Richard Schneider, Jon Neale and Apostolos Papachristos discuss asset liability management for an IFRS 17 balance sheet
IFRS 17 introduces new challenges to the management of insurers’ assets and liabilities, as well as to discount rate estimation. Discount rates will include only relevant factors, such as the time value of money, the characteristics of the cash flows and the liquidity characteristics of the insurance contracts. More details on the theoretical and practical challenges posed by IFRS 17 discount rates are available in the article ‘IFRS 17: Defining the discount rate’, from the August 2021 issue of The Actuary (bit.ly/IFRS17_DefineDisc).
Under IFRS 17, the valuation of liabilities is based on the determination of a current value of the insurance contract, considering market perspectives for financial risks and company-specific perspectives for non-financial risks. The process of asset liability management focuses on the development of strategies that include assets and liabilities. The objectives of asset liability management are:
- To protect the value of own funds against changes in interest rates or, more broadly, changes in asset values
- To influence investment strategies and achieve financial objectives through ‘risk–reward’ optimisation.
The management of assets and liabilities will be affected by the approach adopted to determine discount rates. Several sources of asset liability mismatch can be identified.
First, the well-known duration mismatch. The duration mismatch between the actual portfolio of assets and liabilities is a significant source of profits volatility, should interest rates move. Under IFRS 17, the difference in duration between actual portfolio and reference portfolio should also be monitored, because the reference portfolio is used to estimate the discount rates for the valuation liabilities. Therefore, a material duration gap between the actual and reference portfolio may increase profits’ sensitivity to interest rates.
Next, the treatment and estimation of credit and liquidity risk premiums. The estimation of credit risk premiums remains a significant challenge, and several methodologies have been proposed for estimating credit risk (bit.ly/IFRS17_DefMod). The profits’ sensitivity could be greater if the average credit rating of the reference portfolio was very different to that of the actual asset portfolio. The estimation of liquidity risk premium as a component of the reference portfolio yield to maturity is a difficult task, and several approaches have been proposed to address this issue – examples can be seen in the IAA’s International Actuarial Note 100: Application of IFRS 17 Insurance Contracts (bit.ly/IAAnote_100), Thomas Bulpitt’s analysis IFRS 17: Liquidity characteristics of insurance liabilities (bit.ly/IFRS17_LiqChar) and Apostolos Papachristos’s Case study on the ‘top-down’ approach (bit.ly/IFoA_TopDown), the latter two published as part of the work of the IFoA Future of Discount Rates Working Party. The profits’ sensitivity could be greater if the liquidity profile of the reference portfolio is very different to that of the actual asset portfolio.
From 2023, annuity insurers reporting under IFRS 17 are likely to see their balance sheets behaving differently as market conditions change. Insurers will currently be determining policy choices for IFRS 17 reporting. As well as determining the rate of profits emergence, opening equity and so on, this also has implications for future earnings volatility and hedging.
The IFRS 17 balance sheet has three liability elements. The best estimate liability (BEL) represents the best estimate of the amount needed to pay liabilities, and is heavily impacted by the discount rate, demographic and maintenance expense assumptions, all of which will affect the sensitivity of the BEL to market conditions. For example, a low discount rate will increase the size of the BEL and its sensitivity to interest rates.
Next there is a risk adjustment (RA), which is calibrated to the compensation an insurer requires to take non-financial risk. Broadly, a higher RA will lead to high sensitivity to market conditions, although some methods will also increase sensitivities (a cost of capital approach is likely to be more sensitive than a confidence interval approach).
The last liability item, the contractual service margin (CSM), will be calculated as business is written. It prevents the recognition of any Day 1 profit, instead deferring profit over time. For profitable annuity business, this will essentially lead to the total initial reserve (BEL + RA + CSM) being equal to the premium, meaning the choices over assumptions for the BEL and RA drive the balance between the different liability items, rather than the size of the initial reserve.
The CSM is designed to spread profits over the lifetime of the insurance business. As, say, non-financial assumption changes are made to the BEL, there will be a broadly offsetting impact through the CSM to ensure impacts are spread over time. However, the CSM is only updated for non-financial changes – so changes in market conditions don’t impact the CSM. This means that changes in other liability components due to economic assumption changes will not be ‘offset’ by a corresponding change in the CSM. In other words, while the total reserve at initial recognition is not sensitive to initial assumptions, the total reserve in subsequent periods will be sensitive to economic assumption changes.
