Last update 18/08/2019
The Expected Credit Losses (ECL) requirement in IFRS 9 makes the initial selection of bonds for fixed income investments by financial institutions much more important, as selecting bonds with good long-term credit health is key to reducing the risk of future P&L fluctuations caused by changes in ECL. This is especially important for insurers that would like to adopt a buy-and maintain bond investment strategy.
Under the “expected credit loss” model, an entity calculates the allowance for credit losses by considering on a discounted basis the cash shortfalls it would incur in various default scenarios for prescribed future periods and multiplying the shortfalls by the probability of each scenario occurring. The allowance is the sum of these probability weighted outcomes. Because every loan and receivable carries with it some risk of default, every such asset has an expected loss attached to it—from the moment of its origination or acquisition.
| Stage 1 | Stage 2 | Stage 3 |
| 12 month expected credit losses | Lifetime expected credit losses | Lifetime expected credit losses |
The expected credit losses that result from all possible default events over the expected life of a financial instrument.
Lifetime expected credit losses (Stage 2 + 3 of the Three stages Expected Credit Losses) are the present value of expected credit losses that arise if a borrower defaults on its obligation at any point throughout the term of a lender’s financial asset (that is, all possible default events during the term of the financial asset are included in the analysis).
The requirements in IFRS 9 result in lifetime expected credit losses being recognised only when the credit risk of a financial instrument is worse than that anticipated when the financial instrument was first originated or purchased. If, at the reporting date, the credit risk on a financial instrument has not increased significantly since initial recognition, an entity shall measure the loss allowance for that financial instrument at an amount equal to 12-month expected credit losses [IFRS 9 5.5]. 12-month expected credit losses are defined as the expected credit losses that result from those default events on the financial instrument that are possible within the 12 months after the reporting date.
Lifetime expected credit losses
Lifetime expected credit losses
Lifetime expected credit losses Lifetime expected credit losses Lifetime expected credit losses Lifetime expected credit losses