Aggregation and diversification of the IFRS 17 Risk Adjustment

Published in: IFRS 17

Companies: Moody’s Analytics

Under IFRS 17 the risk adjustment for non-financial risk is "...the compensation an entity requires for bearing the uncertainty about the amount and timing of the cash flows that arises from non-financial risks as the entity fulfils insurance contracts". The calculation method is not prescribed and is the choice of the insurance company, subject to the principles detailed in paragraphs B91 and B92 of the standard.

Cassandra Hannibal, FIA CERA

Under IFRS 17 the risk adjustment for non-financial risk is "...the compensation an entity requires for bearing the uncertainty about the amount and timing of the cash flows that arises from non-financial risks as the entity fulfils insurance contracts". The calculation method is not prescribed and is the choice of the insurance company, subject to the principles detailed in paragraphs B91 and B92 of the standard.

Disclosure of the methodology is also required including the equivalent confidence level of the calculated IFRS 17 risk adjustment.

As the present value of future cash flows is required at contract group level under IFRS 17, so too is the risk adjustment along with the contractual service margin. The minimum aggregation level for contract groups are set according to three criteria:

Portfolio level – contact groups should contain contracts within a product line with similar risks that are managed together.

Profitability level – contract groups should distinguish between contracts that are:

onerous at initial recognition, or 

at initial recognition have no significant possibility of becoming onerous, or

remaining contracts (i.e. neither of the above).

Cohort – contract groups should contain contracts that are issued no more than one year apart.

An insurer may have a substantial number of contract groups so will need a defined approach. Calculating the IFRS 17 risk adjustment at this level of granularity may be broadly split into two approaches:

Bottom-up: Calculate the IFRS 17 risk adjustment at contract group level directly, or

Top-down: Calculate the IFRS 17 risk adjustment at some higher aggregate level and allocate this amount to specific contract groups.

These methods both pose some challenges to the insurance company. One of these challenges is diversification.

Diversification

IFRS 17 anticipates some allowance for diversification as noted in paragraph B88. It is likely that the risk adjustment for a collection of contract groups is smaller than the sum of the risk adjustments for each contract group, reflecting diversification of risk between different contract groups (for example longevity and mortality risks for annuities and term assurance contracts respectively). The insurance company will need to decide how to account for this diversification, specifically at what level of aggregation should the diversification be included?

Types of diversification

Diversification can occur because of the interaction:

Between risks, and

Between collections of contracts e.g. between contracts, contract groups, portfolios, entities and so on.

The IFRS 17 contract grouping requirements mandate that contracts within a contract group have similar risks and are managed together. Therefore it may be reasonable that both the diversification between risks and diversification between contracts in a contract group is included. This diversification is likely to be small because the contracts are so similar.

At higher levels of aggregation the treatment is not obvious, as reasoned arguments could be made either way. For example, due to the other IFRS 17 contract grouping requirements of profitability and cohort, a portfolio (in this case, a group of contract groups) may have similar risks and be managed together and so diversification between risks and contracts is again reasonable. Similarly non-financial risks may be managed across several portfolios and so it may be judged reasonable to take credit for the diversification between the portfolios in the entity. Alternatively, as it is possible to sell or reinsure a portfolio of contracts, it may be judged unreasonable to take credit for diversification between portfolios in the entity because in the event of a sale, the diversification allocated to the portfolio would be not be part of the sale, that is, the diversification benefits would not be realised by the purchaser. This exit value principle is used in some regulatory regimes, such as Solvency II, but is not a requirement under IFRS 17. At even higher levels of aggregation such as entities within a group structure, there has been discussion on whether the compensation required for bearing the non-financial risk, is that required by the entity or that required by the group as a whole. In May 2018 the Transition Resource Group (TRG) proposed that the risk adjustment for a group be the sum of the risk adjustments of the subsidiary entities; the IASB will discuss the proposal in December 2018.

