The UK insurance market - Overview and potential impacts of IFRS 17 - Final Report

Europe Economics Final Report 17 November 2020

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Executive Summary

This study is an input to the work of the Financial Reporting Council looking at the possible impact of the use of IFRS 17 on the UK's economy and, in particular, the UK insurance industry. One of the objectives of IFRS 17 is to introduce a consistent and truly international standard. It replaces IFRS 4, the current standard applicable to insurance companies which largely allowed insurers to keep their previous (usually national) accounting practices. The IFRS standard is optional in the UK, although all insurance companies listed on the London Stock Exchange have to prepare accounts on this basis.

We seek to provide background information that might be relevant when thinking about how IFRS 17 could affect the interests of UK customers wanting to buy insurance, the size and competitiveness of the UK insurance industry, investors in insurance companies, and the UK macro-economy. We have relied primarily on desk-based research, supported by a small stakeholder engagement exercise.

The UK represents the fourth largest insurance market worldwide, with a total value of gross insurance premiums underwritten by UK insurers and reinsurers reaching almost €400 billion in 2018, a level that has risen steadily since 2011. However, the number of firms with authorisations to write insurance has declined in recent years. There was a 21 per cent fall in PRA authorisation for life insurance and a 17 per cent fall in general insurance authorisations. The presence of authorised insurers has been recently shifting from UK-based firms towards EEA-based companies. Despite this, the total amount of insurance services exported from the UK has increased in recent years, from £18.8 to £20.1 billion between 2016 and 2019. Europe appears to be the main source of competition for UK insurers in the UK market. In 2019, the share of imports from the EEA was more than 50 per cent of the overall import figure, standing at more than £1.7 billion (exports to Europe accounted for £7.2 billion in that same year).

The general impression gained from insurer interviews was that IFRS 17 will not affect the competitiveness of UK insurers materially. While the costs associated with the change are significant, these spread out across all the policies sold are unlikely to affect the price competitiveness of UK insurers. It is possible that at the margins the new reporting standards may lead to greater global harmonisation, reducing marginally the barriers to entering the UK market.

The effects of IFRS 17 on product mix and pricing across the whole insurance sector are unlikely to be major. Insurers we spoke with did not envisage major changes in their product mix or pricing, observing that the standard changes how they report results rather than the underlying activity. It is possible that the reporting requirements concerning onerous contracts may deter offering products that serve as 'loss leaders', although regulatory initiatives already in train may be more significant in this regard.

The UK is one of the most active capital markets, attracting investors from all over the world. Between 2010 and the first half of 2020, we found data showing that insurance companies raised £28,388 million on the UK debt market, and £5,062 million in the UK equity market. UK insurers account for more than £23,500 million of the former, and £5,053 million of the latter. All of the insurers we spoke with were keen that their investor base should not become less diverse as a result of IFRS 17. There were no major concerns raised about the possibility that their geographic spread of investors will be significantly curtailed. When grouping investors, it was more common to distinguish between institutional investors focused on the insurance sector and general investors than by geographic location.

The cost of capital for the insurance sector is significantly higher than for banking, another regulated sector. A benefit often cited to justify reporting standards, such as IFRS 17, is that it will lead to a lower cost of capital as greater transparency will remove some investor uncertainty. The potential impacts of IFRS 17 on the cost of capital for insurers could differ depending on the main business on which the insurers are active,

but overall uncertainty is the main feeling we got from insurers about the effects of the new reporting standards on insurers' cost of capital. In general, they do not expect the change to have the intended effect of reducing the cost of capital in the sector, at least in the short run. There are concerns that even specialist investors will feel less sure about how to interpret financial reports in the early years of the new standard. We estimate that the weighted average cost of capital for the insurance sector was higher in December 2019 than seven years earlier. The low gearing in the sector means that the cost of equity is relatively more important than the cost of debt.

Insurers are themselves important investors. One source suggested that the total investment assets held by UK undertakings amounted to £1.60 trillion in assets at the end of 2019. In 2018, the same figure amounted to £1.74 trillion, the majority of which, £1.6 trillion, was held by life insurers. IFRS 17 seems unlikely to have much effect on the asset mix held by UK insurers. Insurers observed that current UK accounting practices already measure contract liabilities at current values and insurers predominantly value investment assets at fair value, so it is unlikely that the standard will change their incentives on asset mix; this conclusion may not extend to the situation facing some non-UK insurers.

