IFRS17 Flashcards
IFRS17 Principles
think about process of working on analysis
(RMPD):
Recognition
Measurement
Presentation
Disclosure
3 building blocks for measuring liabilities under IFRS17
think about how to calculate liabilities
(PV-RA-CSM):
Present value of future cash flows
Risk adjustment for non-financial risk
Contract service margin, represents unearned profit from a group of insurance contracts
- PV buffers the adverse deviation (basicially any uncertainty) for financial risks
- RA buffers the uncertainty for non-financial risks
- CSM is the unearned profit in the contracts
Financial risks are basically the risks easy to quantify as insurance related risks (underwriting,reinsurance, etc)/credit risks/market risks
Non-financial risks are basicially the risks hard to quantify such as regulatory risks/strategic risks/operational risks
Define fulfillment cash flows
Present value of future cash flows
+ risk adjustments for non-financial risk
When is CSM amount established and what’s the amount
When FCF < 0
CSM = - FCF
2 valuation methods under IFRS17
GMA: default approach
PAA:
- simplified version of GMA
- need to meet certain requirements:
» short term contracts less than 1 year
» if PAA is a reasonable approximation to GMA over the life of the contract
» applies only to LRC component of insurance contract liabilities
Define liability for incurred claims (LIC)
Insurer’s obligations to pay claims for events that have already occurred
Define liability for remaining coverage (LRC)
Insurer’s obligations to provide coverage for event that haven’t yet occurred
Define insurance contracts under IFRS17
A contract under which the issuer
- accepts significant insurance risk from policyholder
- by agreeing to compensate the policyholder
- if a specified uncertain future event adversely affects the policyholder
Components of an insurance contracts under IFRS17
think about what insurance contracts are used for
- insurance components (non-financial risks)
- service components (i.e, claims adjudication with reinsurance protection)
- investment components (amounts included in premiums that are returned to customers, regardless of the occurrence of an event. i.e, policyholder dividends)
- embedded derivatives
Insurance component: risk transfer/claims and benefits/premiums
Service component: obligations to provide services to policyholders (i.e, claim adjustification)
Investment component: financial return (i.e, policy dividends)
Formula: insurance for contract liability
LIC + LRC
Formula: LRC under PAA
UEP - DAC
Differences between IFRS17 and current CIA practice for measurement of liabilities relating to LRC
- criteria:
- IFRS17: allows PAA for short-term contracts without testing whether PAA reasonably approximates GMA
- current: allows UEP-DAC to be used only if it’s a reasonable approximation to the explicit valuation approach - DAC deferral:
- IFRS17: either may choose deferral or direct expense for short-term contracts
- current: no deferral in explicit valuation, but deferral if UEP-DAC is held - DAC amount:
- IFRS17: allows deferral of DAC that is directly attributable to the portfolio of insurance contracts
- current: allowable deferral is different - discounting of LRC:
- IFRS17: requires discounting if the contract has a significant financing component
- current: requires discounting - discounting of LIC:
- IFRS17: ignores discounting and financial risk for LIC if PAA is used for LRC and LIC cash flows are received <= 1yr within incurred date of claims
- current: requires discounting
financing component arises when there’s timing difference between receiving premiums and paying claims, especially significant for long-term contracts
discounting always required under current CIA practice
Differences between IFRS17 and current CIA practice regarding discounting
Discounting of LRC:
- IFRS17: entity may choose not to discount
- current: requires discounting
Discounting of LIC:
- IFRS17: ignores discounting and financial risk for LIC if PAA is used for LRC and LIC cash flows are received less than 1 year within incurred date of claims
- current: requires discounting
Examples in Canadian p&c where PAA can&can’t be used to measure LRC
PAA ok:
- auto outside QC
- auto in QC if PAA is a reasonable approximation to GMA
PAA not ok:
- warranty
- mortgage default
2 measurement considerations for contract liabilities under IFRS17
common sense, think about grouping and cutoff point
- Level of aggregation:
— must identify portfolio of contracts
— each portfolio is further subdivided into groups - Contract boundary:
— must identify contract boundary for each contract
— cash flow estimates include only cash flows related to claims incurred within the boundary
Do expenses need to be allocated to group in IFRS17?
