how discount rates are selected when CF vary or not with returns on the underlying item
Hi,
Is my understanding below correct?
- DR is selected using bottom up approach when CF do not vary with returns
- DR is selected using top down approach when CF do vary with returns
Comments
This is not true - You can use either method whether cash flows vary or do not vary with returns. Where are you seeing this in the material?
Ok that was my interpretation based on the 3 battlecards, can you please explain why it's not correct?
Under IFRS 17, how is 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 rate curve (or yield curve)
this sounds like the bottom up approach
Under IFRS 17, how the discount rate is selected when cash flows do vary with returns on underlying items
• Choose a discount rate that makes the value of the liability cash flows equal the fair market value of the underlying assets
this sounds like the top down approach
Briefly describe approaches for coming up with the discount rate curve under IFRS 17
Bottom-up approach:
• adjust the risk-free discount curve by adding an illiquidity premium that reflects the liabilities
• under CIA practice, there's no requirement to identify an illiquidity premium
Top-down approach:
• use the investment return on a reference portfolio of assets that's "similar" to the liabilities, this reference portfolio does not have to be based on assets held by the company (Example: use the 10-year spot rate on a Canadian bond for a 10-year liability cash flow)
• then remove asset characteristics not relevant to the liability (Example: remove credit and market risk)
• under CIA practice, the rate would be tied more closely to assets held by the company
Apologies for the delay. We are looking into your question.
1. The statement "choosing a discount rate" here does not preclude you from using either a top down or bottom up approach. It merely asks that you select a liquidity adjusted risk free rate which can be done with either method.
2. The second statement is a little tricky. When I worked on IFRS17, I did not come across any situation where I had to calculate the discount rate for cash flows that vary with returns of the underlying.This is true in general for the P&C side and is more of a life actuarial problem (universal life and variable annuities
with some guarantees are products I can think of off the top of my head). Again here "choosing the discount rate" can be done with either a top down or bottom up approach with specific modifications to adapt to the underlying dependency. How they are done is not in the paper and is not relevant to us as P&C actuaries.
I wouldn't worry in general about cash flows that vary with the underlying returns as I highly doubt they will be tested being very surface level knowledge
Shall this battle card be modified to include also the top down approach then? Currently the answer sounds like only the bottom up approach is valid.
I think the current battlecard is fine. It is not referring to the bottom up approach specifically, but more the general approach to determining discount rates ( By adjusting for liquidity)