CIA.IFRS17-Ref
Reading: “Changes to the Reference Curves’ Ultimate Risk-free Rate Development Approach” 2023.
Author: CIA
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Study Tips
This is a brand new paper that talks about a change in methodology with respect to selecting an ultimate risk free rate (URFR). The concept of a URFR is rarely relevant to P&C insurance and is more of a life concept. There are very few P&C lines that would require a URFR but examples include latent claims, sexual abuse claims and possible some XOL liability lines. It is not common to have P&C lines with payout periods greater than 30 years, which is where we would have to rely on the URFR. I wouldn't spend too much time on this reading, but given that it is a new paper there might be one or two small questions included. It is difficult to envision too many marks being allocated to this paper
Estimated study time: 3 hours (not including subsequent review time)
BattleTable
No past exam questions are available for this reading.
reference part (a) part (b) part (c) part (d)
In Plain English!
Overview
This paper highlights outlines to the ultimate risk-free rate (URFR) development approach used in reference curves as specified by the Committee on Life Insurance Financial Reporting (CLIFR). THE URFR is basically used to discount cash flows beyond the observable period, or 30 years. This paper is heavy in concepts that are more related to economics, rather than actuarial science and may be more difficult for candidates who are less well versed with interest rate theory and bond markets.
- You should know that nominal rates represent interest rates, which disregards inflation.
- Real rates are interest rates, subtracting inflation.
Current Approach
- Main Components:
- Historical interest rate information
- Bank of Canada's (BoC) inflation target.
A 25-year exponential moving average (EMA) is applied to monthly data starting from December 31, 1960 to estimate short term real rates and estimated term premiums.
EMA(t) = Data(t)*A + EMA(t-1)*(1-A)
The EMA is a recursive algorithm where A = 2/(N+1) and N is equal to 300 months
| URFR = EMA short term real rates(t) + EMA term premiums(t) + inflation target(t) |
| Question: Identify how short term real rates, term premiums and the inflation target are determined? |
- Short term real rates - BoC 3 month treasury bill rate less YoY CPI
- Term premiums - BoC long term bond rate less 3 month treasury bill rate
- Inflation target - Set by BoC, currently 2%
The text also mentions that the URFR is currently 3.65% up to October 2023 and the current approach caps the URFR at 15bps to avoid unnecessary volatility. Being able to describe in words how the URFR is calculated should suffice for this section.
Observations on the Current Approach
Question: What are the disadvantages of the current approach?
- Impact of short-term inflation: Short-term inflation in 2022 led to unintended negative values in long-term real rate estimates, leading to a large decrease in URFR
- Volatility caused by EMA: The use of an EMA introduced undue volatility, especially under extreme economic conditions such as stagflation and deflation.
The effect of short-term inflation can be seen by rewriting the URFR as follows:
| URFR = EMA long term nominal rates(t) - EMA YoY CPI(t) + inflation target(t) |
The first two terms in the formula attempts to find the real long-term rate. However, YoY CPI is merely a proxy for long term inflation expectations and during periods of high inflation that is not expected to persist such as in 2022, this could lead to an implied negative real rate while the true long-term real rate remains positive, underestimating our URFR. Using an EMA then causes the more recent data to have greater weight, leading to increased volatility around the URFR.
Revised Approach New Method
The URFR will now be based on the average of historical nominal interest rates from January 1998 to the end of the preceding year. The URFR will also be adjusted annually, considering new data but changes will be capped to avoid excessive volatility:
Absolute difference in new vs current URFR Action to current URFR < 10 bps No Change 10 bps < change < 15 bps +- 10 bps > 15 bps +- 15 bps
The source describes two other possible methods that were considered to determine the URFR:
- Historical real rates + inflation target
- BoC nominal neutral short-term rate + historical term premium
The following table can be used to summarize their complexities
Consideration Historical nominal rates Historical real rates + inflation target BoC nominal neutral short rate + historical term premium Stability Stable Stable More volatile as forward looking approach puts more weight on short-term fluctuations Simplicity Easy to understand and implement Easy to understand and implement BoC neutral rate involves complex macroeconomic concepts Predictability Needs assumption on long-term nominal rates Needs assumptions on long-term real rates or long-term inflation rates BoC neutral rate requires complex macroeconomic concepts Technical robustness - data Most reliable as plenty of historical transactions of Canada long-term bonds Less robust as not many transactions of Canada real return bonds. Government also plans to suspend issuance or real bonds Relies on modelling and judgement of BoC Technical robustness - theory Retrospective. Assumes rates are mean reverting. Influenced by inflationary economic growth and future inflation expectations may be different than the past Real rates are retrospective but future inflation expectations are forward-looking. Real rates show greater mean reversion than nominal rates. Less influenced by inflationary economic growth than nominal rates Prospective
The historical approach is the best choice for all categories, except for the theoretical robustness section. While the historical real rates + inflation target has a stronger theoretical foundation, long-term inflation implicit in nominal long-term rates has been historically very close to the BoC's 2% inflation target.
Illustrative Scenarios
The paper describes a few sensitivity tests and how they would affect the URFR under each approach. While I think it would be nice to conceptually understand why the URFR moves in a given direction for each scenario, I think that would be a more economic concept and just memorising the direction of the change should suffice.
Scenario Historical real rates + inflation target Historical nominal rates 2022 YE Constant Projection Lower Similar 4% LT Nominal Rate, 2% Inflation Similar Similar Stagflation Similar Higher Deflation Lower Similar