Yes
Do assumptions related to measurements of liabilities need to be allocated to group in IFRS17?
No, allocate at whatever level is most appropriate for estimating cash flows
Differences between IFRS17 and current CIA practice regarding contract boundary
(CRCRESS):
1. Conservatism: IFRS17 less conservative
2. Rights&obligations: IFRS17 considers rights&obligations for both entity&policyholder
3. Coverages: IFRS17 treatment of coverages maybe different
4. Repricing: IFRS17 doesn’t consider the intent of the entity in setting contract boundary
5. Extension for DAC: concept doesn’t exist in IFRS17
6. Segregated funds with material guarantee: concept doesn’t exist in IFRS17
7. Segregated funds supported by hedging strategy: hedging is irrelevant in IFRS17 when determining contract boundary
Examples where IFRS17 boundary may be different from policy term under current practice
- Cancellable contracts:
— under IFRS17, contract boundary = cancel date
— under current, policy term extends beyond cancel date if that would increase the liability - Title insurance (covers defects in the title to land or buildings):
— under IFRS17, contract boundary = period of ownership of land/building (coverage is triggered by discovery of defect)
— under current, policy term = term of contract since coverage is triggered by the defect itself, not its discovery - Onerous contracts:
— under IFRS17, must recognize liability of an onerous contract when signed
— under current: the entity can wait until effective date to recognize liabilities - Reinsurance held:
— under IFRS17, requires reinsurance contracts held to be measured as separate contracts
— under current, determined policy term for underlying direct contract only
How does IFRS17 define estimate of future cash flows
Probability weighted mean of the full range of possible outcomes
Differences between IFRS17 and prior CIA practice regarding probability weighted cash flows
- MfADs for non-financial risk:
— IFRS17 requires separate disclosure of risk adjustment for non-financial risk
— current, the difference between best estimate of cash flow and the best estimate of PfAD is not always quantified - MfADs for financial risk:
— IFRS17 includes financial risk in the present value of future cash flows
— current, MfAD for interest risk is separate from the best estimate of PV for cash flows - Policyholder options:
— IFRS17 accounts for policyholder behavior (selections of limit and coverages)
— current, the effect on cash flows is blurred - Expenses:
— IFRS17 includes only expenses directly attributable to the portfolio
— current, this is not a requirement - Taxes:
— IFRS17 excludes taxes from cash flow estimate
— current, taxes are included
MfAD is margin for adverse deviations, it’s used to account for any uncertainty in underlying assumptions (i.e, expenses, interest rates, etc)
What’s the purpose of discounting
To account for the time value of money
3 things you need for discounting under pre-IFRS17
Assuming have the nominal value of liabilities:
- discount rate
- discount rate MfAD
- payment pattern
Under IFRS17, how’s the discount rate selected when cash flows do not vary with returns on underlying items
Discount rate is based on a liquidity-adjusted risk-free discount rate curve or yield curve
Briefly describe approaches for coming up with the discount rate curve under IFRS17
- bottom-up approach:
- adjust the risk-free discount curve by adding an illiquidity premium that reflects the liabilities - top-down approach:
- use the investment return on a reference portfolio assets that’s ““similar”” to the liabilities
- this reference portfolio doesn’t have to be based on assets held by the company
- then remove asset characteristics not relevant to the liability (i.e, remove credit and market risk)”
bottom-up: a liquid risk-free yield curve is adjusted to reflect the differences between the liquidity characteristics of market financial instruments and the liquidity characteristics of the insurance contracts
top-down: the yield to maturity of a reference portfolio assets is adjusted to eliminate any factors that are not relevant to insurance contracts
How financial risk is incorporated into discounting under IFRS17
think about what’s needed in the discounting calculation
You can build financial risk into
- discount rate
- or cash flows
- or a combination of both
(Under current, there is an explicit provision for investment risk)
Briefly describe how the discount rate is selected when cash flows do vary with returns on underlying premiums
Choose a discount rate that makes the value of the liability cash flows equal the fair market value of the underlying assets