IFRS 17 recognises that RA calculations are complex, so gives an option to treat all changes in the RA the same way, or to separate financial and non-financial impacts. Where financial assumptions are separated out, they will change the size of the RA, but do not impact the CSM. However, if changes are not identified separately, a change in the RA due to, say, interest rates will be offset by a change in CSM, and the sensitivity of the IFRS liabilities is reduced (although the CSM cannot fall below zero).
So how might the sensitivity of IFRS liabilities change from today? Currently, annuity liabilities are set on a prudent basis, so can be viewed as BEL plus a prudent margin. The sensitivity of the IFRS liabilities will therefore depend on how the RA compares to the prudent margin.
The RA will only reflect compensation for non-financial assumptions, whereas the current prudent margins normally also include margins for financial assumptions. As a result, the RA may be lower than current prudent margins. In this case, the sensitivity of the liabilities will fall relative to today. Insurers may also prefer a higher CSM than a higher RA and may select choices that lead to this outcome, driving a reduction in the sensitivity of liabilities.
Where an insurer hedges mismatches between assets and IFRS liabilities and continues to do so, hedging assets will need to be rebalanced, potentially leading to changes in solvency sensitivity.
Even where an insurer hedges solvency, it will be important to consider how IFRS earnings volatility has changed so that stakeholders can be advised accordingly.
With-profits funds are exposed to numerous sources of market risk, including the movement in value and implied volatility of the underlying asset shares backing participating contracts, which affect the value of financial guarantees and options. Further, variability in bonus rates expose both policyholder and – depending on ownership structure – shareholder to market risks. Hedging of these risks can involve taking derivative positions and/or the construction of internal dynamic hedges.
Under IFRS 17, most traditional UK-style with-profits is expected to be measured under the variable fee approach (VFA). As always, recognition of profit is deferred via the CSM. In the with-profits context, this relates to the present value of future shareholder transfers, plus a proportion of the contract’s contribution to the estate, less the contribution to burn-through cost liability.
“From 2023, annuity insurers are likely to see their balance sheets behaving differently as market conditions change”
The specifics will depend on the fund structure, mutualisation features and so on, but this is the basic picture. As always, the CSM is adjusted from one reporting period to the next based on movements in the variable fee, and importantly, under the VFA, the CSM is adjusted for both financial and non-financial risks. But if the CSM is adjusted for financial risk, then why hedge? There are several reasons:
- The CSM only ‘hedges’ in-period market movements; the overall profit and loss impact of a market stress over the life of a contract is unchanged. In other words, the economics of the contract are unchanged.
- Most firms would not focus asset liability management purely on IFRS 17 impacts, and other metrics do not typically have such an explicit profit deferral mechanism.
- As such, the CSM is a pure ‘accounting hedge’. If the fund is already hedged on a more economic basis, there is a potential ‘double-hedge’ effect. In other words, a mismatch arises as the movement in the hedged item is taken to CSM, but the movement in the hedging instrument is recognised in profit and loss.
- Not all with-profit contracts will necessarily be eligible for the VFA.
- The CSM cannot go negative, so large shocks may not always be offset.
Regarding point (3), the standard allows for a risk mitigation option, the effect of which is to allow preparers to ‘switch off’ the VFA in certain circumstances. One of these circumstances is where a documented hedging strategy exists, and in the latest text the scope has been increased to cover both derivative and non-derivative hedging assets. This allows firms to flow market-related liability movements directly through profit and loss to match the movement in the hedging instruments, instead of deferring them via the CSM.
One potential area of contention relates to internal hedging strategies. For example, firms might delta-hedge equity risk by running a short position in equities relative to the stated asset share mix. This is not too different from running a dynamic futures position, and may in fact involve less basis risk. In theory, one might therefore argue that the risk mitigation option should apply to such situations, too. If this argument fails, however, then the VFA stays switched on, and the asset share ‘mismatch’ results once again in profit and loss volatility.
A shifting situation
While we are not suggesting that IFRS 17 will be the primary metric on which asset liability management will be based going forwards, firms will at least want to understand the drivers of profit and loss volatility and how these might be addressed. There are many things to consider, and these differ by product type. We hope the material presented here is of use to firms as the balance starts to shift from building compliant models to the commercial and financial implications of the new standard.
Jon Neale works for a leading bulk annuity insurer implementing IFRS 17
Apostolos Papachristos is an investment actuary involved in asset liability management and IFRS 17 implementation
Richard Schneider is an independent actuarial consultant focusing on regulatory change implementation
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