The risk adjustment to the estimates of future cash flows reflects the compensation an insurance company expects for bearing the uncertainty about the amount and timing of the cash flows that arise from non-financial risks.
|Risk adjustment = compensation that makes an entity indifferent between:|
eg, 50% probability for CU 50 and 50% probability for CU 500
Fulfilling a liability with the same expected present value (CU 275 in this example) but generating fixed cash flows
The purpose of the risk adjustment is to measure the effect of uncertainty in the cash flows of insurance contracts that arise from risks other than financial risks. It should not reflect risks that do not arise from the rights and obligations created by an insurance contract, eg general operational risks.
The risk adjustment is an entity-specific measure of uncertainty and should have the following characteristics:
|Characteristics of the risk adjustment|
The risk adjustment is separate from the estimates of the cash flows or the discount rate. It should not result in double counting.
Reflects entity’s risk diversification
The entity should allow for its own risk profile and any benefits arising from diversification in its management of nonfinancial risks.
Reflects entity’s risk appetite
Both favourable and unfavourable outcomes should be reflected in a way that reflects the entity’s degree of risk aversion.
IFRS 17 does not specify what estimation technique entities should use when calculating the risk adjustment. However, the following guidelines can be used:
|Risk adjustment for:|
|Risk adjustment for:|
A reporting entity should disclose the technique used in the estimation of the risk adjustment and the confidence level corresponding to the result of that technique.
Insurance company’s own view on risk and diversification for risk adjustment
IFRS 17 allows a choice of estimation method and gives entities an opportunity to eliminate the high interest rate sensitivity from the cost of capital approach mandated by Solvency II. An entity specific pattern of risk release could also prove a useful basis for revenue recognition under the Premium Allocation Approach. Subject to the operational challenges of confidence level disclosures, entities could align their financial reporting to their own risk appetite.