liability = fair market value
Briefly describe how are cash flows handled when they vary with assumptions related to financial risk
- either through adjustments to the discount rate or adjustments to the cash flows themselves
- must adhere to market consistency
- IFRS17 suggests using of stochastic and risk-neutral measurement techniques and considering the costs of options and guarantees
Regarding non-financial risk, how’s the measurement objective different under IFRS17 vs pre-IFRS17 practice
- IFRS17: compensation required by entity to bear uncertainty
- current: amount required to provide for the effect of uncertainty
IFRS 17 requires precaution but current only needs to know the amount
how does IFRS 17 define LRC
LRC is an entity’s obligation to:
1. investigate & pay valid claims under existing insurance contracts for insured events that have not yet occurred
2. pay amounts under existing insurance contracts that are not included above and that relate to:
i. insurance contract services not yet provided
ii. any investment components or other amounts that are:
- not related to the provision of insurance contract services and that
- have not been transferred to the liability for incurred claims
examples where PAA may be used in stead of GMA for measuring liabilities under IFRS 17
- short-term contracts < 1yr
- long-term contracts when PAA is reasonable approximation to GMA
what does it mean for an insurance contract to be onerous
a contract is onerous at the date of initial recognition if there is a net outflow for the sum of:
- FCFs
- acquisition cash flows
- cash flows arising from the contract at the date of initial recognition
based on IFRS 17, how shall an entity, at minimum, divide a portfolio into groups
- a group that is onerous at initial recognition
- a group that has no significant possibility of becoming onerous
- a group of any remaining contracts
is an entity permitted to reassess composition of groups after initial recognition
no, group composition is established at initial recognition and shall not be reassessed
how are multi-line reinsurance contracts aggregated under IFRS 17
- based on predominant exposure
- creating a portfolio/group for multi-line contracts
- separating groups into sub contracts and grouping those subcontracts together
does IFRS 17 permit disaggregation of individual insurance contracts
- No. Under IFRS 17, the lowest unit of account is the insurance contract
- In most cases, it is not permitted to disaggregate individual insurance contracts
identify considerations when estimating the risk of non-performance of a reinsurer
- financial strength of the reinsurers
- history of claims and coverage disputes with reinsurers
- risk of contagion across various reinsurance arrangement
- delays in payments and concentration risk
- length of time over which liabilities are expected to be settled
- collateral available to mitigate risk
identify components of LIC
- an unbiased current estimate of future cash flows
- an adjustment for discounting
- a risk adjustment
identify 3 options for grouping data when estimating the present value of future cash flows and RA
- estimate gross&net losses then calculate the ceded as gross-net
- estimate gross&ceded losses then calculate the net as gross-ceded
- estimate net&ceded losses then calculate the gross as net+ceded
how is the provision for reinsurer non-performance risk calculated
measured as an estimate of the future cash flows of reinsurance held
under IFRS 17, how might insurance revenue for reinsurance contracts issued differ from earned premium
- seasonality:
- if the release of risk differs from the passage of time - reinstatement premiums:
- apply against insurance service expenses - ceding commissions on proportional reinsurance treaties
- reinsurer could classify as any of insurance revenue/insurance service expense/investment component
how is LRC estimated under GMA and PAA
GMA: LRC = FCF related to future services + CSM
PAA: LRC = unearned premium - insurance acquisition cash flows
how is the CSM concept modified for reinsurance contract held
- there is no unearned profit
- instead there is a net cost or net gain on purchasing the reinsurance
describe a potential mismatch between revenues&FCFs when an entity uses GMA for LRC for reinsurance contracts held
- revenues are recognized as they are earned
- FCF projections include projected cash flows for policies to the end of the year
if a group of contracts become onerous, when do the losses have to be recognized under IFRS 17
immediately when the groups become onerous
briefly describe the accounting treatment of onerours groups in financial statements
