IFRS 17 transition: loss component, PAA and the audit committee

The two frameworks answer different questions. IFRS 17 is a financial reporting standard: it measures the fulfilment cash flows (expected cash flows, risk adjustment, discounting) and allocates profit over the coverage period. Solvency II is a regulatory capital regime: it measures a best estimate plus a risk margin calibrated to a 99.5% one-year VaR.

Build a bridge.

• Solvency II best estimate: £455m.
• Solvency II risk margin: £41m (6% cost of capital on the SCR).
• Solvency II technical provision: £496m.
• IFRS 17 fulfilment cash flows: £560m.
• Difference: £64m.

Sources of the difference.

1. Risk adjustment vs risk margin. The IFRS 17 risk adjustment is £26m at the 90th percentile; the SII risk margin is £41m. That reduces the IFRS 17 figure by £15m relative to SII.
2. Discounting. IFRS 17 uses current market rates; SII uses the EIOPA risk-free curve with a volatility adjustment and a matching adjustment. If IFRS 17 rates are lower, the liability is higher.
3. Expenses and acquisition costs. IFRS 17 includes directly attributable acquisition costs in the fulfilment cash flows; SII includes expenses in the best estimate but not in the same way.
4. Contract boundary. IFRS 17 and SII may have different contract boundaries, especially for renewable contracts.
5. Loss component. The £38m loss component is part of the IFRS 17 liability but is not a separate SII item. It reflects the fact that the contracts are onerous at inception.

The key message. The £64m is not an error or a 'prudence' difference. It is the net effect of different risk measures, discount rates, and expense treatments. The risk adjustment at the 90th percentile can be lower than the SII risk margin even though it sounds more prudent, because the two are not comparable.

PAA eligibility. IFRS 17 permits the PAA if the coverage period of each contract in the group is one year or less, or if the liability for remaining coverage is a reasonable approximation of the general model. For annual commercial liability policies, the coverage period is one year, so the PAA is eligible in principle. However, eligibility does not mean it is appropriate for the liability for incurred claims, which for long-tail liability still requires actuarial estimation.

What PAA does. Under the PAA, the LRC is measured as premium received minus acquisition cash flows, adjusted for onerous contracts. The LIC is measured using the general model (expected cash flows, risk adjustment, discounting) or a simplified approach. So the long-tail uncertainty does not disappear.

Onerous contracts. The segment is loss-making (combined ratio 112%). At inception, the group is onerous. The loss component of £38m must be recognised immediately in P&L. Under the PAA, the loss component is determined at a group level and is not smoothed. The CFO's hope that PAA 'looks smoother' is not a valid accounting reason. Accounting policies must be neutral and not chosen to achieve a presentation outcome.

Recommendation. Use the PAA for the LRC if it is eligible and the simplification is supportable; but do not use it to avoid the loss component or the risk adjustment. Test whether the PAA gives a reasonable approximation for the LIC. Document the policy and obtain auditor agreement. If the LIC is material and long-tail, the general model may be more transparent.

Start with the purpose. 'IFRS 17 is for reporting to shareholders and policyholders; Solvency II is for regulatory capital. They use different risk measures, so they will not give the same number. Neither is a cash value; both are estimates.'

Use a bridge. Show the £496m SII technical provision, the £64m of adjustments, and the £560m IFRS 17 liability. Break the £64m into risk adjustment vs risk margin, discounting, expenses, and the loss component. Use a waterfall chart.

Explain the risk adjustment. 'The £26m is the amount we add to reflect the uncertainty in the cash flows, calibrated to the 90th percentile. The SII risk margin is £41m because it is a 6% cost of capital on the SCR, which is a different measure. You cannot compare them directly.'

Explain the loss component. 'The £38m is the loss we expect to make on this segment. IFRS 17 makes us recognise it immediately rather than spreading it. That is why the liability is higher and why the profit pattern will be different.'

PAA. 'The PAA is a simplification for the unearned premium, not for the claims liability. It is eligible for annual policies, but it does not remove the need to estimate the long-tail claims. I would not choose it just because it looks smoother; the auditor and the Audit Committee should approve the policy on its merits.'

Governance. Provide a written paper, a sensitivity table, and a clear recommendation. Offer a training session for the committee. Record the questions and answers. If the committee is still uncomfortable, consider a simplified one-page 'IFRS 17 vs SII' explainer for the board.