Financial Reporting in Insurance and International Financial Reporting Standards

Abstract

Financial reporting obligations for financial institutions, including insurance companies, have increased in recent years and insurers needs to stay up-to-date on the latest revisions of International Financial Reporting Standards and data reporting requirements and to comply with it. Many of these reporting obligations on listed and large non-listed insurers will benefit the insurance industry in the long term but it is challenging and costly task for insurance companies. The complexity of organizing high-quality data, transparent and structured reporting processes for different purposes (e.g., financial and regulatory reporting, CSR reporting, and many other types of reporting at local level) with internal and external stakeholders within a specified time frame, have become a strategic initiative, value-based investment, and opportunity for growth of insurance companies. To meet the various reporting requirements while overcoming reporting challenges, insurance companies need to ensure effective data governance and oversight in their reporting processes, which require considerable staff resources, and expertise in a wide variety of area, including appropriate IT architecture setup. In this chapter, we will analyze financial reporting obligations for insurance companies and evolution of the international accounting standards for the insurance industry. Moreover, we will discuss some practical issues facing insurers to comply with different regulatory, financial, and business reporting requirements to fulfill their reporting obligations.

1 Introduction

The global financial crisis of 2007–2008 and subsequent world recession affected large numbers of financial institutions by slowing down their business activities and decreasing their earnings. Although banks were at the center of the financial crisis, for many individual insurers, direct exposure of the crisis has revealed inefficient and ineffective business processes, which were misaligned with a company’s activities and strategic direction (e.g., risk management, rationality in making financial decisions, investment, pricing, reserving or business grow) and inadequate minimum level of capital.¹

The crisis in financial markets was also indicative of market and government failures, unsatisfactory supervisory practice of the financial sector as a whole at both national and international level. In addition, the crisis has exposed shortcomings in financial regulation that left considerable discretion to the Member States by the primary directives that governed the area.² The economic downturn revealed that the solvency regime for the insurance sector is not sufficiently risk sensitive, i.e., it does not contain an incentive to improve risk management and it is necessary to establish more effective financial reporting framework.

Numerous changes in the regulatory frameworks, policy measures, standards tools and practice have been brought forward for both the insurance and banking sectors to build a more resilient financial system.³ For insurance sector, this includes Directive 2009/138/EC (Solvency II)⁴ which is analogous to Basel II’s capital adequacy requirements for banks, Insurance distribution Directive⁵ and International Financial Reporting Standard (IFRS) 17 Insurance Contracts.

The global financial crisis helped with re-assessing the value of corporate reporting and modernizing and optimizing reporting processes. Corporate reporting has become very sophisticated in the last years and in most insurance undertakings is carried out in a very professional manner.⁶

Despite substantial evidence of capital-market benefits from corporate disclosures, the multiplicity of different reporting and disclosure requirements poses great functional and technical challenge for an insurance companies who needs to adapt their businesses to new regulations and to maintain ongoing compliance.⁷ Most of the directives and regulations dealing with financial services are supplemented by various regulatory technical standards, implementing standards and guidance from EU and national regulators and insurance companies are expected to be compliant with all the applicable laws and regulations.

Producing and submitting structured financial and regulatory reports and other type of reports by collecting and combining data from multiple sources, for internal or external stakeholders, is a challenging and time-consuming task. For many financial institutions, including insurance companies, reporting obligations and disclosure is a mandatory obligation and exists only as a subsidiary function within different departments. Many insurance companies struggled how to organize skilled professional team responsible for regulatory compliance with a line of sight over reporting strategy, execution and an understanding of the full regulatory environment.

Additional problem represent how to deliver accurate and timely reports to regulators and the market and to ensure data security, data privacy, and data compliance. Some reporting requirements imposed by different supervisors are additionally costly, inconsistent, and duplicative, and the similar information needs to be delivered to different regulators in different ways and through different technology platforms.⁸

There are significant unrecognized costs associated with errors, duplication of data and inefficient or incorrectly reporting processes that accrues for a variety of reasons (for example, data compiled for a specific purpose was reused for another report, with different underlying requirements and constraints). Some information demands are often excessive or unnecessary (sometimes, data are collected and not used) which leads to inefficiency. There are many open questions about relevance of the information contained in different mandatory reports and usefulness of reporting information for users.⁹

This chapter aims to analyze the evolution of the international financial reporting standards and accounting requirements for insurance contracts. The development of an international standard for the accounting of insurance contracts, which reflects the complexity of the underlying insurance and reinsurance business, was a long and challenging process. Significant diversity in insurance contracts accounting practices has raised several issues regarding a successful implementation of new international standard for insurance contracts by insurers and its contribution to financial stability.