in the statement of financial position:
- LC is booked as part of LRC
in the statement of financial performance:
- LC is recognized as insurance service expense
financial position: think about balance sheet, basically talking about assets, liabilities, equity
financial performance: how well a company is doing, like revenue, expenses, profit or loss
when are onerous groups recognized in financial statements
reconized when bound
briefly describe the accounting treatment of Facility Association’s residual market mechanisms
explain from 3 functions of FA
- UAF: functions as a levy and therefore not considered under IFRS17
- FARM: member companies account for their share of FARM insurance contracts as direct business
- RSPs: member companies use reinsurance accounting where the reinsurer is the collective FA membership
briefly describe the concept of ‘risk adjustment’ under IFRS 17
RA adjusts PV(future cash flows) to reflect the compensation the entity requires for bearing uncertainty about the amount and timing of cash flows
identify methods for calculating the RA under IFRS 17
- quantile methods
- cost-of-capital method
- margin method
- a combination of methods
identify 5 principles for calculating the non-financial risk adjustment in IFRS 17
risk adjustment should be higher for
- risks where there is less information
- low frequency/high severity risks
- longer duration contracts
- risks with wide probability distributions
risk adjustment should be lower with emerging experience
higher uncertainty gives higher risk adjustment
identify 2 further general considerations in calculating the risk adjustment in IFRS 17
- pooling similar risks will lower the risk adjustment
(more risks imply lower variance) - pooling risks that are negatively correlated will lower the risk adjustment
are IFRS 17 measurement requirements based on the ‘unit of account’ or the ‘aggregate level’
unit of account
are IFRS 17 presentation requirements based on the ‘unit of account’ or the ‘aggregate level’
aggregate level
are IFRS 17 disclosure requirements based on the ‘unit of account’ or the ‘aggregate level’
aggregate level
how is reinsurance credit risk reflected under IFRS 17
through a reduction in expected cash flows
key components of reinsurance credit risk:
1. default risk: unable to meet obligations due to insolvency or liquidation
2. settlement risk: delays in payments
3. concentration risk: over-reliance on a few reinsurers increases exposure to credit risk if one major reinsurer fails
4. dispute risk: disagreements between ceding insurer and reinsurer over claim coverage or payment terms
briefly describe the quantile method or calculating the RA under IFRS 17
- quantile methods assess the probability of the adequacy of the FCFs (Fulfilment Cash Flow)
- these probabilities are used to quantify the RA
- specfic methods include VaR and CTE
identify 1 advantage and 1 disadvantage of the quantile method for calculating the RA
advantage: satisfies the disclosure requirements regarding confidence level corresponding to the RA
disadvantage: if misrepresented, it may introduce spurious accuracy
briefly describe the cost-of-capital method for calculating the RA under IFRS 17
RA is based on the compensation an entity requires to meet a target return on capital and has 3 components:
1. projected capital amounts
(for the level of non-financial risk during the duration of the contract)
2. cost of capital rates
(for the relative compensation required by the entity for holding this capital)
3. discount rates
(for the present value calculation)
identify 1 advantage and 1 disadvantage of the cost-of-capital method for calculating the RA
advantage: allows allocation of the RA at a more granular level
disadvantage: method is more complex (projection of capital reqs is an input to the liability calculation)
briefly describe the margin method for calculating the RA under IFRS 17
select margins that reflect the compensation the entity requires for uncertainty related to non-financial risk
identify methods for calculating the risk adjustment for reinsurance held
- quantile methods
- catastrophe models
- proportional scaling
- cost of capital
catastrophe models and proportional scaling are specific to reinsurance held
briefly describe 2 IFRS 17 risk adjustments methods that are specific to reinsurance held
- catastrophe models:
- use output from a CAT model tailored to an entity’s book of business
- select a percentile directly from the given distribution - proportional scaling:
- use the same percentage of FCFs for the ceded RA as for the direct RA
- but percentage could be modified for considerations such as ‘ceding commissions, expense allowances, reinstatement premiums’