Whatever approach is taken for the other levels of aggregation, these decisions should be made in advance and must be consistent with the relevant risk management policies, risk appetite and risk metrics utilised by the insurance company, in order to "reflect the entity's degree of risk aversion".

Materiality of diversification

Before any significant time and resource is dedicated to diversification methodologies, the insurer should consider whether the diversification is material. If it is not then the insurer could decide to use a very approximate method or simply exclude it altogether. In determining whether the diversification is material, the following items should be considered:

Magnitude – if the diversification of risk adjustment between contract groups is material in size, then its treatment should be considered. Materiality should be considered in the context of profit emergence and risk adjustment in isolation.

Sensitivity – the risk adjustment will be recalculated at future time periods where there are changes to both actual experience and future assumptions, so a risk adjustment that may be insignificant in one time period may become significant in the future.

Uses – if the risk adjustment will be used for other purposes then the diversification may be significant. For example, if the aggregated risk adjustment is used as a key metric to manage risk, it is important that the impact of diversification is included when making decisions as diversification may skew the expected impact of any action taken.

Bottom-up contract group approaches

We define a bottom-up approach as an approach where the risk adjustment calculations are carried out at the IFRS 17 contract group level directly. The bottom-up approach is likely to arise when the calculations for the risk adjustment are already executed, or can be readily executed, as part of another IFRS 17 process, for example the present value of future cash flows. This approach has the advantage of outputting the risk adjustment at contract group level but there are some additional considerations when aggregating the risk adjustment across contract groups. In particular, the diversification between contract groups may not be included.

Stress test and correlation – Value at Risk ('VaR')

Under IFRS 17, the present value of future cash flows is calculated for each contract group. This would be the best estimate part of a VaR calculation. Using a stress test and correlation approach, the calculation would be repeated with different assumptions, i.e. the stress tests, then the difference between these runs is aggregated using a correlation matrix. Considerations for this approach include:

Appropriateness – Stress tests and correlations should be consistent with the chosen confidence interval. Using existing stress tests and correlations could minimise the additional calibration work but only if the confidence level is suitable for the risk adjustment and the stress tests are suitable for the IFRS 17 cash flows.

Scalability and timing – Systems are required to perform the additional valuations for each contract group. These calculations are not fundamentally different to the present value of future cash flows calculation however efficient use of resource and capacity are essential to carry these calculations out within the required timescales for the reporting process.

Diversification – This method allows for the diversification between risks but not for the diversification between contract groups.

An example of this approach may be for an insurance company that already uses the Standard Formula for Solvency II Reporting. An initial proposal for the IFRS 17 risk adjustment is to assume a 99.5th percentile confidence level and use the Standard Formula stress tests for each of the non-financial risks that directly impact cash flows, and aggregate them using the relevant subset of the Standard Formula correlation matrix. This approach would exclude general operational risk. It assumes that the confidence level, stress tests and correlation are available in advance and are appropriate for this company and this purpose. However, that is unlikely to be the case for a 99.5th percentile capital measure. Justification of the appropriateness of any approach is required in the disclosures.

Aggregation

The first thing to assess is whether this diversification is material. With a stress test and correlation approach as in our example, the diversification between contract groups may be small for contract groups of the same product type, but larger when aggregating across different product types.

In the bottom-up approach there is no allowance for diversification between the contract groups. The risk adjustment for any collection of contract groups (such as a portfolio, an entity or an insurance group) is the sum of the risk adjustment for each contract group. This adjustment makes reconciliations across contract groups at different levels of aggregation very simple. However as there is no allowance for diversification, the risk adjustment at (a specific) aggregate level is potentially overestimated.

An alternative approach is to apply the bottom-up calculation at each level of aggregation (that is for each collection of contract groups) to identify the diversification benefit at that level, and then either:

note this diversification benefit at each level of aggregation for internal reconciliation purposes, or

allocate it down to each contract group using a top-down approach (discussed in the following section)

While this approach has the advantage of including the diversification benefit, it involves many more calculations and is much harder to reconcile. This approach may also require additional disclosures, depending on the level of aggregation used in the published report and accounts.

