perhaps they need to be repriced.

Market prospect ratios 

Market Prospect ratios include metrics such as dividend yield, P/E ratio, EPS and price/book; metrics that are used to predict earnings and future performance. Many of these are based on the value of a business. For the purposes of this article, I will refer to them as Value Metrics.

These metrics are of critical importance to insurance companies, because, unlike most other industries, the transaction with the policyholder is not one-and-done. It takes time. Though we see some very short term insurance business, such are monthly renewable cash plan business. It is more typical to see policies with terms of 1-3 years in non-life business and group life business, while life insurance policies can range extend to whole of life with 20-year terms are very common.

Some of the key-value metrics used currently include Embedded Value (NAV + VIF, or SII Own Funds + uplift), New Business Value (PVNB) or Gross Margin (PVNB/AP(E)).   

Investors have not always liked these value metrics and consider them with a degree of caution or scepticism. This has resulted in more expensive capital for the industry and has also driven some insurers to engage in "VIF capitalisation" transactions which deliver cash to the balance sheet at a cost (typically a # bps above IBOR).

New metrics:   

IFRS17 calculates two new value metrics: the Fulfilment Cashflows (Present value of future cash outflows minus inflows) and the Contractual Service Margin (CSM), both of which will be contained in the disclosures.  These are consistent at the outset, using the same assumptions and discount rates, and the same contract boundaries. However, over time they move out of alignment as the Fulfilment Cashflows remain market consistent and on best estimate biometric assumptions, while the CSM uses locked in financial assumptions under the General Measurement Model (GMM). Furthermore, the Fulfilment Cashflows unwind as cashflows occur, but CSM unwinds, or is amortised, in line with coverage units at the level of aggregation used. So the pattern of release of the two metrics is quite different.

The Fulfilment Cashflows reflects the actual cash flows that are expected to happen on all policies.

The CSM reflects the value of profits yet to be recognised in the P&L on groups of insurance contracts (GICs) that are not onerous. 

Which one should be used and when? 

That will depend on the user and the purpose. For example:

  1. A potential buyer for a business will most likely be interested in the Embedded Value of the whole business. Shareholder Equity + release of (CSM +RA) is useful here because there is consistency in relation to onerous GICS.  
  2. A buyer of a book of business within a portfolio will be more interested in the PVFCs + corresponding RA.  
  3. Analysts and Investors who are interested in year on year dividend streams will be interested in the CSM yet to be released, as there tends to be a correlation between profits recognised and dividend distributions.  
  4. Management wanting to understand the value of new business may wish to consider both.
    Fulfilment Cashflows will give a full view most comparable to the NB Gross Margins they have considered previously. CSM is problematic in that it relates only to profitable cohorts, and to express it as a % of APE would overstate the overall profitability of new business due to the exclusion of the losses recognised on onerous cohorts of new business.
    As mentioned earlier, the value of Onerous Contracts is expected to be a focus for management; it will highlight cross-subsidies in pricing and will give greater sight of unprofitable products generally. This will enable management to consider if this is appropriate (perhaps from a strategic perspective) or if repricing is required
  5. CSM release as a % of CSM could be a useful management metric for the aggregate book and for individual cohorts and lines of business. The inverse of it, i.e. CSM / Insurance Revenue, would provide a useful rule of thumb as to the capitalisation factor for the business.  
  6. Management wishing to capitalise future profits, e.g. in a VIF capitalisation – may be able to negotiate better terms if they only capitalise the profits on non-onerous contracts, as this could be considered to provide greater certainty and a faster repayment schedule for lenders. 

In summary

As set out above, IFRS17 will have a significant impact on MI & KPI produced by insurance companies. Profitability metrics are likely to see the biggest change, and most likely will include a greater number of metrics post-implementation. Within Value metrics, we are likely to see new metrics replacing the old, hopefully delivering added insight and value to management. Other metrics are unlikely to change. But each business is different, and you know yours best. If you're at the stage of beginning to look at MI, I would suggest that you start with the following three questions:

  1. What MI do I currently receive that I do not find useful?  
  2. What new MI would be useful?
  3. Looking out 3-5 years, what would our current metrics look like under IFRS17?

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