Insurance contract discount rates

Insurance contract discount rates – The second element of measuring fulfilment cash flows under the general model is an adjustment to the estimates of future cash flows to reflect the time value of money and financial risks related to those cash flows (to the extent that they are not included in the cash flow estimates).

Here is how the insurance contract discount rates fit into the general model of measurement of insurance contracts. The general model is based on the following estimation parameters:

The adjustment is made by discounting estimated future cash flows. Discount rates must [IFRS 17 36]: Insurance contract discount rates

  • Reflect the time value of money, characteristics of the cash flows and liquidity characteristics of the insurance contracts
  • Be consistent with observable current market prices (if any) for financial instruments with cash flows whose characteristics are consistent with those of the insurance contracts (e.g., timing, currency and liquidity)
  • Exclude the effect of factors that influence such observable market prices, but do not affect the future cash flows of the insurance contracts

Discount rates used to measure the present value of future cash flows should reflect the characteristics of the cash flows; for example, in terms of currency and timing of cash flows and uncertainty due to financial risk. The effects of uncertainty in cash flows due to non-financial risks are included in the risk adjustment for non-financial risk.

The discount rates calculated according to the requirements above should be determined, as follows [IFRS 17 B72]: Insurance contract discount rates

Insurance liability measurement component Discount rate

Fulfilment cash flows

Current rate at reporting date

Contractual service margin interest accretion for contracts without direct participation features

Rate at date of initial recognition of group

Changes in the contractual service margin for contracts without direct participation features

Rate at date of initial recognition of group

Changes in the contractual service margin for contracts with direct participation features

A rate consistent with that used for the allocation of finance income or expenses

Liability for remaining coverage under premium allocation approach

Rate at date of initial recognition of group

Profit or loss component

Disaggregated insurance finance income included in profit or loss for groups of contracts for which changes in financial risk do not have a significant effect on amounts paid to policyholders (see ‘Financial risks not effecting insurance payments’)

Rate at date of initial recognition of group

Disaggregated insurance finance income included in profit or loss for groups of contracts for which changes in financial risk assumptions have a significant effect on amounts paid to policyholders (see ‘Financial risks effecting insurance payments’)

Rate that allocates the remaining revised finance income or expense over the duration of the group at a constant rate or, for contracts that use a crediting rate, uses an allocation based on the amounts credited in the period and expected to be credited in future periods

Disaggregated insurance finance income included in profit or loss for groups of contracts applying the premium allocation approach (see ‘Financial risks effecting insurance payments’)

Rate at date of incurred claim

To determine the discount rates at the date of initial recognition of a group of contracts described above, an entity may use weighted-average discount rates over the period that contracts in the group are issued, which cannot exceed one year [IFRS 17 B73]. This can result in a change in the discount rates during the period of the contracts.

When contracts are added to a group in a subsequent reporting period (because the period of the group spans two reporting periods) and discount rates are revised, an entity should apply the revised discount rates from the start of the reporting period in which the new contracts are added to the group [IFRS 17 28]. This means that there is no retrospective catch-up adjustment.

For insurance contracts with direct participation features, the contractual service margin is adjusted based on changes in the fair value of underlying items, which includes the impact of discount rate changes (see Contracts with discretionary participation features).

Discount rates and characteristics of cash flows

Estimates of discount rates must be consistent with other estimates used to measure insurance contracts to avoid double counting or omissions; for example [IFRS 17 B74]:

  • Cash flows that do not vary based on the returns on any underlying items must be discounted at rates that do not reflect any such variability.
  • Cash flows that vary based on the returns on any financial underlying items must be discounted using rates that reflect that variability or adjusted for the effect of that variability and discounted at a rate that reflects the adjustment.
  • Nominal cash flows (i.e., those that include the effect of inflation) must be discounted at rates that include the effect of inflation.
  • Real cash flows (i.e., those that exclude the effect of inflation) must be discounted at rates that exclude the effect of inflation.

Cash flows can vary based on returns from financial underlying items due to a contractual link to underlying items, or because the entity exercises discretion in providing policyholders with a financial return on premium paid. An entity need not hold related underlying items for cash flows to vary based on returns from underlying items [IFRS 17 B75].

When some of the cash flows vary based on returns from underlying items and others do not (e.g., a participating contract has fixed or guaranteed cash flows in addition to providing policyholders with financial returns), an entity may [IFRS 17 B76-B77]:

  • Divide the estimated cash flows and apply appropriate discount rates to each type
    Or
  • Apply discount rates appropriate for the estimated cash flows as a whole (e.g., using weighted average rates, stochastic modelling or risk-neutral measurement techniques)

The requirement for discount rates to be consistent with the characteristics of the cash flows of insurance contracts is from the perspective of the entity. IFRS 17 requires an entity to disregard its own credit risk when measuring the fulfilment cash flows [IFRS 17 31 and IFRS 17 BC 197].

Considerations:

IFRS 17 does not require an entity to divide estimated cash flows into those that vary based on the returns on underlying items and those that do not. By not dividing the cash flows, an entity avoids the complexity of having to disentangle cash flows that may be interrelated.

However, if an entity does not divide the estimated cash flows in this way, it should apply discount rates for the estimated cash flows as a whole in a way that is consistent with the principles of the standard; for example, using stochastic modelling or risk-neutral measurement techniques. Both approaches, dividing or not dividing cash flows, have their own conceptual and practical implications, so entities should carefully assess what methods will be most suited to the particular circumstances.

Entities should be aware that, even for participating contracts, at least some of the cash flows to policyholders are independent of returns on underlying items; for example, payments for fixed death benefit or expenses of the entity that do not vary with the underlying items.

Current discount rates consistent with observable market prices

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].

Considerations:

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:

  • Whether a different method could be applied to some types of (cash flows of) participating contracts
  • Whether an entity could use an approach to convert a curve in a single rate as a practical simplification for some types of products. However, this requires careful consideration as an entity would still have to substantiate in every reporting period, whether the IFRS 17 discount rate principles are satisfied. As such, there will be a number of challenges to such an approach. In addition, this method differs from the approach followed to discounting in the Solvency II regulatory regime
  • Whether to use a flat rate for short-term liabilities as for such liabilities, the impact of the timing may not be significant. However, it would be a practical expedient that requires a definition of ‘short’ for these purposes. In addition, materiality aspects may have to be considered

Bottom-up approach

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].

Top-down approach

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].

Insurance contract discount rates 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].

Considerations

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. In these situations, the entity will have to extrapolate the discount rate yield curve beyond that period, as illustrated in the diagram below.

Insurance contract discount rates 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

Considerations

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.

Insurance contract discount rates

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