Risk adjustment (margin) Insurance IFRS Seminar December 1, 2016 Bill Horbatt Session 19

Agenda Definition of Risk Adjustment Risk Adjustment Techniques

Risk Adjustment (B76) Compensation that an entity requires for indifference between fulfilling: (a) Insurance contract liability that has a range of possible outcomes; and (b) fulfilling a liability with fixed cash flows with the same expected present value as the insurance contract.

Risk Adjustment (B77) (a) diversification and Risk adjustment is the compensation that the entity requires for bearing uncertainty about the amount and timing of cash flows that arise as the entity fulfils the contract, Risk adjustment reflects: (a) diversification and (b) both favourable and unfavourable outcomes.

Risk Adjustment (B78) The purpose of the risk adjustment is to measure the effect of uncertainty in the cash flows that arise from the insurance contract. Risk adjustment reflects all risks associated with the insurance contract, except those reflected through the use of market consistent inputs

Explicit risk adjustment (B79) Separate from estimates of future cash flows and discount rates that adjust for time value of money. These are disclosed separately from risk adjustment

Observations Risk adjustment is not a “cushion” to absorb volatility No cash value floor Risk adjustment is dynamic (“unlocked”) Independent of gain at issue (see “service margin”) No references to 3rd parties Liability adequacy test (loss recognition) not required

Risk Adjustment Techniques

Replicating portfolio (B80) The requirement that a risk adjustment must be included in the measurement in an explicit way does not preclude a ‘replicating portfolio’ approach. To avoid double-counting, the risk adjustment does not include any risk that is captured in the fair value of the replicating portfolio

Desirable Characteristics of Risk Margins IAA Risk Margins Paper (and in the insurance contract ED B81) 1. The less that is known about the current estimate and its trend; the higher the risk margins should be. 2. Risks with low frequency and high severity will have higher risk margins than risks with high frequency and low severity. 3. For similar risks, contracts that persist over a longer timeframe will have higher risk margins than those of shorter duration. 4. Risks with a wide probability distribution will have higher risk margins than those risks with a narrower distribution. 5. To the extent that emerging experience reduces uncertainty, risk margins will decrease, and vice versa.

Judgement (B82) Apply judgement choosing an appropriate risk adjustment technique. Requirement to translate the result of that technique into a confidence level if a different risk adjustment technique is used.

Risk Adjustment Techniques Prior ED (2010)Techniques for estimating the risk adjustment: Confidence Interval; Conditional Tail Expectation (CTE); and Cost of Capital. Other possible techniques Explicit margins in actuarial assumptions

Exposure Draft Confidence Interval: Likelihood that the actual outcome will be within specified interval. Sometimes referred to as Value at Risk (VaR). Easy to communicate and calculate. Not as useful for distribution that are not statistically normal. Conditional Tail Expectation (CTE or tail VaR): Better reflection of extreme losses. Focuses on the tail of the probability distribution → reflects aspects of insurance. Judgment required to determine band and may need to change in future periods.

Exposure Draft Cost of Capital: Applied in pricing, valuations and regulatory reporting, etc. Reflects estimated cost of holding required capital to meet obligations with high confidence. Need to determine capital rate that reflects risk relevant to liability. Approach used in SII for risk margin.

Desirable Characteristics of Risk Margins IASB Insurance Contract Discussion Paper 1. Applies a consistent methodology for the entire lifetime of the contract; 2. Uses assumptions consistent with those used in the determination of the corresponding current estimates; 3. Be determined in a manner consistent with sound insurance pricing practices; 4. Varies by product (class of business) based on risk differences between the products; 5. Ease of calculation; 6. Is consistently determined between reporting periods for each entity, i.e. the risk margin varies from period to period only to the extent that there are real changes in risk; 7. Is consistently determined between entities at each reporting date; i.e., two entities with similar business should produce similar risk margins using the methodology; 8. Facilitates disclosure of information useful to stakeholders; 9. Provides information that is useful to users of financial statements; 10. Consistent with regulatory solvency and other objectives; and 11. Consistent with IASB objectives.

Thank You