2 The Evolution of the International Financial Reporting Standards

The globalization of financial market and rapid growth of the trade in goods and services that goes beyond national borders, have triggered the need for a free movement of capital, goods, services and access to information included in the financial statements of companies that operate in several countries.¹⁰ However, there were legal and accounting standard difficulties to achieve corporate disclosure, due to interest group resistance and the variety in national laws of the Member States.¹¹

Companies engaged in foreign trade (multinational, international, transnational and global companies) needed to comply with the different accounting frameworks and standards applicable in countries in which they operate. Information from financial statements of these companies created confusion and had limited value to users in other countries if they were not familiar with the accounting standards underlying these statements.

Many national interest groups in various countries realized that the growth in global trade is possible to achieve with international accounting harmonization system and uniform EU company law, which involves harmonization of company financial reporting.¹² A number of international organizations engaged in process of development of accounting standard such as: United Nations, the OECD, the European Economic Community (EEC), Accounting Standards Committee (independent professional accounting body—IASC)¹³ and the International Federation of Accountants. The aim was to develop understandable and enforceable accounting standard, which will serve equity investors, lenders, creditors, and others in globalized capital markets.

However, the harmonization of financial statements by developing standards that could serve as a model on which national standard setters could base their own standards was a long-term process. The first steps towards harmonizing accounting standards were to align accounting standards in Europe.¹⁴

The harmonization of accounting standard started with the adoption of the Fourth Council Directive 78/660/EEC of 25 July 1978 on the annual accounts of certain types of companies and Seventh Council Directive 83/349/EEC of 13 June 1983.¹⁵ Those two directives had a significant impact on company reporting in the Member States and they have remained largely unchanged until 2013.

The Fourth Council Directive’s first draft was published in 1971, amended drafts were issued in 1974 and adopted in 1978.¹⁶ Member States were supposed to implement the Fourth Council Directive 78/660/EEC until 1980 but they have failed to do so. The Directive was transposed with considerable delay in some countries. For example, the Fourth Council Directive was transposed into German law in 1985,¹⁷ Spain and Portugal in 1989, Austria in 1990,¹⁸ Italy in 1991 and Sweden in 1995, etc.

To ensure agreement between Member States on a numerous issue, existing due to the different legal accounting rules and policy approaches, the Directive allowed Members States with a lot of flexibility on how to individually implement it. Moreover, certain flexibility were left to companies to prepare their financial statements to meet the needs of users. Thus, the Fourth Council Directive 78/660/EEC served more as recommendation, which provides guidance on how the provisions of the Directive should be used than an agreed standard.

Despite the fact that Fourth Council Directive 78/660/EEC was first stage of the harmonization process of accounting standards and it improved the comparability of annual financial statements of companies throughout Europe, there were some practical problems of its implementation.¹⁹

There are a number of very significant accounting issues on which the Fourth Council Directive 78/660/EEC is silent. For example, the Fourth Council Directive 78/660/EEC does not include provisions about translation of foreign currency transactions, accounting for the effects of changing prices on financial statements or problem of deferred-tax accounting.²⁰

A few years later, The Council took additional steps towards a harmonized European accounting system with the adoption of two Directives dealing specifically with annual accounts and consolidated accounts specific to banks²¹ and insurance undertakings.²²

The International Accounting Standards Committee (IASC) has undertaken even bigger task to produce accounting standards that would be implemented worldwide.²³ During the period between 1973–1987, the IASC generated most of the International Accounting Standards (IAS).²⁴

The IAS (which were all prefixed with “IAS”—e.g., IAS 10 Events After the Reporting Period, IAS 14 Segment Reporting, IAS 21The Effects of Changes in Foreign Exchange Rates, IAS 34 Interim Financial Reporting) represent an attempt to find “middle ground” between national accounting regulations, where the financial reporting standards are already highly developed, as opposed to an effort on international standardization in financial reporting. The level of harmony of financial reporting within and between countries depends on the degree of compliance with the IAS. IAS standards were increasingly used as a model by national accounting standards setters but they were not implemented by a significant number of large companies.²⁵

Some commentators questioned the scope and authority of IAS Standards.²⁶ IASC was established in 1973 as a part-time, voluntary organization, run by the professional accounting bodies from nine countries. The IASC was not a government body and the IAS Standards could not be imposed as a set of accounting rules that could be part of a standard international listing agreement and applied by all national regulators.²⁷

The Restructuring structure of the IASC started in 2001. IASC handed over its functions to the International Accounting Standards Board (IASB). The newly formed IASB took over the standards of the IASC and decided to name new accounting standards issued by the IASB as International Financial Reporting Standards (IFRS).

