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The IAIS supports the IASB and FASB’s efforts to produce a converged approach to both financial instrument and insurance accounting, in so far as is possible. In the event that the Boards cannot reach convergence, the IAIS encourages the Boards to ensure that a full comparison of expected credit losses recognised under IFRS and US GAAP is possible.
The ED, in common with FASB’s alternative model, likely represents an improvement over the incurred loss approach to impairment. The ED achieves an acceptable balance between the faithful representation of the underlying economics and the cost of implementation and will lead to more timely recognition of expected credit losses compared to the current standard. It introduces a number of important changes aimed at strengthening accounting recognition of impairments, including the requirement to consider more forward-looking information, facilitation of earlier loss recognition, and the inclusion of credit deterioration model that is likely to better align with how firms assess credit risk on their financial instruments. The IAIS believes it makes an appropriate distinction between financial assets that have deteriorated in credit quality and those that have not and will improve the measurement requirements for loan commitments and financial guarantees.
The IAIS applauds the objective of having a single expected credit loss impairment model for originated debt, purchased debt instruments and loan commitments, irrespective of whether those items are held at amortised cost or fair value through other comprehensive income (FVOCI) given the different challenges that accounting for those types of instruments bring. The IAIS encourages the Board to ensure that the impairment model works equally well for all of these circumstances and that sufficient simplification, guidance and examples are included to ensure that the model is operational for significant holders of these financial instruments such as insurers while appropriately recognising the credit risk inherent in these instruments.
To this end, the IAIS provides recommendations for enhancing the Board’s proposal focusing on two main issues: being the ability to build-up the allowance in stage 1, and ensuring an appropriate point of transfer to lifetime losses (stages 2 and 3).
Exception for low credit assets
The IAIS is concerned about the proposal within the ED for an exception for low credit risk assets, which provides the ability for those assets to remain within stage 1 even if subject to significant deterioration. This could result in firms failing to ensure the appropriate tracking of credit migration for these assets. The IASB should ensure that the model clearly requires firms to ensure continuous or regular tracking of credit quality, either individually or in blocks of investments, the absence of which could lead a firm to mistakenly believe that an asset is of higher quality than it is, or could lead to under-provisioning under either the stage 1 approach or under a full lifetime loss. The IAIS is concerned that paragraph B16 of the application guidance could be interpreted as implying that for low credit risk items no reassessment of the allowance as determined at initial recognition would be required. Such an interpretation would be inconsistent with the model as the IAIS understands it. The IAIS acknowledges that the tracking of credit quality from inception for each individual financial asset could lead to operational burden and implementation costs for insurers, where relevant historical information is not always available in the risks systems, and so it is important that the IASB clarify whether the tracking of individual instruments is required, or whether tracking based on aggregation at a suitable level is sufficient.
Also, the ED defined assets of ‘low credit risk’ is those equivalent to an external rating of ‘investment grade’. This implies that only limited changes to the initial estimate of expected credit losses for investment grade assets would be recorded to reflect credit deterioration within investment grade. Where that credit deterioration is significant, for example where a financial asset migrates from AAA to BBB, under this proposal the IAIS is not convinced that the change to the initial estimate of expected credit losses within stage 1 would adequately reflect the extent of deterioration observed on the asset.
The IAIS also notes that ‘investment grade’ is not homogenous, is subjective, and may not in all instances represent high credit quality. Probabilities of default can vary significantly, particularly towards the lower end of the investment grade range and for those with more distant maturities. It is therefore important that transfer mechanism should also take into account of the tools and judgements developed by risk management.
Consequently, the IAIS encourages the IASB to consider whether the exception for low credit risk assets is appropriate. It may be preferable to explicitly require that the allowance changes to reflect credit deterioration of assets in stage 1 so that the allowance builds gradually and well before the transfer to phases 2 and 3.
Transfer criteria (significant credit deterioration)
In IAIS´s view the boundary between stage 1 and stage 2 is crucial given the potential difference from applying a 12-month versus a lifetime probability of default. Ensuring that this boundary is clearly demarcated would help to ensure consistent application of the standard and comparability between firms. It is important that expected credit losses are provided for sufficiently in advance of when actual losses/defaults occur and, to this end, it is important that the model considers all information reflecting a build-up of credit risks in a loan or investment portfolio and that transfer occurs when there has been a material deterioration in credit quality since initial recognition of the financial asset.
However, it is not clear from the ED what extent of deterioration is required to occur before a ‘significant’ change in credit risk is considered to have occurred. Indeed, the IAIS believes that the scope for judgement here is such that the model may not be consistently applied and, as such, that the results may not be comparable across firms.
Another concern is that paragraph 6 of the ED states that credit risk is considered to be low “if a default is not imminent and any adverse economic conditions or changing circumstances may lead to, at most, a weakened capacity of the borrower to meet its contractual cash flow obligations”. This could be interpreted as implying that imminent default is required before transfer to stage 2 or 3 should occur. The IAIS does not believe that this is the Board’s intention and, as such, encourages the Board to clarify its intention and improve the text.
Other comments
The IAIS recommends that the Board considers whether some parts of the application guidance might be more appropriately included within the main body of the standard. The inclusion of important text outside the main body of the standard may cause some preparers to overlook, or pay less consideration to, such text with a potential consequence of poorer application of the model. In particular, the guidance on measuring the stage 1 allowance included in paragraph B7, which appears to be integral to the appropriate application of the impairment model, might be better included in the main standard rather than in the application guidance. It may also be of use to include guidance contained in paragraph B16 subject to the clarification that continued or regular tracking of credit quality is expected. In respect of making the assessment of a significant increase in credit risk the IAIS believes that the text in paragraph B20, which sets out factors to consider in such an assessment, might be more appropriately included in the main standard and would help to reinforce the Board’s intention that the model is more forward-looking.
The IAIS would like to reiterate the importance of synchronised application of IFRS 9 and the expected insurance contracts standard. The IAIS believes that the Board should consider whether a general delay in the effective date of IFRS 9 is now appropriate in light of the IASB’s recent exposure draft on proposed amendments to IFRS 9 and its current proposals on expected credit losses. If not, the IAIS encourages the Board to consider introducing an exception for insurers so as to enable implementation of IFRS 9 and IFRS 4 phase II concurrently. Moreover it is important that the IASB allow sufficient time for implementation of both standards.