Investment Highlights

Key changes ahead

• FRS 17 will come into effect for insurance companies (both conventional insurance and takaful companies) on 1 January 2021. It will have a profound impact on insurance companies, more than FRS 9. Although it seems a long way with more than 2 years to go for the effective implementation of the new accounting standard, the changes are seen as complex and challenging for insurance companies. It is expected have a more significant impact on life than general insurance companies owing to the former’s longer duration for contracts/policies.

• Companies are permitted to apply the standard earlier than the 1 January 2021. This will allow some insurance firms to even commence applying FRS 17 in 2020. Under the deferral approach, it is permissible for insurance companies to defer the adoption of FRS 9 and implement it concurrently with FRS 17 on 1 January 2021.

• As of now, we understand that there will be retrospective adjustments to insurance companies’ retained earnings. Also, there will be changes to the liabilities recorded in the balance sheet when FRS 17 is implemented.

• The new standard will enhance the comparison of insurance companies in the future and provide greater transparency in their financials.

• From our perspective, there will be significant changes to the insurers’ reporting of profit and loss (P&L) statement and balance sheet. Not only that this is expected to impact the analysis of the financials but also the valuations of insurance companies ahead.

Implications on the sector from FRS 17

• Amongst the key changes, premium income will no longer appear on the P&L of insurance companies. Hence, gross written premium (GWP) will not be stated as part of insurers’ revenue in the future. This will be replaced by profits from contracts which will gradually be amortized/released and recognized on the P&L of insurers from their contractual service margins (CSM). CSM represents the unearned profit of the group of contracts of insurance companies. It can also be viewed as the present value (PV) of future profits.
  We understand that extensive work will be involved in the gathering, storage and usage of data for the new standard. There will be a need to group insurance contracts which are similar in risk together (aggregation). This will be for the purpose of recognizing losses from a group of onerous contracts and the timing of recognizing profits from a group of profitable contracts. Contracts can be grouped into any of the following categories: i) Onerous at inception, ii) Those with no significant possibility of becoming onerous subsequently or iii) Other profitable contracts. 
  FRS 17 will smooth out earnings of insurance companies. Additionally, it is also expected to smoothen insurer’s profits in the event of any changes in assumptions.
  Losses on onerous insurance contracts will be flagged immediately on P&L statements under FR 17. This will result in transparency on less profitable contracts which can then be compared with the other insurance companies on the profitability/health of their policies. Clearly, earnings for insurance companies with lower losses from onerous contracts will be less volatile. This is expected to result in lower betas and consequently a favourable valuation compared to insurers with higher losses from a large number of onerous contracts.
• We gather that with the new standard, it would be more difficult to harvest the fruits of equity investments for insurance contracts with direct participation features. This is in view of the fact that any fair value gains from investments will be amortized out instead of recognizing it in full immediately on the P&L of the companies.
• Insurance service expenses will become more transparent with the actual and expected expenses reported.

• Under FRS 17, financial risk will be presented separately from the insurance service results. Volatility of the financial risk will be captured either under the P&L or other comprehensive income.

• Investments in systems and processes for the preparation of the new standard will be necessary. Besides, there is likely to be the need for higher actuarial employees as actuarial models could be more complex with the adoption of the new standard.

• It is still preliminary to assess the impact on the retained earnings of insurance companies under our coverage from FRS 17. Changes to guidelines could be still be taking place before the effective implementation date on 1 January 2021.

• We have a NEUTRAL rating for the insurance sector as premium (topline) growth for insurance companies is expected to be modest with the slowdown in GDP growth. Also, we are seeing a rising trend for claims of motor and medical insurance of general insurance companies.
  We have a HOLD call on LPI Capital (FV: RM15.30/share) due to the stock’s rich valuation. Meanwhile, on Tune Protect, our recommendation is a BUY with an FV of RM1.10/share. This is premised on undemanding valuation with a decent FY19 ROE of 11.6%. The other salient points include the improved premiums for its travel insurance business with an increase in the number of policies issued and stronger underwriting profits from its general insurance segment. Also, improvement in combined ratio has been evidenced with a decline in claims, a benefit realized from the derisking of its motor portfolio with a higher quota share.

Source: AmInvest Research - 26 Sept 2018