- method may also work for non-proportional reinsurance if the ceded RA can consistently be expressed as a portion of the gross RA
why might ceded losses for CAT reinsurance need a separate RA analysis from an entity’s direct losses
think about why need separate CAT analysis in general
- catastrophe reinsurance covers low frequency, high severity events
- a standard quantile method may produce an RA that is too small or even 0
describe a method for calculating an RA for ceded losses related to CAT reinsurance and high percentile events
use a cost-of-capital method with an assumption for required capital set at a higher percentile
(captures compensation required at higher levels of the treaty)
describe a way of combining RA methods for a ‘unit of account’ approach
- for groups with less skewed distributions -> use VaR
- for groups with highly skewed distributions -> use cost of capital method or margins
identify the primary methods for calculating the RA under an ‘aggregate approach’
- quantile methods
- cost-of-capital methods
does IFRS 17 require disclosure of a confidence interval around the RA
yes
identify the best RA method for incorporating a confidence interval
quantile methods
basic concept behind simplified CoC approach
target profit margin is allocated among:
- reserve risk
- underwriting risk
- other risks that are not relevant to the RA
identify a disadvantage of thie simplified approach
the target profit margin may vary by portfolio or group
simple formula for ‘LRC’ under IFRS 17
LRC = LRC excl. LC + LC
(LC is only required for onerous contracts)
simple formula for ‘LRC’ that uses cash flows
LRC = FCFs + CSM
(CSM exsits only for non-onerous contracts)
what does it mean for a portfolio to be in an ‘asset position’
expected cash inflows > expected cash outflows
what does it mean for a portfolio to be in an ‘liability position’
expected cash inflows < expected cash outflows
at contract inception what is the value of LIC
0
at contract inception what is the value of paid claims
0
at contract termination what is the value of LRC
0
all liabilities are part of LIC at contract termination
at contract inception how much of the CSM has been released
none
at contract termination what is the value of CSM
0
all CSM has been released by contract termination
identify the main steps in any discounting procedure
- determine a payment pattern
- apply discount factors
identify a procedure for estimating the timing of LRC cash flows on a group basis under IFRS 17
- estimate a payment pattern on a group basis
- adjust the AY payment pattern used for LIC to a pattern consistent with the average accident date of the group
formula for: carrying amount of CSM @ end of reporting period
carrying amount of CSM @ start of reporting period + adjustments
identify adjustments relevant to the CSM carrying amount
- the effect of new contracts added to the group
- interest on the CSM carrying amount during the reporting period
define ‘coverage units’ according to IFRS 17
the quantity of insurance contract services provided by the contracts in the group
simple example: # of policies
what’s the key concept that relates ‘coverage units’ to the CSM
coverage units determine how CSM is released into profit or loss
how are coverage units determined
determined by considering for each contract the quantity of the benefits provided under a contract within its expected coverage period
key formula for how CSM is amortized
CUqtr = # of coverage units in quarter
CUend = # of coverage units remaining at the end of quarter
proportion of CSM released = CUqtr / (Cuqtr + CUend)
key principle for determining coverage units based on judgment & experience
to reflect the insurance contract services provided in each period
identify general considerations for counting coverage units
- quantity of benefits relates to the amount that can be claimed by the policyholder
- discounting is optional
- coverage period extends to the end of the period in which insurance contract services are provided
CSM amortization pattern if the policy limit doesn’t change over the coverage period
uniform
CSM amortization pattern if the policy limit decreases over the coverage period
declining
less CSM released toward the end
CSM amortization pattern if the policy limit increases over the coverage period
increasing
more CSM released toward the end
an example of an insurance product with a declining policy limit over the coverage period
mortgage insurance
an example of an insurance product with a increasing policy limit over the coverage period
product warranty with replacement coverage
