AASB 17 Insurance Taskforce Update: Risk Adjustment and Discount Rate Work Stream

Brett Pickett is Head of Actuarial (Group Risk) at TAL and a member of the AASB 17 Insurance Taskforce. Here, Brett provides an update of the Taskforce’s activities, including issues around risk adjustment and discount rates.

The work stream is one of six tasked with producing guidance for Australian Actuaries implementing AASB 17. The work stream consists of representatives across all affected industries. We meet fortnightly to discuss the new standard and the potential impact on Australian insurance companies.

Progress to date

The work stream has drafted a Question and Answer (“Q&A”) style chapter separately for risk adjustment and discount rates. These chapters will be consolidated with Q&A from other workstreams into a single Q&A document to be published by the taskforce in due course. The Q&A document is intended to supplement the International Actuarial Association (“IAA”) guidance and provide a tailored view of the impact of AASB 17 on the Australian insurance industry.

Risk Adjustment

The risk adjustment is one of the “building blocks” in the measurement model in AASB 17. The purpose of the risk adjustment is to reflect:

“the compensation an entity requires for bearing the uncertainty about the amount and timing of the cash flows that arises from non-financial risk as the entity fulfils insurance contracts” (AASB 17 Appendix A).

Its purpose therefore differs from a solvency objective of acting to cover adverse deviation that can be expected in normal circumstances, with capital to cover adverse deviation in more unusual circumstances.

The risk adjustment can be calculated in a number of ways and the standard does not prescribe the approach that should be taken; it does require disclosure of the level of confidence over the best estimate liability that is implied by the resulting risk adjustment used by the company.

The work stream discussed a number of the potential impacts on Australian insurers for inclusion in the Q&A – examples include:

• The definition and types of risk that would be considered to be “non-financial risks”
• Whether the risk adjustment was a material change for the life industry (yes given there is no risk margin currently), the general insurance industry (no, apart from the requirement to report the gross risk adjustment and the extent of additional disclosure required) and the health insurance industry (no since the current standards also require a similar risk margin)
• The interaction and relationship with the risk management framework and regulatory, economic and target capital; the discussion included consideration of the ability for insurers to leverage existing risk frameworks in deriving the risk adjustment under AASB 17
• The five key steps in calculating the risk adjustment:
  • Understand and assess the risk aversion of the entity;
  • Understand the extent to which the entity considers diversification benefits in setting the compensation it requires to bear risk;
  • Understand and assess the uncertainty and variability (i.e. risks) inherent in the insurance contracts being valued;
  • Assess a value that reflects the entity’s risk aversion, in the context of those risks, and in the context of that diversification; and
  • Communicate how the risk adjustment is derived and any judgements in arriving at that assessment.
• The calculation of the risk adjustment at inception and subsequent measurement as well as transition arrangements

Finally, the Q&A discusses some estimation techniques for calculating the risk adjustment – namely, the confidence level approach, the cost of capital technique and a simplified approach.

Risk Discount Rates

Risk discount rates are a familiar concept to all actuaries although the extent to which they are applied often depends on the term of the insurance contract. AASB 17 includes the risk discount rate as one of the building blocks in the measurement model.

AASB 17 specifies that discount rates should:

• “reflect the time value of money, the characteristics of the cash flows and the liquidity characteristics of the insurance contracts” (AASB 17.36(a));
• 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, in terms of, for example, timing, currency and liquidity“ (AASB 17.36(c)); and
• “exclude the effect of factors that influence such observable market prices but do not affect the future cash flows of the insurance contracts” (AASB 17.36(b)).

Financial risks are only included in the discount rate “to the extent that the financial risks are not included in the estimates of cash flows”. Financial risk is defined as:

“The risk of a possible future change in one or more of a specified interest rate, financial instrument price, commodity price, currency exchange rate, index of prices or rates, credit rating or credit index or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract (AASB 17 Appendix A).”

As noted above, uncertainty about the amount of the cash flows which arises from non-financial risks is reflected through the risk adjustment, and not in the discount rate.

The Q&A includes commentary on:

• The estimation of market consistent discount rates
• A comparison to the current requirements in AASB 1023 and AASB 1038
• The derivation of discount rates for a group of contracts
• A discussion of the derivation of discount rates using the “bottom up” and “top down” approaches in AASB 17
• The difference in approach for cash flows depending on the return of underlying items vs. those that do not depend on the return of underlying items

The work stream has also produced decision trees to help actuaries determine which discount rates are required in the building blocks approach (including the modifications in the variable fee approach) and the premium allocation approach. A decision tree has also been produced to assist in determining the disclosures that are required.

Conclusion

AASB 17 will have a significant impact on the Australian insurance industry and the actuarial profession. International interpretation will evolve and develop over time; so too will the Q&A. We intend that it provides a good starting point to help actuaries in the implementation of the new standard over the coming years.