Top-down aggregate approaches

A top-down approach is used when the risk adjustment calculation is performed in aggregate across different IFRS 17 contract groups. This methodology is likely to be the result of an insurance company using an existing metric in order to derive the IFRS 17 risk adjustment. The use of existing systems and processes could substantially reduce the additional resource required to derive the IFRS 17 risk adjustment from heavy model runs through to analysis and review. It also forces consistency with the existing metric.

This approach assumes that the existing metric is well documented, widely understood and suitably governed. It also assumes any adjustments are sufficiently accurate, thoroughly explained and can be efficiently produced in each reporting period. These are significant assumptions, as for example, for many insurers IFRS reporting is first in the reporting cycle, with other bases following after, so these other metrics may not be available in the necessary timeframe.

Where existing metrics are available, it is likely that the metric covers a collection of IFRS 17 contract groups, for example all business in a particular entity or fund, or business of the same product type. It implicitly includes an allowance for the diversification between the contracts. So in order to identify the IFRS 17 risk adjustment for each contract group an allocation method is required.

Scalar allocation

A scalar or pro-rata allocation is one of the simplest methods of allocation to carry out and to explain. It uses a reference measure, which acts as a proxy for the relative size of the non-financial risks at the contract group level. The reference measure could be anything that is available at the contract group level, for example, guaranteed benefits or present value of future cash flows. Under this method the aggregate risk adjustment is allocated to the contract groups in proportion to the reference measure. Therefore the key decision is an appropriate reference measure for the allocation. Important considerations are:

Availability – a reference measure that is already output will avoid the need for further data and/or calculations.

Relevance – the reference measure should in some way reflect cash flow uncertainty so that more of the risk adjustment is allocated to the contract groups with the greater cash flow uncertainty.

Appropriateness – cash flow uncertainty changes over time so the reference measure should be relevant at inception and both relevant and accessible at future time periods. It should allow the risk adjustment to unwind in relation to the remaining uncertainty around the remaining cash flows associated with the insurance contract. This point might tend toward a measure that is related to or is the same as the coverage unit.

Comparability – the reference measure should be meaningful across all the contract groups. This is particularly relevant when allocating the risk adjustment across contract groups of different product types.

Communication – a reference measure that is simple to explain and justify will ease the additional communication burden internally and externally via the disclosures.

There are several approaches that can be used for a top-down risk adjustment allocation; only one has been described here. Many approaches are parallel to the methodology allowed for capital attribution. However it should be noted that for capital attribution the stand alone capital is available at the aggregate level and the granular level. The task is to attribute the aggregate diversified capital to the granular level. For the risk adjustment, the standalone risk adjustment may not be known at contract group level.

Conclusions

The risk adjustment will have a significant impact on the reporting of insurance policies. Therefore the choice of methodology is a key decision for insurers to take in the coming months. Different methods, assumptions and confidence levels should be considered under different future scenarios to investigate the implications of this decision.

Alongside the methodology choice are some of the practical issues of implementing any methodology. One such issue, highlighted here, is how to implement this methodology at the level of granularity required for the reporting standard. Both top-down and bottom-up approaches have their own merits and issues including aggregation, diversification, allocation and choice of reference measure.

Whether an insurer uses an entirely new process or leverages its existing methodology and systems as far as possible, the practical considerations including additional inputs or data requirements, links with existing reporting processes, interfaces with existing reporting systems, the impact on existing reporting timelines and communication of results should not be underestimated.

Read more about "Calculating the IFRS 17 Risk Adjustment"

Explore this additional paper from Cassandra Hannibal which provides an overview of the calculation of the risk adjustment. It opens with a short review of the requirements for calculating the IFRS 17 risk adjustment. Three potential calculation methods for the IFRS 17 risk adjustment are briefly described, with benefits and corresponding issues to consider. The final section summarizes the conclusions and discusses next steps.


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