(replacement costs could increase due to inflation)
GMA formula for FCFs at initial recognition of the contract
FCF = future cash inflows - future cash outflows + effect of discounting - RA
describe the measurement of onerous contracts subsequent to initial recognition
if no changes in underlying assumptions:
- LC is expected to be systematically decreased
if changes in underlying assumptions:
- allocate changes to the LC until it reached 0 then a CSM may be re-established
describe the measurement of non-onerous contracts that ‘becomes onerous’ subsequent to initial recognition
reduce CSM to 0 and establish an LC
why are non-onerous groups of contracts ‘good’
because they have net cash inflows
why are onerous groups of contracts ‘bad’
think about what’s onerous
because they have net cash outflows
why do onerous and non-onerous contracts need to be tracked separately for accounting purposes
- non-onerous contracts have a CSM but no LC
- onerous contracts have an LC but no CSM
identify 2 things that make PAA simpler than GMA for LRC
- PAA doesn’t require estimation of FCFs
- PAA doesn’t require a CSM
under PAA, how is LRC excluding LC calculated differently for onerous and non-onerous contracts
no difference, just onerous contracts have LC component
formula for LRC under PAA at initial recognition
+ premiums
- insurance acquisition cash flows (unless the entity chooses to recognize the payments as an expense)
+/- amounts rising from derecognition of ‘certain’ assets & liabilities
formula for LRC under PAA at subsequent measurement
+ carrying amount at start of starting period
+ premiums received in period
- insurance acquisition cash flows
+ amortization of insurance acquisition cash flows recognized as an expense in the reporting period
+ adjustments to a financing component
- insurance revenue (premium earned for insurance contract services provided in that period)
- investment components paid/transferred to LIC
identify facts & circumstances for the qualitative assessment of whether a group of contracts is onerous
common sense when it comes to explain the rationale for business
- a group of contracts in the portfolio that are known to be onerous at initial recognition
- past losses in the portfolio
- aggressive underwriting or pricing
- unfavorable experience trends
- unfavorable external conditions
describe the quantitative assesement of a potentially onerous group of contracts
- if FCF > LRC excl.LC, then onerous
- if onerous, then book LC on P&L
- increase LRC to FCF (LRC = FCF = LRC excl.LC + LC)
briefly describe the accounting steps if a quantitative assessment indicates a group of contracts is onerous
- recognize a loss in the insurance service expense immediately for the net outflow for the onerous group
- establish an LC as part of the LRC for the onerous group
briefly describe the accounting steps required for the LC at subsequent measurements
the LC is released into insurance service expense and amortized from LRC over the duration of the contracts
so LC = 0 by the end of the coverage period
describe the difference between LRC under GMA&PAA for: acquisition costs
GMA: can’t recognize acquisition costs immediately
PAA: can recognize acquisition costs immediately if coverage period of all contracts in group <= 1 year
because PAA is a simplified version, basically quick and dirty analysis
describe the difference between LRC under GMA&PAA for: discounting
GMA: discounting required
PAA: discounting not required unless there is a significant financing component
because PAA is a simplified version, basically quick and dirty analysis
describe 2 differences between LRC under GMA&PAA aside from acquisition costs & discounting
- application:
- GMA: applies to any P&C contract
- PAA: applies to P&C contracts with a coverage period <= 1 year - cash flow projections:
- GMA: for non-onerous contracts -> yes (required)
- PAA: for non-onerous contracts -> no (not required)
describe the difference between LRC under GMA&PAA for: initial measurement
GMA: LRC = PV(cash flows) + RA + CSM
PAA: LRC = premiums - initial acquisition costs unless recognized as expenses when incurred -> non-onerous contracts
describe the difference between LRC under GMA&PAA for: risk adjustment
GMA: RA is required for non-onerous contracts
PAA: RA is not required for non-onerous contracts
because PAA is a simplified version, basically quick and dirty analysis
describe the difference between LRC under GMA&PAA for: CSM
GMA: CSM is required for non-onerous contracts
PAA: CSM is not required for non-onerous contracts
if an underlying insurance contract is onerous, when must it be recognized in financial statements?
