Risk adjustment for non-financial risks

Risk adjustment for non-financial risks – The third element of measuring fulfilment cash flows in the general model (see ‘General model of measurement of insurance contracts‘) is a risk adjustment for non-financial risk.

Here is how the risk adjustment for non-financial risks fits into the general model of measurement of insurance contracts. The general model is based on the following estimation parameters:

  • fulfillment cash flows, comprising of:
    • a current estimate of unbiased and probability-weighted future cash flows expected to arise during the life of the contract;
    • a discount adjustment to reflect the time value of money and financial risks, such as liquidity and currency risks (layers of discounting);
    • an explicit risk adjustment for non-financial risks; and
  • a contractual service margin representing the unearned profit from the contract.

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].

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

Example – Risk adjustment for non-financial risk Risk adjustment for non-financial risks
[IFRS 17 B87] Risk adjustment for non-financial risks

Compensation an entity requires to be indifferent between fixed and variable outcomes Risk adjustment for non-financial risks

The risk adjustment for non-financial risk would measure the compensation the entity would require to make it indifferent between fulfilling a liability that, because of non-financial risk, has a 50% probability of being CU90 and a 50% probability of being CU110, and fulfilling a liability that is fixed at CU100. As a result, the risk adjustment for non-financial risk conveys information to users of financial statements about the amount charged by the entity for the uncertainty arising from non-financial risk about the amount and timing of cash flows.

The risk adjustment for non-financial risk reflects the entity’s perception of the economic burden of its non-financial risks; it is not a current exit value or fair value, which reflects the transfer to a market participant [IFRS 17 BC209]. The risk adjustment for non-financial risk reflects [IFRS 17 B88]: Risk adjustment for non-financial risks

  • The degree of diversification benefit the entity includes when determining the compensation it requires for bearing that risk Risk adjustment for non-financial risks
  • Both favourable and unfavourable outcomes, in a way that reflects the entity’s degree of risk aversion Risk adjustment for non-financial risks

IFRS 17 does not specify the estimation technique(s) used to determine the risk adjustment for non-financial risk. However, the risk adjustment for non-financial risk must have the following characteristics (IFRS 17 B91 – B92):

  • Risks with low frequency and high severity generally will result in higher risk adjustments for non-financial risk than those with high frequency and low severity.
  • For similar risks, contracts with a longer duration generally will result in higher risk adjustments for non-financial risk than contracts with a shorter duration.
  • Risks with a wider probability distribution generally will result in higher risk adjustments for non-financial risk than those with a narrower distribution.
  • The less that is known about underlying assumptions used to determine the current estimate and its trend, the higher the risk adjustment for non-financial risk.

To the extent that emerging experience reduces uncertainty about the amount and timing of cash flows, risk adjustments for non-financial risk will decrease and vice versa. IFRS 17 does not specify the estimation technique(s) used to determine the risk adjustment for non-financial risk. Because the risk adjustment for non-financial risk is an entity-specific perception, rather than a market participant’s perception, different entities may determine different risk adjustments for similar groups of insurance contracts.

Accordingly, to enable users of financial statements to understand how entity-specific assessments of risk aversion might differ from entity to entity, the entity must disclose the confidence level used to determine the risk adjustment for non-financial risk or, if a technique other than confidence level is used, the entity must disclose the technique used and the confidence level corresponding to the technique (see ‘Disclosure of significant judgements for insurances’). Risk adjustment for non-financial risks

Considerations

The risk adjustment reflects diversification benefits the entity considers when determining the amount of compensation it requires for bearing that uncertainty. This approach implies that diversification benefits could reflect effects across groups of contracts, or diversification benefits at even a higher level of aggregation. However, when determining the risk adjustment at a level more aggregated than a group of contracts, an entity must establish a method for allocating the risk adjustment to the underlying groups. This will form part of the requirements for systems and processes that an entity will need to develop when implementing the standard.

Changes in the risk adjustment will reflect several factors, for example: release from risk as time passes, changes in an entity’s risk appetite (the amount of compensation it requires for bearing uncertainty), changes in expected variability in future cash flows and diversification between risks. Entities will need to distinguish between changes in the risk adjustment relating to current and past service (reflected immediately in profit or loss) and those relating to future service (which adjust the CSM — see ‘Contractual service margin‘).

The standard does not prescribe particular techniques for estimating the risk adjustment for a group of contracts. The standard incorporates guidance with the aim to aid companies in selecting an appropriate method [IFRS 17 BC213 – 214].

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:

IFRS 17 does not specify what estimation technique entities should use when calculating the risk adjustment. However, the following guidelines apply:

Lower – Risk adjustment for:

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Higher – 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 non-financial 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.

Practical insight – entities’ 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.

Risk adjustment for non-financial risks

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