Insurances risk adjustment for non-financial risks

Insurances risk adjustment for non-financial risks – The risk adjustment for non-financial risk is the compensation that the entity requires for bearing the uncertainty about the amount and timing of cash flows that arise from non-financial risk [IFRS 17 37]. The risks covered by the risk adjustment for non-financial risk are insurance risk and other non-financial risks such as lapse risk and expense risk [IFRS 17 B86].Insurances risk adjustment for non-financial risks

Risk adjustment = compensation that makes an entity indifferent between:

Fulfilling a liability with a range of possible outcomes:

eg, 50% probability for CU 50 and 50% probability for CU 500

AND

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. Insurances risk adjustment for non-financial risks

The risk adjustment is an entity-specific measure of uncertainty and should have the following characteristics: Insurances risk adjustment for non-financial risks

Characteristics of the risk adjustment

Explicit

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 non financial 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:

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Risk adjustment for:

GENERALLY >

Risk adjustment for:

Contracts with:

  • low frequency and high severity of claims
  • longer duration for similar risks
  • wider probability distribution
  • emerging experience increases the uncertainty on non financial risks.

Contracts with:

  • high frequency and low severity of claims
  • shorter duration for similar risks
  • narrower probability distribution
  • emerging experience decreases the uncertainty on nonfinancial risks

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.

In theory, the risk adjustment for non-financial risk for insurance contracts measures the compensation that the entity would require to make it indifferent between [IFRS 17 B87]:

  • Fulfilling a liability that has a range of possible outcomes arising from non-financial risk, and 
  • Fulfilling a liability that will generate fixed cash flows with the same expected present value as the insurance contracts

Risk adjustment

Insurance company’s own view on risk and diversification for risk adjustment Insurances risk adjustment for non-financial risks

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.

Insurances risk adjustment for non-financial risks

Insurances risk adjustment for non-financial risks

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