recognized when issued even before coverage period begins
briefly describe the steps in calculating LC under PAA within IFRS 17
Add FCF:
1. determine the UPR (unearned premium reserve)
2. estimate future claims and loss adjustment expenses as follows:
- apply a selected ELR and an unallocated loss adjustment expense factor to the UPR by contract group
3. discount the result of step 2 to the evaluation date
4. apply the RA, acquisition costs, other attributable expenses to the result of step 3
Substract LRC excl. LC
identify a key consideration in adapting MCT for the implementation of IFRS 17
how to select the ELR
define IFRS 17 term: discount rate
rate used to discount the estimates of future cash flows which is consistent with the timing, liquidity and currency of the insurance contract cash flows
define IFRS 17 term: fulfillment cash flow (FCF)
FCF = future cash flows + RA for non-financial risk
define IFRS 17 term: liquidity premium
- adjustment made to a liquid risk-free yield curve
- reflects differences between
–>liquidity characteristics of the financial instruments that underlie the risk-free rates and
–>liquidity characteristics of the insurance contracts
highly liquid investment have low liquidity premium
define IFRS 17 term: reference portfolio
- a portfolio of assets used to derive discount rates based on current market rates of return
- the portfolio rate of return is then adjusted to remove returns related to risk characteristics that are not in insurance contracts
identify considerations in deciding whether to use net or gross&ceded data for analysis
- data availability:
- if data is sparse, it may not be possible to directly estimate the present value of ceded cash flows - cash flow volatility:
- different approaches may be warranted for different segments of business depending on the volatility of cash flows by segment - reinsurance held:
- consider type and consistency of reinsurance held
identify considerations in segmenting data for selecting payment patterns
common sense
- business segments used for analyzing undiscounted data
- payout period
- existence of a predetermined schedule of payments
identify characteristics an IFRS 17 discount rate should possess
- the discount rate should reflect the:
- time value of money
- characteristics of cash flows
- liquidity characteristics of insurance contracts - the discount rate should be consistent with:
- market prices for financial instruments with similar cash flow characteristic as insurance contracts - the discount rate should exclude:
- factors that affect market prices but do not affect cash flows for insurance contracts
identify methods for selecting a discount rate for validation of insurance contract liabilities under IFRS 17
- bottom-up approach:
- a liquid, risk-free yield curve is adjusted to reflect differences between the liquidity characteristics of market financial instruments and the liquidity characteristics of insurance contracts - top-down approach:
- the yield to maturity of a reference portfolio of assets is adjusted to eliminate any factors that are not relevant to insurance contracts
identify risk factors that may differ between a reference portfolio and insurance contracts
- liquidity
- investment risk (i.e, credit risk, market risk)
- timing
- currency risk
examples of credit risk adjustments
default risk, downgrade risk
downgrade risk means the risk of credit rating going down
1 or more insurance contract features that increase liquidity
- low inherent value of contract
- high exit value of contract (large portion of inherent value is paid out)
an increase in liquidity means lower liquidity premium
1 or more insurance contract features that decrease liquidity
- high exit costs for contract (i.e, surrender penalties)
a decrease in liquidity means higher liquidity premium
surrender penalties are fees or charges imposed when policyholders terminated or withdraw funds before the term end
which set of insurance contract liabilities is more liquid: LIC or LRC
LRC is more liquid:
- since no claims have yet occurred, it’s easier to cancel or otherwise get rid of the contract
identify the steps in a ‘combined approach’ for estimating the Liability Liquidity Premium LLP
- create a reference portfolio and calculate the rate of return
- substract the risk-free rate to get the indicated asset liquidity premium ALP
- then LLP = r*ALP + constant liquidity premium difference
under IFRS 17, what is a reference curve
a ‘standardized’ yield curve used to facilitate comparison among entities in the unobservable period
under IFRS 17, should discount rates vary with the timing of cash flows
yes
under IFRS 17, what is a locked-in yield curve
a yield curve determined at the initial recognition of the group contracts
under IFRS 17, when would a locked-in yield curve be used for discounting
