IAA.RiskAdjs

This reading has been removed from the syllabus but still contains relevant information as indicated by links in other wiki articles.

This reading, Risk Adjustments for Insurance Contracts discusses principles for estimating risk adjustments under IFRS 17. Note that for the exam, you only need to cover the Overview and Chapter 1.

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Study Tips

Since this is a new reading for 2019.Fall, there is little history of exam questions. That makes it harder to predict likely questions, but the questions on new readings are often easy. That means if you put in the time, it should be easy points. It's a short reading and there are no calculations, just memorization.

Also, much of this reading is covered in other articles namely CIA.IFRS17 and CIA.MfAD which means it's good for review. Regarding the actual learning of IFRS 17, the bulk of your time should be spent on CIA.IFRS17.

Estimated study time: 1 hour (not including subsequent review time)

BattleTable

• this reading is new for 2019.Fall

Questions held out from Fall 2019 exam: #27. (Skip these now to have a fresh exam to practice on later. For links to these questions, see Exam Summaries.)

reference	part (a)	part (b)	part (c)	part (d)
no questions prior to fall 2019

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In Plain English!

Overview

You are only responsible for the overview and chapter 1 of this reading but there isn't much substance in chapter 1. Instead Alice has an IFRS 17 review exercise for you:

Can you give a 30-second elevator speech to your CEO about IFRS 17?

• Before Alice gives you her answer, let me explain the concept of an elevator speech. If you find yourself in the elevator with the CEO and they ask you what you're working on, you should be able to give them a 30-second synopsis. And you should be able to do it confidently. (This is a great opportunity to impress someone in a position of power!) It's something you need to practice and it's also a good skill for a job interview. If your resume lists experience with IFRS 17, it would be perfectly reasonable for the interviewer to ask you for a synopsis.

• Anyway, to do this you first need to have the main bullet points in mind. Then you need to string these bullet points together into a concise speech.

IFRS 17 bullet points:

   - new international standard for financial reporting

   - effective date changed to Jan 1, 2023

   - applies to valuation of insurance contract liabilities

   - different from current Canadian practice (Canada: PV + 3 different kinds risk provisions)

   - IFRS 17 uses current interest rates for calculating PV (could lead to higher liabilities & volatility of results)

• Ok, that's probably enough detail. The first 3 points are very general. The last 2 are the ones the CEO would be most interested in since the interest rate (discount rate) has a direct effect on the balance sheet. Here's what Alice would say:

IFRS 17 Elevator Speech: IFRS 17 is a new international standard for reporting insurance liabilities. The effective date has been moved again Jan 1, 2023 to give everyone more time to fully understand the implications. A crucial difference versus current practice is how the discount rate is selected for calculating the present value of liabilities. IFRS 17 uses current interest rates which are probably lower than actual investment return rates. That means balance sheet liabilities would be higher than in the past and that's a big deal. The benefit though would be better standardization across the industry in terms of financial reporting.

Your CEO (or the interviewer if you're in a job interview) might then have follow-up questions, but after your expert synopsis they will forever remember you as a confident knowledgeable actuary worthy of a fast rise within the company!

Chapter 1

Section 1.1: Objectives of Risk Adjustment for Financial Reporting

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
2. to cover adverse deviation in claims experience

This reading covers the first reason (the reward for assuming risk.) This section also discusses the needs of users of financial statements but I can't see how to create a good exam question out of it. There are 2 points mentioned as part of IASB's Conceptual Framework:

• IFRS 17 uses resources & claims for financial reporting (instead of assets & liabilities)
• IFRS 17 uses risk versus reward for financial reporting (instead of prudence, with its emphasis mainly on solvency)

I suppose the point they're trying to make is that IFRS is changing the conceptual basis for financial reporting. The reason for the change is to better reflect the economic realities of the insurance business where the true cost of the product is not known at the time of payment.

