Why IFRS 9 could threaten diversity for insurance investors
Matteo Riccardi, Chief Investment Officer at Bipiemme vita spa explores why IFSR 9 could mean more volatility on insurance balance sheets and the challenges it poses for investing in equities and corporate bonds.
Sara Benwellposted on Thursday, February 18, 2021
Sara Benwell: What does IFRS 9 mean for insurers and what has changed?
Matteo Riccardi: IFRS 9 is the new accounting standard for asset classification and evaluation on the Balance Sheet. Banks have fully applied this new standard since 2018.
Insurance companies are still in a transition phase because they can already apply IFRS 9 (and they are encouraged to do so), but the full application of IFRS 9 will be totally effective when the IFRS 17 on the liabilities side is in place, which should be in 2023 based on the last update.
The integration of the new accounting standards into the whole management of an insurance company is commonly defined as a “revolution” comparable to (or, for some, even more disruptive than) Solvency II.
From an asset-liability point of view, IFRS 9 and IFRS 17 should be analysed together to appreciate their comprehensive effects; however, I will mainly focus on the IFRS 9 in my comments, due to its more direct impact on investment management strategies.
Sara: What are the overarching implications of this regulation for insurance investors?
Matteo: The main impacts will be more evident for those Insurance Balance Sheets with a very big portion of assets classified as “Available for Sales” (AFS) under the previous IAS 39 standards. This AFS category used to be the more crowed accounting classification for assets, due to its flexibility as the trading activity can be implemented without restrictions for securities portfolios.
However, because the unrealised capital gains or losses are not reported to Profit and Loss the financial markets’ volatility does not undermine the “bottom line” results for the AFS classification.
“This additional exacerbation in terms of accounting results will potentially discourage Insurance Investors from increasing their allocation to equities”
Under the new IFRS 9 standard, some of the assets previously classified as AFS will have to be reclassified as “Fair Value through Profit and Loss” (FVTPL), which would imply more volatility on the Balance Sheet results generated by the impact of unrealised capital gains and losses.
Equities investments (both single stocks and equity pooled vehicles such as equity mutual funds) are one of the most clear examples of assets which will be classified by Insurances as FVTPL under IFRS 9.
Considering that equities are already very penalised by Solvency II capital charges, this additional exacerbation in terms of accounting results will potentially discourage Insurance Investors from increasing their allocation to equities.
Fixed income type investments are primarily candidates to be classified as “Fair Value through Other Comprehensive Income” (FV-OCI) or as “Amortised Cost”. The accounting treatment of FV-OCI is very similar to the previous AFS classification and so, for example, Government bonds (held as single bonds or via pooled vehicles) will maintain their “status quo” and there will not be significant changes compared to the past.
Sara: Why are corporate bonds an issue – what is the concern here?
Matteo: The case of corporate bonds is more complex. A new kind of analysis is introduced, which is called SPPI test (Solely Payment of Principal and Interest test) and which is based on the analysis of the cash-flows of each single bonds.
The SPPI test is required for Government bonds as well, but due to the “plain-vanilla” features that Government bonds usually have, it is highly possible that the great majority of Government bonds will pass the SPPI test and so they are classified as FV-OCI (as already mentioned above).
On the other hand, for corporate bonds it is not so easy to “guess” ex-ante whether they fulfil the SPPI test or they do not; however, quite a relevant portion of corporate bonds will pass and they will maintain an accounting treatment like the previous AFS classification.
For the bonds which do not pass the SPPI test, the FVTPL would be unavoidable, introducing another source of higher volatility on the Profit and Loss than in the previous accounting regime.
Sara: Are insurance investors likely to pull out of FI corporate funds?
Matteo: Fixed income pooled vehicles (such as mutual funds) which invest in corporate bonds (both financial or non-financial issuers) would be classified as FVTPL “tout court” without any chance to check the SPPI test of the single underlying bonds.
Insurance companies traditionally invest in Government bonds via single bonds, mainly for ALM and cash-flows matching reasons; however, they usually invest in corporate bonds via mutual funds, especially in the case of small-medium size portfolios for a better diversification.
“Investing in corporate bonds via mutual funds seems to be penalised by IFRS 9”
Consequently, in the case of corporate bonds, IFRS 9 would penalise an asset allocation strategy implemented via mutual funds rather than via single bonds, due to the almost sure classification of mutual funds as FVTPL.
Considering the same financial risk implied by the two different ways of implementing the allocation to the same asset class, investing in corporate bonds via mutual funds seems to be penalised by IFRS 9 and investing in corporate bonds via single bonds seems to be supported by IFRS 9.
This conclusion could lead Insurance investors to switch their assets from fixed income corporate funds to invest in single bonds portfolios or mandate, even while keeping the same asset allocation.
Sara: What does this mean for diversification and how can insurance investors maintain diversification amidst these regulations?
Matteo: Even when maintaining the asset allocation unchanged, the just mentioned switch from fixed income corporate funds to single securities portfolio could reduce the diversification in terms of credit risk allocation or single issuers’ exposure, especially for small-mid Insurance companies, which would face some issues in implementing well-diversified corporate bonds portfolios under the IFRS 9 regime.
“An insurance investor must decide between facing more volatility on the Balance Sheet or reducing the credit risk diversification”
A possible mitigation of this negative effect could be found after the full introduction of the IFRS 17 standard (probably in 2023, following the last indications), but in the current transition phase (with the only IFRS 9 is in place), an Insurance investor must decide between facing more volatility on the Balance Sheet (maintaining the allocation to corporate bonds funds and classifying them as FVTPL) or reducing the credit risk diversification (switching from mutual funds to single corporate bonds, classified as FVTPL in case the SPPI test is passed).