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A balancing act 

Companies should not assume their existing discount rate approaches will comply with IFRS 17, warns Daryl Boxall 


05 SEPTEMBER 2019 | 
DARYL BOXALL

balancing ikon

Firms’ existing discount rate approaches under IFRS 4 will likely no longer be appropriate


Following more than 10 years of development, the International Accounting Standards Board issued IFRS 17 Insurance Contracts in May 2017, replacing the interim standard IFRS 4.

Under IFRS 4, insurers were able to adopt a wide range of approaches to account for insurance contracts. This complexity made it difficult for investors and analysts to compare insurance companies across products and jurisdictions, and ambiguity in reporting can create a barrier to investment in the insurance sector. The purpose of IFRS 17 is to provide a single accounting model so that investors can better understand the financial performance of insurers and compare the sector more readily with other industries.


What is changing?

IFRS 17 will fundamentally change how insurers construct their balance sheets, report profit or loss, and disclose information. 

The standard introduces a fundamental measurement approach called the ‘general model’ – this is the default approach for assessing insurance contracts. There are two adaptations to this: the ‘variable fee approach’, which applies to contracts with certain (‘direct’) participation features, and the ‘premium allocation approach’, which is a simplification for eligible contracts with a coverage period of a year or less. This article focuses on the general model.

Insurers’ balance sheets will look different under IFRS 17, and will consist of four building blocks, as shown in Figure 1.


Figure 1: Insurers’ balance sheet elements under IFRS 17
Figure 1: Insurers' balance sheet elements under IFRS 17


What are the requirements around discount rates?

Under the general model, an adjustment for time value of money is made by discounting future cashflows. IFRS 17 refers to two methods for deriving appropriate discount rates:

Bottom-up: “an entity may determine discount rates by adjusting a liquid risk-free yield curve to reflect … the liquidity characteristics of the insurance contracts”


Top-down: “an entity may determine the appropriate discount rates … based on a yield curve that reflects… a reference portfolio of assets … [and] eliminates any factors that are not relevant to the insurance contracts.”


Figure 2: Bottom-up and top-down discount rate approaches under IFRS 17
Figure 2: Bottom-up and top-down discount rate approaches under IFRS 17


The discount rate has a number of purposes in the IFRS 17 framework, and will impact both balance sheet and profit or loss accounts:

  • Discounting fulfilment cashflows: contracted cashflows are discounted to reflect time value of money and allow for illiquidity of insurance liabilities

  • Measuring changes in the Contractual Service Margin (CSM): CSM is determined at policy inception, and the rate used to calculate the CSM is ‘locked in’ at that date. Changes in the expected cashflows of the policy will result in a recalculation of the CSM at that ‘locked-in’ rate. The discount rate also determines interest accrued on the CSM which is a negative to profit or loss account

  • Determining the insurance finance income/expense in profit or loss: Firms can choose to recognise the change in liabilities due to discount rate movements in other comprehensive income, which will reduce volatility in reported profit or loss.

 
Given these applications, it is important to consider which features of discount rates will be desirable. Firms will look to adopt a discount rate approach that optimises the level, timing and volatility of shareholder equity and profit or loss. For some, this will mean a high illiquidity premium in order to maximise CSM and provide loss absorbency; for others, it will mean close matching of illiquidity premium to the treatment adopted for the firm’s assets in order to minimise volatility in profit or loss.


How does this compare with existing approaches?

Given the changes introduced by IFRS 17, firms’ existing discount rate approaches under IFRS 4 will likely no longer be appropriate. However, there are some clear parallels with the discount rate methods outlined in the standard and the volatility adjustment (VA) and matching adjustment (MA) under Solvency II.

There are operational reasons why firms may wish to align with their existing approaches under Solvency II, rather than incur the development cost of complex new systems and processes. However, several features of the MA and VA calculations are not compliant with the standard.


FIGURE 3: Comparison of the IFRS 17 discount rate principles with Solvency II matching adjustment and volatility adjustment
FIGURE 3: Comparison of the IFRS 17 discount rate principles with Solvency II matching adjustment and volatility adjustment


CLICK HERE TO SEE FIGURE 3 


Adjusting for liquidity of insurance contracts

Under both approaches, the standard asserts that discount rates should be appropriate to the liquidity of the relevant insurance contracts. IFRS 17 is principles-based, so there is little guidance provided on how to determine insurance contract liquidity, but we can take a steer from how other industry activities have approached this problem.

During the development of Solvency II, before the adoption of the MA and VA methodologies, the European Commission’s Quantitative Impact Study 5 recommended grouping liabilities into different ‘buckets’ depending on the nature of their liquidity – for example 100% of the calculated illiquidity premium was applied to immediate annuities, 75% to with-profits business and 50% for all other business. More recently, work on the International Capital Standard has heralded a similar approach, grouping liabilities into ‘top’, ‘middle’ and ‘general’ buckets, which receive 100%, 90% and 80% of the calculated illiquidity premium respectively.

While this grouping approach makes operational sense for many firms, it is not clear that it is always appropriate to haircut the illiquidity premium – for example, it is optional in the standard for firms using a top-down approach.

It is generally expected that an illiquidity premium derived from high quality corporate bonds will be lower than an illiquidity premium derived from less liquid assets (eg infrastructure debt). Similarly, it may not be appropriate to further reduce illiquidity premiums where they have been derived from assets that are more liquid than liabilities (eg for immediate annuities). The industry has further work to do in determining the most appropriate approach.

While there are operational benefits from aligning the IFRS 17 discount rate method with existing processes, firms should not assume that their existing discount rate approaches will be compliant. Solvency II MA and VA offer sensible starting points for consideration, but they will not meet the requirements of the standard without methodological changes. 

There are likely to be significant commercial benefits available to firms that invest time and resources into determining an approach that balances compliance, development costs and optimal financial outcomes. This may not be a trivial exercise – particularly for firms with complex product ranges or those which operate across a number of economies.


Daryl Boxall is a capital management actuary at Prudential plc, and a member of the IFoA IFRS 17 Futures of Discount Rates working party