In June 2002, the European Union has endorsed the International Accounting Standards (IAS/IFRS) for all EU companies (including many of the largest insurance companies in Europe) that are listed on European exchanges through the adoption of the Regulation (EC) No 1606/2002.²⁸ From 2005 all companies were required to prepare and publish their consolidated financial statements in accordance with IFRS.²⁹ The Regulation (EC) No 1606/2002 authorizes EU Member States to extend the IFRS requirement to the consolidated financial statements of non-listed companies.³⁰

Since 2011, the European Commission has taken steps with the goal of imposing obligations on listed and large non-listed entities to disclose certain non-financial information about sustainable development and environmental policy in the annual reports.³¹

The result was a new law on accounting, the Directive 2013/34/EU of 26 June 2013³² on the annual financial statements, consolidated financial statements and related reports of certain types of undertakings, which also applies on credit institutions and insurance companies.³³ Directive 2013/34/EU combines and updates the requirements of the 4th and 7th Council Directives and refers both to the individual financial statements and consolidated financial statements.³⁴

The main focus of Directive 2013/34/EU is to harmonize accounting and simplify reporting and disclosure requirements which will lead to reducing administrative burdens and the lower costs of financial reporting for small- and medium-sized enterprises ((SMEs) and micro-enterprises. However, the reduction of the administrative burden for SMEs has not been fully achieved due to the different transposition of the Directive 2013/34/EU in some Member States, and the fact that there are no middle-sized entity categories in some countries.³⁵

Directive 2014/95/EU amended Directive 2013/34/EU and represents first step in the field of mandatory sustainability reporting. This directive requires large companies (exceeding 500 employees) to include annual non-financial statements on sustainability and diversity, either as a part of their management report or as a separate document from 2017 onwards.³⁶

3 Evolution of Accounting Rules and Financial Statements for Insurance Companies

The lack of quality and consistency in insurance reporting and accounting practices has resulted in weak usefulness of financial statement information for investors, creditors and analysts to evaluate a company’s financial position and performance. Compared with the banking sector, the insurance sector in the EU was not known for its transparency in financial reporting that reflects economic reality towards supervisory authorities and stakeholders. Moreover, insurance sector has not followed financial reforms that was developed by the Basel Committee on Banking Supervision (BCBS) in banking (Basel reforms).³⁷

An internationally accepted accounting standard for the measurement of insurance contracts did not exist until 2004.³⁸ The absence of international standards for insurance industry, both in accounting and in solvency, has resulted to the fragmentation of the existing insurance accounting practices, which are often inconsistent with accounting practices of other industries. Significant diversity in insurance contracts accounting practices was also the result of different accounting standards and different types of insurance products in each jurisdiction.³⁹

The IASB (formerly IASC) has been working on a new international standard for insurance contracts based on fair value for many years to reduce the differences among the accounting principles used in insurance industry and improve comparability and understanding of the income statement of companies issuing insurance contract across entities, jurisdictions, and capital markets.⁴⁰

The development of an international standard for the accounting of insurance contracts has raised several conceptual and practical issues regarding its application. Some issues are general and affect all financial institutions and some specific to the insurance sector.

Insurance is a unique financial service and preparation of financial statements of insurance business requires the application of actuarial science to determine results, and then to integrate those results with accounting rules.⁴¹ The preparation and production of high quality financial statements of insurance business can be very complicated; whether the insurance business is long-term such as life insurance or health and long-term care insurance; or short insurance business duration with a long term such as workers’ compensation insurance.⁴²

Insurance is interdisciplinary topic and interacts with various fields of law, accounting, marketing, economics and finance.⁴³ It can be defined from legal aspect (contract of law,) risk management and risk transfer tool, social or commercial device providing financial compensation and for accounting , insurance is an intangible product of insurance business.⁴⁴ Definition of insurance contracts are relevant regarding insurance accounting standards for insurance contracts and determines whether a contract is within the scope of IFRS or another standard.