For the UK macro-economy, the implications for tax policy seems to be the area where IFRS 17 could have a material impact. According to a recent report published by Statista, in 2019 the sector made the largest tax contributions of any sector, approximately £75 billion (representing over 12 per cent of the total HMRC tax receipts). Because IFRS 17 will change the way profits are reported, the tax due in a given year will change absent changes in the tax code. Parties we spoke to said that they are in discussions with HMRC but do not yet know exactly how the changes will affect their business, much less the wider insurance community. It is also possible that dividend payments will be affected by IFRS 17 not because of any change in the underlying profitability of insurers' activities, but because of changes in how profits are reported. However, the insurers we spoke with suggested that Solvency II will remain the main constraint on dividend payments and none planned any change in dividend payments in the immediate future. The sector's importance to the UK economy in terms of GDP and employment seems unlikely to change due to IFRS 17. In 2018, just over 300,000 jobs were linked to the insurance and reinsurance sectors, respresenting just less than 1 per cent of total UK employment.

1 Introduction

This study is an input to the work of the UK Endorsement Board secretariat looking at the possible impact of the use of IFRS 17 on the UK's economy and, in particular, the UK insurance industry. IFRS 17 is a new accounting standard that will replace IFRS 4, the current IFRS standard applicable to insurance contracts. The IFRS standard is optional in the UK, although all insurance companies listed on the London Stock Exchange have to prepare accounts on this basis.

1.1 Background to the Study

The IFRS Foundation seeks to develop globally accepted accounting standards and to promote their adoption. It claims that this standardisation of financial reporting rules brings three main benefits: (i) transparency, since they enable the comparability of international companies; (ii) accountability by reducing the information gap between investors and management; and (iii) efficiency, by allowing investors to evaluate opportunities across the world. The International Accounting Standards Board (IASB) sets the IFRS Standards.

The IASB first issued the IFRS 17 Insurance Contracts in May 2017. It was originally scheduled to come into force on 1 January 2021, although its effective date has recently been postponed to 1 January 2023.[^2]

One of the objectives of IFRS 17 is to introduce a consistent and truly international standard. It replaces IFRS 4, the current standard applicable to insurance contracts which largely allowed insurers to keep their previous (usually national) accounting practices. As a result, the accounting principles currently employed by insurers around the world vary significantly between countries (and even potentially within countries).

There are a number of key changes that IFRS 17 introduces.

• Liabilities will be estimated based on (i) the net present value of best estimate cash flows, (ii) risk adjustment, and (iii) the contractual service margin (i.e. unearned profits).
• For contracts which are identified as loss-making (i.e. onerous) the loss will be recognised upfront. Expected profits for profitable contracts (i.e. non-onerous) will be recognised throughout the duration of the contract to reflect the provision of insurance services.
• Contracts will be grouped into portfolios of contacts subject to similar risks and managed together. Combined with the different treatment of onerous and non-onerous contracts described above this will prevent insurers from offsetting losses from onerous contracts by grouping them with profit-making contracts.
• Income statement will distinguish between "Insurance service result" (comprising insurance contract revenue, and incurred claims and other expenses) and finance income/expenses.

The diversity in current accounting practice means that the impacts of these changes are likely to differ from country to country and, indeed, from one insurer to another.

1.2 Objectives and structure of the present study

An assessment of the likely impact of IFRS 17 needs to think about how it will affect UK insurers and financial groups directly (how will the sector's global competitiveness be affected?) and the knock-on implications for

UK consumers and other interested parties. This study reports information that helps to understand these impacts.

We start by describing the current UK insurance market (chapter 2).

We then look at competition in the product market. We think about this both from the perspective of UK-based insurers trying to compete (in the UK and globally) and UK consumers of insurance products. In Chapter 3 we provide a brief analysis of how UK insurance firms currently compete. We look at the competition from insurers based in other countries, such as countries from the European Economic Area (EEA) and the US, and then look at the activities of UK-based insurers overseas, analysing to what extent UK insurers compete in other countries. Chapter 4 looks at the insurance products available in the UK and the pricing of them. It looks at how the IFRS 17 could impact the product mix offered by UK insurance companies and their prices, assessing also if the new standards could affect the innovation of the market.

The study then looks at data that might be relevant when thinking about IFRS 17's possible implications on the capital markets, first looking at evidence relevant to questions about UK insurance firm's ability to raise money in the capital markets. In Chapter 5 we look at the evidence on competition from non-UK insurers in UK capital markets. Chapter 6 analyses the cost of capital of UK