Sri Lankan Insurers’ Regulatory Capital Positions Drop on IFRS 16 Adoption
Sri Lankan insurers’ risk-based capitalisation (RBC) ratios have fallen with the adoption of new accounting standards for lease contracts; SLFRS 16, the local equivalent of IFRS 16, Fitch Ratings says. This is because right-of-use (RoU) assets recognised under SLFRS 16 are currently inadmissible under Sri Lanka’s RBC regime and are deducted from total available capital – the numerator of the regulatory RBC ratio. RoU assets are also subject to a 1% operational-risk charge in calculating regulatory RBC ratios.
We estimate that the RBC ratios of Fitch-rated Sri Lankan insurers were around 5pp lower on average at end-September 2019 under SLFRS 16, compared with what they would have been under the previous accounting standard. However, we believe the impact on insurers with sizable RoU assets in relation to smaller capital buffers and RBC ratios that are close to the 120% regulatory minimum would be considerably higher. Fitch expects insurers with a large drop in RBC ratios may change their short-term investment allocations and asset duration as an immediate fix.
SLFRS 16 became effective on 1 January 2019, replacing LKAS 17 (Leases). The new standard removed the distinction between operating leases and finance leases. Most contracts classified as operating leases, which were previously off balance sheet, are now recognised on the balance sheet as RoU assets, along with a corresponding lease liability. Operating leases were primarily on business premises for most insurers, including branch offices and motor vehicles.
Insurers have requested the regulator, Insurance Regulatory Commission of Sri Lanka, to revise its approach and permit the deduction of net RoU assets after removing the corresponding lease liability from total available capital to calculate RBC ratios. This is because RoU assets are closely matched by lease liabilities, which effectively limits the effect on equity. Some regulators in the Asia-Pacific region allow tangible assets to be included in available capital and extend this treatment to RoU assets if the underlying asset is tangible. In some instances, net exposure – RoU asset less the corresponding lease liability – is risk charged based on applicable risk factors.