Another debate concerns the question of fair value accounting for insurance contracts in financial reporting. Insurance contracts are not tradable financial instruments (unless considering their tradeable stock or debt in the secondary market) and market values cannot be objectively presumed. Insurance accounting measurement models involves using judgment, estimation and clear and precise rules for fair value for insurance.⁴⁵

The IASC/IASB and Financial Accounting Standards Board (FASB) have been dealing with the challenges in auditing fair value measurements on assets and liabilities arising from insurance contracts for a number of years.⁴⁶ IASC/IASB and FASB have promulgated a number of conceptual frameworks for Financial Reporting and fair value measurement Standards requiring fair value accounting for selected (largely financial) assets and liabilities.⁴⁷ There is still ongoing discussions among professionals with respect to the application of fair value accounting of Insurance Contracts but it is difficult to reach complete consensus about this topic.

There are many other challenges involved in adopting and implementing international standards for insurance contracts which involves, how to ensure effective accounting rules, how to increase reporting transparency and give users a better understanding of the sources and trends of earnings or excessive implementation costs. Another important challenge is how to ensure that the long-term nature of insurers’ business is captured in annual reporting.

The development of the new international accounting standards for insurance contracts is part to a European Union’s initiative to converge their financial reporting standard to International Financial Reporting Standards.⁴⁸ There was no accounting standard for insurance contracts before the establishment of the European Union (EU) in 1992, and IFRS for insurance contracts relied on local GAAP.⁴⁹

In 1997, the IASB initiated a two-phase project called “Insurance Contracts” and set up a steering committee to carry out the initial work on new accounting requirements for insurance contracts.⁵⁰ This project was split in two-phase, mainly because of complexity to develop a full standard by the time of EU’s 2005 year-end deadline for the mandatory adoption of IFRS. About the same time, the EU started work on Solvency II, a framework directive aimed at enhancing policyholder protection; improve (international) competitiveness of EU insurers and streamlining and strengthening solvency requirements across the EU in an effort to create a single market for insurance.⁵¹

In December 1999, the IASC Steering committee published an Issues Paper on Insurance and in June 2001 developed first Draft Statement of Principles—Insurance contract (DSOP) which was based on its work and the 138 comment letters to the issue paper.⁵² The DSOP was never approved because of many issues raised by actuaries, insurance companies but it created a foundation for further work. In October 2001, the IASC Steering committee published last DSOP and in July 2003, the IASB Published Exposure Draft ED 5—Insurance Contracts.⁵³

The IASB’s insurance accounting project, phase 1, was completed in March 2004 when IFRS 4 was released an interim standard. IFRS 4 provides only limited improvements to accounting practices for insurance contracts until comprehensive accounting standard (IFRS 17) could be finalized. IFRS 4 permits an entity to continue of existing accounting practices (paragraph 25) and requires to disclose information that identifies and explains the amount, timing and cash flow assumptions from insurance contract (paragraph 15). Thus, many IFRS jurisdictions where IFRS is used for general purpose financial reporting do not also use IFRS 4 for regulatory purposes because of the absence of a consistent accounting framework for all insurance contracts in IFRS 4. They instead specify supervisory methods for the determination of insurance contract liabilities. For example, in the European context, solvency assessment is not based on IFRS but on balance sheets using the Solvency II framework.⁵⁴

On 18 May 2017, IASB published IFRS 17 “Insurance Contracts” which replaces interim standard, IFRS 4 Insurance Contracts. The IFRS 17 Standard will be effective for annual reporting periods beginning on or after 1 January 2023. Subsequently, after a period of consultation, the IASB issued amendments to IFRS 4⁵⁵ which allows an insurance entity to use the overlay approach⁵⁶ and temporary exemption from applying IFRS 9 Financial Instruments to annual reporting periods beginning on or after 1 January 2023. This means that insurers will still be able to apply IFRS 17 and IFRS 9 at the same time, thus reducing implementation costs and possibly accounting mismatches.

4 Financial Stability and the Insurance Sector

Financial reporting transformation and development of an international standard for the accounting of insurance contracts started much later than in banking sector.⁵⁷ There were several reasons for a late start: global insurance market is characterized by differences between developed and developing countries; thus, insurance business model is less globalized than other areas in finance (e.g., capital markets or investments).⁵⁸ There were also limited research of the insurer’s business model and its interactions with financial and other financial intermediaries.⁵⁹

As mentioned, the financial crisis of 2008 and the subsequent recession had negative effects on economy, including decreased of business activities of global and regional financial and insurance companies. Some insurers experienced substantial capital deterioration, some of them required government support (e.g., the case of American International Group—AIG) or some insurers needed to seek changes to accounting rules to provide capital relief.⁶⁰