- when an entity uses the GMA to determine the LRC for some or all groups of insurance contracts and
- when an entity elects the OCI option for some or all portfolios of insurance contracts
OCI = other comprehensive income
under IFRS 17, identify 2 lines on the income statement where insurance expenses are reported
- insurance service expense
- insurance finance expense
under IFRS 17, what does ‘insurance finance expense’ (or income) refer to
it refers to the change in the carrying amount of the group of insurance contracts arising from:
- the effect of the time value of money and changes in the time value of money
- the effect of financial risk and changes in financial risk
under IFRS 17, what is meant by the ‘unwinding of discounts’
the difference between discounting the cash flows to the beginning of the period and discounting to the end of the period
under IFRS 17, identify methods for calculating the unwinding of discounts
- constant yield curve:
- uses the same discount curve at the beginning and end of the period - unwinding using spot rates:
- uses an end of period discount curve that is equal to the beginning discount curve shifted by one period - expectation hypothesis:
- proposes that the term structure of interest rates is solely determined by market expectations of future interest rate changes
under IFRS 17, what level of aggregation should be used for calculating FCFs
any level of aggregation provided estimates of LIC and/or LRC can be allocated back to portfolios and groups
describe the carrying amount for LRC using PAA (calculated at the initial recognition)
premium received
- acquisition cash flows at that date (unless already expensed)
+ any assets for acquisition cash flows derecognized
- liabilities previously recognized
identify differences between GMA and PAA for calculating LRC
think about advantages of using PAA
- PAA is simpler
- PAA doesn’t require estimation of FCFs
- PAA doesn’t require a CSM
Maybe also mention GMA requires discounting but PAA doesn’t.
how can you determine if LRC using PAA differs materially from LRC using GMA
- quantitative assessment: calculate LRC using PAA&GMA and compare the difference with the materiality threshold
- qualitative assessment: assess a similar group of contracts
briefly describe what the URFR is used for
to discount cash flows beyond the obserable period
what is the difference between nominal and real rates
nominal rates disregard inflation while real rates adjust for inflation
what is needed to calculate the URFR
historical interest rates ~ BoC inflation target
current URFR formula
EMA short-term real rates(t) + EMA term premiums(t) + inflation target(t)
how are short-term real rates determined
BoC 3 month treasury bill - YoY CPI
how are term premiums calculated
BoC long term bond rate - 3 month treasury bill rate
BoC’s current inflation target
2%
what are the disadvantages of the current approach to calculating the URFR
short-term inflation can lead to negative long-term real rates ~ volatility caused by EMA, especially during extreme economic conditions
how does the short-term inflation rate affect the URFR
can lead to negative estimates of long-term real rates, causing a large decrease in URFR
why does the use of an EMA introduce volatility in the URFR
gives more weight to recent data, increasing volatility during periods of economic instability such as stagflation and deflation
how is the URFR calculated in the revised approach
average of historical nominal rates from Jan 1998 to end of preceding year
how often is URFR adjusted in revised approach
annualy, but changes are capped to avoid excessive volatility
Actions that will be taken for the following absolute differences in new vs. current URFR:
- less than 10bps
- between 10 and 15bps
- greater than 15bps
- no change
- adjusted by +/- 10bps
- adjusted by +/- 15bps
two other methods to determine URFR
- historical real rates + inflation target
- BoC nominal neutral short-term rate + historical term premium
which method is most table and easy to understand/implement (URFR)
both historical nominal rates and historical real rates + inflation target
which method is the most technical robust with respect to data reliability (URFR)
historical nominal rates
how does historical real rates + inflation target method compare in theoretical robustness
stronger theoretical foundation but relies on assumptions about future inflation expectations
usually not recommended to use your own asset portfolio as reference portfolio due to which 3 factors (IFRS 17 Sample 2)
- currency: your asset portfolio is usually not fully dominated in the currency of your liabilities
- timing: the duration of your liabilities does not usually match the duration of your assets
- liquidity: insurers generally invest in very liquid assets to support their liabilities, such as highly rated and widely traded bonds