Section 1.2: Requirements of IFRS 17 (risk adjustments)

The first bullet point list from this section of the source text is very similar to the building blocks of IFRS 17 measurement discussed in CIA.IFRS17. Unfortunately however, there is an inconsistency between that source text and this one. This is explained below.

Question (building blocks): on initial recognition, how are insurance contracts measured in IFRS 17

According to the International Actuarial Association the measurement is the total of:

FCF (Fulfilment Cash Flows)

• estimates of future cash flows
• adjustments for the time value of money and financial risks not otherwise included in the cash flow estimate
• adjustment for non-financial risk

CSM (Contractual Service Margin)

• represents unearned profit from a group of insurance contracts

The inconsistency is the inclusion of explicit financial risks in FCF. I believe the above presentation is correct and that the source text from the Canadian Institute of Actuaries, CIA.IFRS17 is in error. (If this question comes up on the exam, I recommend submitting an appeal immediately after the exam.)

The next bullet point list covered in the text relates to a point in the previous section regarding the Conceptual Framework of IFRS 17. It's the idea of framing non-financial risk as the insurer's reward for assuming risk. (This is in contrast to adding PfADs for claims development and reinsurance risk. The amounts might be the same but the conceptual basis is different.) Anyway...

Question: what does non-financial risk measure in IFRS 17

• non-financial risk measures the compensation required to make the entity indifferent between:

choice 1: fulfilling a liability with a range of possible outcomes due to non-financial risks

choice 2: fulfilling a liability with fixed future cash flows equivalent to the expected value of choice 1

Pop Quiz A!    :-o

• This pop quiz has been deleted and replaced with a better example of the concept of risk adjustment. See this forum discussion.

Characteristics of a Good Risk Adjustment

The next bullet point list is ALMOST EXACTLY the same as the one in the section Risk Margin Traits in CIA.MfAD that discusses characteristics of a good risk margin. You should do a quick review of that before continuing.

Question: identify 5 qualitative 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

Question: identify 2 further general considerations in calculating the risk adjustment in IFRS 17

• pooling similar but independent risks will lower the risk adjustment (law of large numbers → more risks implies lower variance)
• pooling risks that are negatively correlated will lower the risk adjustment (because negatively correlated risks will offset each other)

(It seems like these 2 points contradict each other, and I suppose they do. You just have to use judgment on which will have the more beneficial effect.)

Something else discussed briefly in this section is the effect of reinsurance contracts. One of the purposes of reinsurance (recall cat-SWIGS from BK.Reins) is to Stabilize loss experience. This is achieved by "cutting off" the right tail of the distribution - in other words ceding losses above a certain amount. Note however that IFRS 17 specifically requires the risk adjustment to be calculated without the benefit of reinsurance. Instead, the benefit of stabilization (or risk mitigation) is reported as a reinsurance asset on the balance sheet.

Section 1.3: Risk Adjustments in Other Contexts

These "other contexts" might include pricing, economic capital, and Solvency II, among others. The point here is that risk adjustments under IFRS may be different from risk adjustments in those other contexts because of differences in purpose. As stated earlier in this wiki article, IFRS 17 strives to frame its principles in terms of risk versus reward and this is different from simply requiring, for example, that an insurer remains solvent and has sufficient funds to cover policyholder obligations.

The last few paragraphs in this section don't seem terribly important but I didn't want to ignore them completely. (Alice reminded me it's better to err on the side of giving a little too much information rather than too little for new readings where we don't yet know what the exam committee is going to emphasize.)

Question: identify an entities' reporting/disclosure requirements for risk adjustments under IFRS 17

• must report a liability for risk adjustment (this is added to the PV of expected cash flows)
• must disclose a confidence interval for the risk adjustment (for benchmarking against other entities)

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Pop Quiz A - Answer

Scenario 1: non-financial risk adjustment = $5,000

(this is the difference between the total coupon payments of $15,000 from the bond and the premium payment of $20,000)

Scenario 2: trick question - you can' calculate it because the premium has to be compared to a fixed cash flow and equities would provide only an uncertain and variable cash flow (a common incorrect answer is $10,000)

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