IFRS 17 volatility

Many life insurance companies are struggling with increased volatility in their profit-and-loss (P&L) statements and balance sheets following the introduction of IFRS 17. This volatility may be driven by fluctuations in the contractual service margin (CSM), mainly due to changes in the economic environment or policy lapses. An even greater concern is the impact of the loss component (LC) or its recovery, which flows directly into the P&L statement without any amortization.

This paper addresses the volatility arising from economic changes in products accounted for under the variable fee approach (VFA) and demonstrates how it can be mitigated through asset hedging, using interest rate sensitivity as of a specific date. Under the VFA approach, changes in the variable fee—defined as the entity’s expected share of the returns on underlying items minus any expected cash flows that do not vary directly with those items—are reflected in the CSM when they result from changes in financial risks like interest rates. For example, an increase in interest rates may reduce the value of underlying items, but not in proportion to the reduction in the present value of future cash flows (PVFCF) and the risk adjustment (RA), due to factors such as financial guarantees or duration mismatches.

Products accounted for under the building block approach or reinsurance contracts were excluded from this analysis, as were any potential impacts on IFRS 17 planning exercise over three or four years.

Hedging advantages under IFRS 17

Effective asset-liability management involves more than simply selecting assets that have the highest expected return within a given investment mandate. It also requires analyzing the risk factors of the liabilities and ensuring that the asset portfolio’s risk profile aligns with them. Many insurance products are sensitive to financial risk factors such as interest rates, equity movements, credit spreads, illiquidity premiums, and inflation. Large changes in these factors can significantly impact the value of liabilities. If a firm lacks assets that match the liability’s sensitivity to key risk factors, its P&L could be more volatile as markets fluctuate. This can also impact net equity on the balance sheet, since changes in asset values may not offset corresponding changes in liability values. As a result, incorporating hedging strategies into asset portfolio management—while taking the liability risk profile into account—can help reduce volatility in a company’s P&L statement and balance sheet. By purchasing additional hedge assets and structuring the asset portfolio to align with the risk factors (such as equity delta and key rate duration) of the liability, the insurer can largely insulate itself from the quarterly volatility of capital market data.

The challenge, however, is to hedge the risks without creating excessive accounting volatility, while also designing a hedge that performs reasonably well under the Solvency II framework. Derivatives are frequently used for hedging purposes and are accounted for at fair value through P&L. For this reason, hedging is generally more aligned with a fair value valuation approach. Many insurers also use the fair value through other comprehensive income (OCI) option for insurance liabilities; however, this leads to an accounting mismatch with the fair value through P&L treatment of derivatives. For this reason, the remainder of the paper assumes that both assets and liabilities are accounted for at fair value through P&L.

As mentioned before, under IFRS 17, for products under the VFA, changes in the variable fee due to financial risks—such as movements in market variables like interest rates—are reflected in the CSM. As long as the CSM balance is large enough to cover losses, its release into the P&L over time can help smooth the company’s earnings. If not, an LC could generate an immediate impact on the P&L statement. For example, when the initial CSM is close to zero, a sudden financial or nonfinancial shock is more likely to trigger an LC. However, changes in the CSM can be mitigated by using a hedging strategy to reduce the impact of financial shocks.

Not hedging under IFRS 17 also could be problematic if total losses exceed the initial CSM balance, as losses can only be absorbed into the CSM when it remains positive. However, once the CSM is depleted, any additional losses from market risk flow directly into the P&L statement, as the CSM cannot be negative. As a result, in scenarios where the CSM is insufficient to cover losses, hedging can help reduce P&L volatility caused by movements in market variables.

A conceptual numerical example is shown below in Figure 1. Without a hedging position, an entity's share, which is -50, could result in an LC with an initial CSM of 20, due to change in financial or nonfinancial assumptions. However, with a hedging position, the entity's share could be reduced to avoid reaching an LC through an asset hedging strategy and application of a risk mitigation option.

Hedging under IFRS 17 offers several advantages. First, the CSM does not fully protect the company from the total losses that can occur from adverse movements in market variables, meaning cumulative earnings remain unchanged. However, hedging can reduce volatility in the P&L by mitigating the possible creation and reversal of the LC. While the slow release of CSM can reduce short-term P&L volatility, the cumulative P&L at the end will be the same whether or not a hedging position is in place. Therefore, hedging primarily helps reduce volatility in the cumulative P&L. In addition, IFRS 17 allows the application of a risk mitigation option, under specific circumstances, which enables changes in the fair value of assets to be accounted for through the P&L while the effect in the insurance liabilities (variable fee) flows into the CSM. This is particularly relevant when hedging is achieved through the use of derivatives.

