Risk Adjustment Definition (IFRS17-1 & IFRS17-2)
IFRS17-1:
"RA: Risk Adjustment (for non-financial risk)
→ claims development"
IFRS17-2
"Risk Adjustment for non-financial risk, or RA, is defined as follows:
RA adjusts PV(future cash flows) to reflect the compensation the entity requires for bearing uncertainty about the amount and timing of cash flows"
I am not sure to understand how claims development relates to a compensation of uncertainty.
Thank you
Comments
There is uncertainty related to the development of claims -> For example, IBNR and ultimate loss ratio changes at every valuation period. If we knew for sure that ultimate claims would be 1000, then we wouldn't need any Risk adjustment because there is no uncertainty as to whether it could possibly increase to 1000 or decrease to 800. We would just reserve 1000. However, given that there is a range of possible outcomes and 1000 just represents the expected value, we need additional padding or compensation to bear this uncertainty or risk
I see. When I first read the 'Claims Development', I thought we needed RA for the Ultimate calculation and not necessarily the uncertainty around the ultimate.
It makes more sense now, thank you!
No problem, the RA in general is meant to pad for uncertainty in any aspect, not just specifically for claims development
Risk Adjustment associated with reinsurance contracts held can be estimated by "cost of reinsurance". While by definition, RA should only concerns about non-financial risk, but I assume "cost of reinsurance" would include estimation of ceded cash flows - which should not belong to RA for non-financial risk. Can you explain? Thank you
Cost of reinsurance here is not about the estimation of ceded cash flows but rather the cost of purchasing reinsurance. The risk adjustment here is basically the amount of risk transferred to the reinsurer which is well approximated by the cost of reinsurance as the reinsurance premium gives insight into how much the market (the reinsurer) views the risk to be worth. By using this cost as an estimate, the insurer can approximate how much compensation it would require to hold that risk itself.