In 2014 the IASB published a discussion paper (accounting for dynamic risk management: a portfolio revaluation approach to macro hedging). The IASB has since refined its proposals, which are set out in various papers to the IASB Board and are explained in a series of webinars. An exposure draft for a new accounting standard is now expected in the first half of 2025.

The DRM proposals are a response to criticism that the hedging approaches in IAS 39 and IFRS 9 do not reflect the true nature of risk management undertaken in banks. Notably, banks’ risk management practices are often to dynamically (i.e., on an ongoing basis) manage their net open positions (i.e., what is left after natural hedging), whereas the accounting standards focus on establishing a relationship between specified hedging and hedged instruments over set periods of time.

As a result, investors cannot easily understand the effect of hedging on a banks’ financial position and future cash flows because an accounting measurement mismatch can arise between the instruments giving rise to the net open position and the hedging derivatives, as the former are typically carried at amortised cost while the later are carried at fair value.

Overview of current IASB DRM proposals

The aim of the IASB proposals is to better reflect the effects of an entity’s interest rate risk management in its financial reporting.
It does this by considering the ‘current net open position’ of the reporting entity, its target profile, its risk mitigation intent, and constructing a benchmark portfolio of derivatives to reflect the intended hedged exposure.

The benchmark portfolio enables the effect of the hedging strategy to be measured and produce a value that can be recognised on the balance sheet as a balance to the actual hedging derivatives entered into. The entity will review the effectiveness of its risk management strategy over time and adjust for changes. Simplistically, any differential (i.e., ineffectiveness) between the benchmark portfolio and the actual hedging derivatives entered into (‘designated derivatives’ using IASB DRM terminology) is recognised in profit or loss.

Interest rate risk in insurance

The IASB defines interest rate risk as “The risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market interest rates”.
Interest rate risk arises in different ways within insurers. Assets are typically carried at fair value which may fluctuate with changes in rates. Insurance contract liabilities under IFRS 17 are calculated using a current discount rate for the fulfilment cash flows and a locked in discount rate for the CSM.

Any residual differences between the asset and liability movements are reflected in the financial statements, in contrast to the amortised cost position reflected in banks for a similar residual exposure.

However, insurers are in some ways similar to banks: both operate interest rate management strategies to manage their economic exposure in accordance with their risk appetite or target risk profile. They also both engage in natural hedging, whereby they look to generate a stream of cash inflows on their assets to match the stream of cash outflows payable on their liabilities; and use derivatives.

Challenges for insurers when applying the DRM proposals

The IASB’s proposals were designed with banks in mind. There is however a significant difference between banks and insurers in their risk management strategies, and one which means that the current IASB proposals may not work for insurers.

A bank’s risk management strategy will typically target a risk measure that is closely linked to the assets and liabilities within the IFRS financial statements and their related income and expenses – so for example, a bank might target a stable net interest margin over time.

An insurer on the other hand more typically targets a risk measure connected to its regulatory requirements – for example to maintain a stable Solvency II coverage ratio, or to maintain a Solvency II surplus. These regulatory requirements potentially measure assets, insurance liabilities and capital requirements on a different basis to that used by the IFRS financial statements. For example, IFRS 17 and IFRS 9 liabilities issued by insurers may have different contract boundaries or underlying cash flows to their regulatory equivalents and regulatory capital requirements are not recognised in IFRS .

With the adoption of IFRS 17 in the UK, there has generally been an increase in the differences, and interest rate exposure, between the accounting and regulatory frameworks, particularly for general model business . The scale of these differences are particularly significant for insurance contracts with long duration cash flows and higher regulatory capital requirements such as annuity business.

Applying the IASB DRM proposals to insurers is not meaningful in this situation, as the potential risk or volatility in the regulatory requirements that is being hedged is not reported in the IFRS financial statements, whilst the hedging instruments are.

Next steps

We need to see the final IASB proposals to undertake a full assessment of their implications for insurers, but it seems likely they will not generally provide a useful framework for insurers to present their risk management approaches, and so UK insurers, at least, seem unlikely to benefit.

There is a range of risk management strategies and objectives in use within the insurance sector, in part determined by individual risk appetite choices; but also, in part, determined by the differing nature of the insurance business written and the resultant differing interest rate risk profiles.

This suggests any future hedge accounting approach will need to be heavily principles based and flexible to allow for this range of practices. The challenge however is that such an approach may not contribute to greater consistency and comparability. There may, therefore, need to be a trade-off between a model that can provide investors with more useful information about an individual insurer’s risk management strategy and the effects, with reduced comparability.

As we look forward to the IASB’s exposure draft, the IASB, preparers and investors need to consider whether the DRM project should enable insurers to better reflect their interest rate hedging strategies which are more focused on regulatory rather than IFRS results.

Unfortunately, there does not seem to be a quick or easy solution, somewhat echoing the time it has taken the IASB to develop an approach for interest rate risk within banks.