Risk Margin Reward?

stratthixx

The reading states:

"There are 2 obvious reasons for adding a risk margin to your estimate of insurance liabilities:

1. to reward the insurer for taking on risk"

My question is, how is a risk margin seen as a "reward" to the insurer? I do not see how this is an obvious reason for a risk margin. My understanding is risk margins exist to cover adverse deviations (whether in your data or not).

chrisboersma

mfAD paper:

Actuaries are reminded that the purpose of margins for adverse deviations in an analysis of policy liabilities is to reflect the degree of uncertainty of the best estimate assumptions. Thus, the margins for adverse deviations are not expected to be so high that the probability of an unfavourable development is less than 1% or 5% (i.e., scenarios under dynamic capital adequacy testing).

The SOP is a little clearer: Standards of Practice paragraph 1740.03

Otherwise, if a provision promotes expectations for financial security, then the calculation should include a provision that strikes a balance among the conflicting interests of those affected by the calculation, and

Risk Adjustments IAA

IFRS 17: Compensation required by entity to bear uncertainty.

IFRS 17 requires the entity to adjust the present value of future cash flows to reflect “the compensation that the entity requires for bearing the uncertainty about the amount and timing of the cash flows that arises from non-financial risk” (IFRS 17.37).

The main difference is that IFRS 17 requires the entity’s view of the cost of risk (i.e., compensation required for bearing uncertainty) to be taken into account in setting the risk adjustment for non-financial risk.

graham

Thx @chrisboersma for looking up all the details.

@stratthixx is right that the essential reason for a risk margin is to protect against adverse deviations. The additional reason to reward the insurer for taking on risk under IFRS 17 is more conceptual. The idea is similar to when you purchase investments:

• you get a higher return for more risky investments

In our case, the insurer is permitted to include a higher risk margin if the contract is seen as being more risky. Now, the insurer isn't actually getting any more money, at least not directly. They are just being better protected against adverse development than in the old way of doing things with MfADs.

The insurer may indirectly get a financial benefit because if their liabilities are higher then their taxes are lower. (That benefit would be reversed in the future however if development is favourable rather than adverse.)

The insurer may also get a financial benefit in the form of higher future rates. If rates are based on past experience, then holding higher liabilities may feed into the ratemaking process. (But again, this might be reversed later on if there is favourable rather than adverse development.)

So that's the way I think about. In general, IFRS 17 seems to try to break down this whole process into the smallest possible components. Then these components can all be analyzed separately. The intended final result is be better management of risk.

stratthixx

I have a better understanding now. Thanks Chris and Graham. I had a problem understanding that using a higher risk margin could be seen as a reward. The way I saw it was if the insurer has to hold a higher PfAD due to higher risk margins for riskier business, then that is money that could have been spent on investments (i.e. earning investment income) instead.

graham

Hey @stratthixx,

Just to point out - you can earn investment income on these amounts. See:

• https://battleactsmain.ca/wiki6c/CCIR.ARinstr#Investment_Income_from_Insurance_Operations

The investment strategy might be different if you're investing amounts that will eventually be paid to settle claims versus investing surplus. You can take more risks with surplus because if you lose it, the policyholders wouldn't necessarily suffer.