Lifecos face ‘really epic’ accounting change – here’s why it matters

Rarely does something earth shattering happen in the accounting world, but there’s a much-anticipated change coming that may alleviate headaches for investors when assessing the financials of Canada’s big life insurance companies.

EffectiveJan. 1, 2023, Sun Life Financial Inc., Manulife Financial Corp., and Great-West Lifeco Inc. will be subject to a new International Financial Reporting Standard for insurance contract accounting (IFRS 17).

The transition to IFRS 17 is expected to materially reduce the Canadian lifecos’ book value of equity, moderately lowering underlying net income compared to previous years. Sun Life shares took the biggest hit following an investor education session on May 31, when that company estimated the accounting change will reduce shareholders’ equity by 15 to 20 per cent — a larger hit than analysts expected.

“Anytime you have this uncertainty in the marketplace, there’s always concern especially in the near term,” said Scott Chan, managing director of equity research in financials with Canaccord Genuity Corp., in a phone interview.

Below, BNN Bloomberg breaks down the basics of IFRS 17 for insurance contracts and why it matters to the average Canadian investor.

What is IFRS 17?

While the pandemic raised global mortality risk and hit the big lifecos’ bottom lines, IFRS 17 has been discussed by stakeholders and the International Accounting Standards Board (IASB) since 2017.

The standard requires companies to make changes to the presentation and reporting of insurance contracts, including a simplified view of the income statement, disclosures on the sources of earnings, and new key performance indicators (KPIs).

Why the need for such a standard?

In a global investing environment, there have been calls for a standard like IFRS 17 to compare entities across jurisdictions.

“Whatever is being done now is developed by actuaries and insurance regulators, but you have all these different jurisdictions applying different kinds of insurance accounting,” said Linda Mezon-Hutter, chair of the Accounting Standards Board, in a phone interview.

With the new standard, analysts will be able to hone in on lifeco earnings that will now distinguish income from insurance and investment-related sources, thus providing additional insights into the fundamentals of the business.

“The issue [currently] is that life insurance companies don’t split this out,” said Nigel D’Souza, a financial services analyst with Veritas Investment Research, in a phone interview. “I think [IFRS 17] will lead to better comparability and more consistency.”

“There was nothing like that for insurance until IFRS 17,” added Mezon-Hutter. “And that’s really epic.”

What are the key changes?

The key change is the timing in which earnings from insurance products are recognised.

“It’s very different if it’s life insurance, because now suddenly you’ve got a policy that you may actually be paying over 20, or 30, or 40 years. You’re building up some value in that life insurance policy,” said Mezon-Hutter. “In today’s world, [the premium] would be returned. Whereas in tomorrow’s world, only the part associated with the insurance coverage is returned and the rest is a deposit.”

This results in a new KPI that analysts will be tracking: the Contractual Service Margin (CSM), reflected as unearned revenue (ie a liability on the balance sheet) and then recognized as earned (on the income statement) over the life of the contract (compared to immediate recognition under existing standard, IFRS 4).

What are the potential impacts of this change?

“The main impact of IFRS 17 is that adjusted earnings are expected to decline across the board on transition simply because instead of recognizing the profit upfront, you’re now recognizing it over the lifetime of that contract,” said D’Souza. “So it reduces the run rate of earnings.”

Scott Chan at Canaccord noted that potential target prices should be materially discounted because of this accounting change. “Nothing really changes in their business purpose [investors] may think about perhaps a higher multiple to reflect the higher [return on investment] yields that are expected [in the future],” he said.

Since revenue is going to be recognized over a greater period of time under IFRS 17, there is potential for companies to overstate revenue. Companies may get what’s called a “qualified opinion” – an audit opinion that suggests the company’s financials are not fairly represented in a specific area.

Mezon-Hutter said the industry is ready for the accounting change. “These companies do not want to get qualified opinions,” she explained.

According to a statement from Sun Life, 60 per cent of its diversified businesses – which span across health, wealth and asset management – ​​are expected to face little or no impact from the transition to IFRS 17. The company has maintained a medium-term objective of eight to 10 per cent growth for underlying net income.

Why should this matter to the average Canadian investor?

IFRS 17 matters for the average Canadian investor since, according to Mezon-Hutter, banks and life insurance companies are among the most widely held investments in retail investor portfolios because of their dividends. “People like the safety and security of banks and insurance companies,” she said.

D’Souza noted that dividends will likely be affected more by overall market conditions rather than an accounting change. While dividends are expected to grow in line with earnings, he said a fund that owns broad-based equities tied to the S&P/TSX Composite Index would have exposure to the big lifecos, and therefore IFRS 17.

D’Souza said he believes the new standard will have the biggest impact on Manulife given the company’s net new business gains for insurance contracts, which totaled more than $1 billion in fiscal year 2021, account for approximately 20 per cent of its post-tax adjusted earnings.

While Canadian lifecos were hit hard at the onset of the pandemic, analysts are not expecting the pandemic will be a permanent overhang for the sector.

“Canadian life insurance companies may actually end up [benefitting] because a global pandemic raises awareness of the risk of death and illness,” said D’Souza. “It can potentially even increase demand for life or health insurance products, particularly in regions that are under-penetrated in terms of insurance products like Asia, which is the fastest growing business segment particularly for Manulife and Sun Life.”

Cathy Miyagi is a segment producer with BNN Bloomberg based in Vancouver, and is also a chartered professional accountant (CPA, CMA).

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