Differences between IFRS and Solvency II in the context of hedging

While Solvency II and IFRS share some similarities in their valuation principles, Solvency II is a broader, multidimensional framework, as it serves as a capital regulation directive. Conceptually, hedging accounting volatility under IFRS can be compared to hedging the volatility of own funds under Solvency II. However, hedging under Solvency II may have different objectives—for example, stabilizing the Solvency II ratio, which is a distinctly different from accounting volatility. This is one of the critical differences between the two regimes.

To avoid comparing apples and oranges, our discussion of Solvency II will focus solely on aspects related to the valuation of own funds. However, it is important to stress that any hedging program should not be assessed in isolation. Its impact on other key measures must also be considered. Insurers typically manage several objectives simultaneously. For example, when implementing a hedge with IFRS as the primary focus, it is essential to also evaluate its effects on Solvency ratios, capital generation, and other related metrics.

IFRS accounting principles

Financial instruments are covered under the IFRS 9 standard, while insurance contracts are covered under the IFRS 17 standard.

Under IFRS 9, financial assets can be measured at fair value through P&L, at fair value through OCI, or at amortized cost. The choice of accounting treatment is driven by the entity’s business model and the results of the solely payments of principal and interest (SPPI) test.

IFRS 17 provides principles for measuring both the liability for remaining coverage and the liability for incurred claims. The measurement consists of the fulfilment cash flows—which include the best estimate and a RA for nonfinancial risk—and the CSM.

Similar to assets under IFRS 9, the best estimate of liabilities under IFRS 17 can be recognized either through P&L or through OCI, but not at amortized cost.

Under the general model in IFRS 17, the CSM can absorb only the impact of changes in nonfinancial assumptions, such as lapses and expense rates. However, if an insurance contract is eligible for the VFA, the CSM can absorb both financial and nonfinancial risks. Eligibility for the VFA depends on the presence of direct participation features. While unit-linked products are a typical example of VFA-eligible contracts, the actual scope of eligible contracts is broader.

Solvency II valuation principles

Under Solvency II, financial assets are valued according to Article 75(a) of the Solvency II directive, which closely aligns with the fair value definition. As a result, if assets under IFRS 9 are measured at fair value through P&L, their valuation should generally align with Solvency II. However, if a different accounting treatment is applied under IFRS 9, a discrepancy may arise between IFRS 9 and Solvency II valuations.

Achieving full alignment between Solvency II valuation and IFRS 17 accounting on the liability side is more challenging, although some companies aim for this. Under Solvency II, the value of technical provisions is defined as a sum of the best estimate liability (BEL) and the risk margin (RM). While the BEL is conceptually similar to the best estimate under IFRS 17, true alignment requires that contracts under IFRS 17 be accounted for at fair value through P&L. Even then, notable differences may remain—for example, in the construction of the yield curve. (It is worth noting that many companies try to minimize these differences by adopting EIOPA yield curves for IFRS 17 purposes.) Other key differences between Solvency II and IFRS 17 may include differences in expense allocation and contract boundaries.

Regarding the risk margin, Solvency II is generally more prescriptive in terms of the methodology compared to IFRS 17, which provides companies with more flexibility in their choice of approach for the RA. Although it is not necessarily common practice, some companies aim to align the IFRS 17 RA calculation with the Solvency II risk margin to minimize discrepancies between the two frameworks.

The last IFRS 17 component, the CSM, does not have an equivalent under Solvency II, which can create a mismatch between the IFRS and Solvency II positions. In such cases, when applying hedging programs, the risk mitigation option should be chosen to avoid this discrepancy.

In summary, although Solvency II and IFRS 9/IFRS 17 share some similarities, a hedging program designed to manage the volatility of the IFRS balance sheet will not necessarily be equally effective in hedging Solvency II own funds, and vice versa.

IFRS 17 case study

Below, we present a case study on hedging of interest rate risk for an Italian-style participating product within a segregated fund, known as Gestione Separata. It is common practice in Italy to apply the VFA for such participating products.

The products used in this case are typical of the Italian market: savings products with a minimum guarantee (often set to 0 for more recent offerings) and profit-sharing features linked to the return of a dedicated pool of assets that is segregated from the company’s other activities.

