An entity should discount cash flows using current discount rates that reflect the time value of money, characteristics of the cash flows and the liquidity characteristics of the insurance contracts. Discount rates should be consistent with observable market prices. The use of current discount rates that are consistent with observable market prices is in line with the requirement that entities should use current estimates of cash flows in the measurement of insurance contracts and estimates of any relevant market variables should be consistent with observable market prices for those variables.
An entity should maximise the use of observable inputs and reflect all reasonable and supportable internal and external information on non-market variables available without undue cost or effort. In particular, the discount rates used should not contradict any available and relevant market data, and any non-market variables used should not contradict observable market variables [IFRS 17 B78].
It is unlikely that there will be an observable market price for a financial instrument with the same characteristics as an insurance contract in terms of the timing and nature of the estimated cash flows. An entity will need to exercise judgement to assess the degree of similarity between the features of the insurance contracts measured and those of the instruments for which observable market prices are available and adjust those prices to reflect the differences.
The standard refers to yield curves in several places, without specifying that discount rates should be a curve or a representative single rate. However, IFRS 17 requires that the discount rates applied reflect the characteristics of the liability. One such relevant characteristic is timing and duration of the cash flows, which would the particularly prominent for long-term liabilities. IFRS 17 therefore seems to raise the expectation that, typically, the characteristics of timing and duration need to be reflected through the use of a curve. Notwithstanding the expectation of using a curve to adequately reflect timing and duration of the insurance liability, possible practical considerations might be:
For cash flows of insurance contracts that do not vary based on the returns on underlying items, the discount rate reflects the yield curve in the appropriate currency for instruments that expose the holder to no or negligible credit risk, adjusted to reflect the liquidity characteristics of the group of insurance contracts. That adjustment must reflect the difference between the liquidity characteristics of the group of insurance contracts and the liquidity characteristics of the assets used to determine the yield curve. Yield curves reflect assets traded in active markets that the holder can typically sell at any time without incurring significant costs. In contrast, under some insurance contracts, the entity cannot be forced to make payments earlier than the occurrence of insured events, or dates specified in the contracts [IFRS 17 B79].
For cash flows of insurance contracts that do not vary based on the returns on underlying items, an entity may determine discount rates by adjusting a liquid risk-free yield curve to reflect the differences between liquidity characteristics of the financial instruments that underlie the rates observed in the market and liquidity characteristics of the insurance contracts [IFRS 17 B80].
Alternatively, an entity may determine the appropriate discount rates for insurance contracts based on a yield curve that reflects the current market rates of return implicit in a fair value measurement of a reference portfolio of assets (a top-down approach). An entity should adjust that yield curve to eliminate any factors that are not relevant to the insurance contracts, but is not required to adjust the yield curve for differences in liquidity characteristics of the insurance contracts and the reference portfolio [IFRS 17 B81].
In principle, a single illiquid risk-free yield curve should eliminate uncertainty about the amount and timing for cash flows of insurance contracts that do not vary based on the returns of the assets in the reference portfolio. However, in practice, the top-down and bottom-up approach may result in different yield curves, even in the same currency. This is because of the inherent limitations in estimating the adjustments made under each approach, and the possible lack of an adjustment for different liquidity characteristics in the top-down approach. An entity is not required to reconcile the discount rate determined under its chosen approach with that of another approach [IFRS 17 B84].
Entities will need to determine an appropriate method to adjust the observable market information in a way that reflects the illiquidity characteristics of the insurance contracts. The illiquidity characteristics will depend on the specific nature of a contract, for example, annuities in payment are generally viewed as very illiquid as they cannot be surrendered and only expire on the annuitant’s death. Different methods to estimate an illiquidity premium are available, for example, it can be derived from collateralised bonds or estimating it by adjusting a spread in an instrument for credit risk spreads based on credit default swaps.
Discount rates beyond the market observable range
Some insurance contracts will have a contract boundary that extends beyond the period for which observable market data is available (see ‘Contract boundary‘ and ‘Cash flows within the contract boundary‘). In these situations, the entity will have to extrapolate the discount rate yield curve beyond that period, as illustrated in the diagram below.
An entity must apply the following guidance for estimating the discount rate curve [IFRS 17 B82]:
- Use observable market prices in active markets for assets in the reference portfolio where they exist
- If a market is not active, an entity should adjust observable market prices for similar assets to make them comparable to market prices for the assets measured
- If there is no market for assets in the reference portfolio, an entity must apply an estimation technique. For such assets:
- Develop unobservable inputs using the best information available. Such inputs might include the entity’s own data and, in the context of IFRS 17, the entity might place more weight on long-term estimates than on short-term fluctuations
- Adjust data to reflect all information about market participant assumptions that is reasonably available
IFRS 17 provides no specific guidance on estimation techniques to extrapolate the discount rate curve. In practice, multiple techniques exist. The general guidance in IFRS 17 indicates that applying an appropriate estimation technique requires judgement, weighing the principle to use the best information available and adjusting for information about market participant assumptions. This will require establishing a robust estimation process for discount rates, including related controls for determining the inputs to discount rates based on the conditions at the reporting date.
Curves used for regulatory purposes may be a starting point to determine the discount rate curve (or components of that curve) under IFRS 17. However, an entity would have to decide if an estimate is consistent with the requirements in IFRS 17 and make necessary adjustments.