Authors: Jasper Hoogenstraaten, Servaas Houben
link: http://theeuropeanactuary.org/downloads/TEA%2020-JULY2019.pdf (pages 14-16)
pdf: TEA 20-JULY2019_RA
Publisher, publication date: The European Actuary, 2019-06
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Executive summary
In the new IFRS17 accounting standard a margin is added to best estimate liabilities for non-financial risks, called the risk adjustment. The risk adjustment represents a buffer that compensates insurance undertakings for non-financial risks in their cashflows due to different levels and timing in expected and actual claims and payments.
The risk adjustment concept is based on a similar concept within Solvency II, the risk margin. Contrary to Solvency II, IFRS17 allows insurance companies to use their own judgment to determine the techniques used and the level of risk adjustment. As a result, insurance companies have more freedom to value the risk adjustment based on their own view on the risks involved and their own level of risk aversion and risk preferences. This will allow the risk adjustment to not only be a calculation exercise prescribed by regulations, but also a metric which can be actively used to manage risks and the business.
Solvency II Legacy
In the Solvency II EC Directive 2009 the value of technical provisions is defined as the sum of a best estimate and a risk margin (77.1), and expresses the amount required to take over insurance and reinsurance obligations (77.3) on a transfer basis. The risk margin is defined as the cost of capital a third party incurs for taking over the best estimate liabilities on its balance sheet and is determined as the net present value of the future Solvency Capital Requirement (SCR) and the accessory Cost-of-Capital (CoC). The corresponding CoC rate is set at 6% independent of the solvency position of the selling (re)insurance undertaking. EIOPA’s second set of advice outlines the reasons for applying a 6% CoC assumption and mentions that the CoC rate is the same for all insurance and reinsurance undertakings. Furthermore the risk margin is assumed to be “a long-term average rate, reflecting both periods of stability and periods of stress” therefore avoiding procyclical effects (increase in reserve requirement at times of stress) resulting in a constant rate over time. Although avoiding procyclical effects seems desirable from an undertaking and regulator point of view, it is unclear if this is a realistic perspective from a market based view as during times of stress risk premiums tends to increase.
Considering that the risk margin refers to a buffer required for transferring liabilities to a third party, the assumption of independence of company or country specific circumstances does not seems unreasonable: the value of cash flows from the perspective of the receiving undertaking won’t be impacted by either the credit rating or the country of residence of the selling undertaking. However the second set of advice does provide interesting links to studies from finance professor Damodaran showing that CoC rates are industry, country and business cycle dependent.
Although Solvency II can be considered to a market value framework, a fixed 6% CoC rate independent of the economic cycle does not seem to fully reflect changes in economic reality. Moreover it does not reflect a level of risk as perceived by the insurance company itself on a going concern basis.
IFRS17 Changes
Fundamentally different to Solvency II, IFRS defines the risk adjustment as a compensation the insurance company itself requires for bearing the uncertainty in the timing of cash flows from non-financial risks. Hence the risk adjustment is defined on a going-concern basis and reflects the company’s own perspective, not the perspective by a third party on a transfer basis.
| Solvency II Risk Margin | IFRS 17 Risk Adjustment | |
| Valuation perspective | Transfer to third party | Going concern own entity |
| Scope | All relevant SCR risks including operational risk and non-hedgeable financial risk | Contract specific non-financial risk only |
| Valuation method | Cost of capital | Own estimation technique |
| Stress level | 99.5% following SCR | Dependent on company’s own degree of risk aversion |
| CoC rate | 6% | Not predefined, can be company specific or other method may apply |
| Shock type | Unfavourable outcomes | Assess risk aversion to favourable and unfavourable outcomes |
IFRS17.B88b mentions that the risk margin reflects the entity’s degree of risk aversion (i.e. risk appetite) which results in differentiation between (re)insurance undertakings, for example:
- Business units: risk appetite for life, pension and non-life domains might differ;
- Geographies: some geographies might be expanding whilst others might be closed book resulting in different levels of risk appetite;
- Business strategies: some companies might want to expand in growth times and shrink in recessions while others might have the opposite strategy resulting in the level of risk aversion changing over time depending on business strategy and the economic cycle;
- Financing: companies might apply different levels of debt to equity financing (Damodaran), the cost of debt and equity financing might differ per company and financing strategies might change over time depending on the organization life cycle;
- Risk types: companies might have other tolerance levels depending on the risk type. Company sensitive risks (e.g. operational risk/reputation risk) may be less desired than other general non-financial risks (morbidity, mortality risk) that follow overall industry and population trends, hence resulting in different levels of risk aversion depending on the risk type.
Compared to the generic Solvency II risk margin, the IFRS 17 risk adjustment is a much more company specific metric. This makes it less likely and convincing that the risk adjustment is the same across the industry. Furthermore IFRS17B88b mentions that the risk adjustment should reflect “both favourable and unfavourable outcomes” implying that entities should assess their risk aversion to uncertainty in both positive and negative scenarios.
Conclusion
IFRS17 defines the risk adjustment in valuing liabilities as the compensation the insurance company itself requires for bearing the risks of a specific insurance contract and hence forces undertakings to fully understand their level of risk aversion and how this may differ between business lines, geographies and might change over time. We believe that the risk adjustment approach in IFRS17 should stimulate insurance undertakings to appreciate differences in risks, products and financing their business. Instead of a fixed charge specified by regulation, the risk adjustment will respond to management actions and will provide management a tool for better managing their business reflecting actual risk and their own risk appetite. To be able to manage their business accordingly, insurance companies should keep an open mind to the extra level of complexity the risk adjustment requires compared to the current risk margin.
References:
Damodaran information on weighted average cost of capital,
- http://pages.stern.nyu.edu/~adamodar/
- http://www.stern.nyu.edu/~adamodar/pc/datasets/wacc.xls (US, similar setup for other geographies)
- EIOPA’s second set of advice, https://eiopa.europa.eu/Publications/Consultations/EIOPA-18-075-EIOPA_Second_set_of_Advice_on_SII_DR_Review.pdf
- Final CEIOP’s advice for Level 2 implementing measures on Solvency II: technical provisions – article 86 (d) calculation of the risk margin, https://eiopa.europa.eu/CEIOPS-Archive/Documents/Advices/CEIOPS-L2-Final-Advice-on-TP-Risk-Margin.pdf
- Solvency II Directive, https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:02009L0138-20140523&from=EN
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