The profit-sharing for these products is calculated in one of two ways:

1. For most products, a management fee—on average around 1%–1.2%—is deducted from the annual gross rate of return.
2. In residual cases, companies apply a profit-sharing rate to the gross return of the segregated fund. This rate generally varies from 80% and 95%, with the higher percentages applied to corporate policies involving larger premium amounts.

Of course, interest rate risk is not the only driver of accounting volatility under IFRS 17. Other financial risk factors—such as spread risk, basis risk, equity risk, and second-order effects like the illiquidity premium or UFR (Ultimate Forward Rate) drag—also contribute. Nevertheless, interest rate risk remains the most important financial risk factor for Italian companies and therefore gets the most attention in the context of hedging strategies.

This hedging analysis focuses on the structure, operational framework, and impact on the P&L. The aim of the exercise is to simulate a sudden shock at the evaluation date in order to assess how the CSM would have responded under different economic scenarios (e.g., +/-100 bps). Starting from the actual P&L, the paper shows how the results could have differed if market conditions had changed during a single reporting period (t0). By examining this specific Italian model, we aim to provide insights into its effectiveness and potential applicability to other segregated funds.

The asset allocation of the segregated funds comprises 81% bonds, with maturities ranging from 1 to 30 years, and 19% common stock. On the liability side, the reserves are split as follows: 68% have a minimum guaranteed rate of 0%, 22% have a minimum guaranteed rate of 2%, and the remaining falls within a range of 1% to 2.5%.

The objective of this example is to show how changes in interest rates can impact the P&L—and how applying a risk mitigation option can help smooth these effects. The hedge positions were constructed using interest rate swaps to match the key-rate duration of the liabilities. Any potential transaction costs related to the hedging were assumed to be negligible. Key-rate duration sensitivities of the liabilities were calculated at the 1-, 5-, 10-, 20-, and 30-year tenor points, and interest rate swaps with the corresponding tenors were used to hedge each respective key-rate bucket. As a result of this construction, the hedge also offsets changes in liability values arising from parallel shifts in the interest rate curve. The derivative positions are assumed to be acquired at the reporting date, meaning no market value changes are reflected initially. In subsequent reporting periods, the insurer would need to assess the applicability of the risk mitigation option under IFRS 17.

Moreover, after hedging the CSM using derivatives, the insurance company could consider applying a risk mitigation option to reduce accounting mismatches. These mismatches arise because, while derivatives help smooth the CSM under IFRS 17, their own fair value changes under IFRS 9 flow directly through the P&L, creating volatility. Based on the actual 2023 P&L, an estimate was made to assess how the P&L would have been affected under different parallel shifts in the interest rate curve. These hypothetical shocks were modeled at +/-10 bps, +/-50 bps, and +/-100 bps.

Below, for each sensitivity scenario, the corresponding change in the CSM or the emergence of an LC is shown.

Figure 3 below shows the CSM and P&L positions, along with the differences (deltas) between each sensitivity scenario and the base case.

These sensitivities were calculated by adjusting changes in the underlying items to reflect market value movements under different shocks, as well as changes in the PVFCF . In addition, marginal changes in the RA were taken into consideration by updating the corresponding RA driver.

After applying the interest rate swap hedges described earlier, the sensitivities were re-run. The results are shown in Figure 4 below.

As shown in Figure 6, applying hedging significantly reduces the sensitivity of the CSM to interest rate shocks, resulting in smoother performance. This reduction in volatility is due to the recalibration of the CSM under shock scenarios, where changes in underlying assets are adjusted using the delta NAV and the base case closing PVFCF is replaced with the PVFCF under the shock scenario. This methodology preserves the expected cash flows from the opening position, along with actual data and realized gains and losses. Consequently, this approach reduces the impact on the P&L and, in scenarios such as a +100-bps shock, helps prevent full depletion of the CSM, thereby avoiding the creation of an LC.

This happens because the hedging position is designed to reduce the delta in NAV, as shown in Figure 7.

Conclusions

Effective risk management practices must be continuously reviewed and updated, especially after significant regulatory changes such as the introduction of IFRS 17. As shown in this paper and case study, different shocks—such as those to interest rates or credit spreads—can lead to varying outcomes for both P&L results and the CSM. Therefore, risk management should go beyond analyzing asset and liability cash flows and also consider the broader impact on the company’s overall P&L and balance sheet. Moreover, hedging strategies should be reviewed regularly, and potentially rebalanced, to reflect changes in the economic outlook. Lastly, further analysis is needed to assess both the beneficial and adverse effects that IFRS 17-focused hedging may have on a company’s Solvency position.