For insurers, financial crisis and economic recession simultaneously influenced the decrease in the value of assets and an increase in the value of liabilities because it had strong negative impact on all insurers’ business activities (underwriting, investments and risk transfer).⁶¹ The financial crisis has exposed multiple failures in the financial system and their implications for financial system stability. A number of tighter regulations of the financial sector have been issued to prevent future financial crise, including set of changes to accounting practice (US GAAP and IFRS).⁶²

One of the key issues in the post-crisis environment was a restoring public confidence through the structural changes in the insurance industry. Some of legislator’s objective were: to strengthen the oversight of insurance companies that are considered important for systemic financial stability in the global financial system; and to develop a credible and coherent accounting standards and prudential capital standard for internationally active insurance groups (IAIGs).

Traditionally, banks have been connected with concept financial stability (i.e., the absence of systemic risk) because of their maturity transformation and their leading role in the transmission of monetary policy, the payment system and the reallocation of savings to investments.⁶³ The contribution to systemic risk by insurers has been regarded less significant than in banks.

Insurance industry is going through a period of transformation driven by a number of factors, such as changes in the insurance sector environment, new disruptive technologies, regulatory activities. Insurers are expanding their activities beyond their core business which leads to a closer integration between insurance and banking undertakings.⁶⁴ This is especially the case in the OTC derivatives markets, bancassurance or unit-linked or index-linked products.⁶⁵ For this reason, the role of insurance companies in financial market and relevance of the insurance sector for the overall stability of the financial sector has gained importance over the years.⁶⁶

Discussions about remedial measures to address financial stability risks and vulnerabilities in the insurance sector started after the financial crisis and failure of AIG’s CDS (credit default swaps) business in 2008, decline in equity markets that began in 2000 and subsequent low interest rate environment.⁶⁷ Moreover, strong interconnections between the insurance industry and the rest of the financial system, non-traditional or non-insurance activities of insurance companies (including their activities in credit risk transfers) has become increasingly relevant for maintaining a stable financial system. It is necessery to understand interaction between insurance companies with financial markets, banks and other financial intermediaries and the fluctuations in the business cycle to determine potential risk transfer from one sector to another.

Banks and insurance companies are both financial institutions but very different in terms of business models, funding structure, financial products, different nature of underlying risks which is the result of many factors such as demographics, the structure of liabilities, the scale of operations, regulation, accounting practices and distribution channels.⁶⁸ There have been attemps to push towards convergence between banking and insurance setor, including integration insurance regulation with the regulation of banking and investment business at EU level.⁶⁹ However, this regulatory approach is not sufficiently taking account dfferences between banks and insurers.

Bearing in mind contrasting business models and balance sheet structures of banks and insurers, different roles of capital, leverage, and risk absorption, it is clear that the banking model of capital cannot be applied to insurance. The case is the same with the accounting regime.

The primary goal of IFRS 17 insurance contract is transparency, accountability and efficiency to financial markets which at same time promotes the long-term financial stability of the global economy. Insurers can be consider systematicly important because of the economic role of the insurance sector.⁷⁰

It is hard to assess the extent to which insurers can be originators or transmitters of systemic risk in the financial system.⁷¹ However, IFRS 17 will contribute to financial stability by providing more granular contractual data about insurers’s current and future profitability.

5 Conclusion

Financial institutions and insurance companies are facing with a regulatory environment that changes rapidly, complex and expensive reporting requirements and numerous regulatory disclosures obligations. Many of these reporting requirements are not only limited to the financial performance of a company, but also include a relevant non-financial information statement on company’s impact on social and environmental matters. International Financial Reporting Standards and high quality of financial statement information have two main objectives. First, to bring high transparency, accountability and efficiency to financial markets through the international standards and second, transparency in financial reporting and accountability derived from accounting standard represent a significant factor for achieving financial stability and underpin the trust that investors creditors and other interest groups place. IFRS 17 insurance contract represents first harmonized accounting model for insurance contracts. This new accounting requirements for insurance contracts was created to provide more transparent information about the effect and revenue of insurance contracts on financial statements for stakeholders, investors, analysts, and consumers. IFRS 17 insurance contract is complex regulation, which will require insurers to take a different approach to measuring and reporting insurance and reinsurance assets and liabilities for insurance contracts. Complying with this regulation will raise many practical implementation issues, including significant operational costs for most companies. Another challenging task will be the organization of IFRS 17 compliance reporting structures, assigning roles and reporting responsibilities between different departments in a company. Smaller insurers, whose resources are limited, will need to consider outsourcing compliance processes to fulfill their reporting obligations.