What is a risk adjustment?



IAN 5 – Risk AdjustmentThis International Actuarial Note (IAN) is promulgated under the authority of the international Actuarial Association. It is an educational document on an actuarial subject that has been adopted by the IAA in order to advance the understanding of the subject by readers of the IAN, including actuaries and others, who use or rely upon the work of actuaries. It is not an International Standard of Actuarial Practice ("ISAP") and is not intended to convey in any manner that it is authoritative guidance. This IAN provides background and suggested practice on the criteria and measurement of the risk adjustment required as part of the Building Block Approach (BBA) under IFRS X. It is structured in the form of a series of questions and answers.What is a risk adjustment?Under IFRS X, insurance contract liabilities are principally measured as “… the amount of the fulfilment cash flows … plus … any contractual service margin …” [[IFRS X 18]. Contractual service margins are the subject of IAN 6. The fulfilment cash flows comprise:a current estimate (see IAN 2); plusa risk margin, the subject of this IAN.In other contexts, risk adjustments may be referred to as risk margins [[IFRS X any others?].What is the purpose of the risk adjustment in IFRS X fulfilment value?“The purpose of the risk adjustment is to measure the effect of uncertainty in the cash flows that arise from the insurance contract.” [[IFRS X B78] As summarised above, it measures the (negative) value that the entity places on the uncertainty and variability inherent in insurance cash flows. What should the risk adjustment do? The risk adjustment is meant to inform users of accounts about the (negative) value that the entity places on the uncertainty and variability of insurance cash flows. As IFRS X does not specify how this should be done, it is important that any such quantification be based on robust actuarial methodology and/or approaches and should be a fair reflection of this value.As most general users see only see what is published in the entity’s financial statements, it is important that these are based on an adequate understanding of the basis on which the risk adjustment is determined and of any changes in that basis, so that the entity is able to provide appropriate disclosures to enhance that understanding. The disclosures in an actuary’s report will inform the entity’s disclosures and seek to enhance the entity’s understanding, enable consistency to be recognised and allow comparisons to be made, as appropriate.An important aspect of this is to clarify the actuary’s understanding of the entity’s risk aversion and its policy on diversification, to avoid misunderstanding between actuary and entity.More discussion about the company-subjective nature of the risk adjustment, no “one right way”, no “one overriding principle” – just those “five basic qualitative principles”What are the IFRS X requirements for risk adjustment?IFRS X does not provide guidance on appropriate techniques and methods to set the risk adjustment. IFRS X itselft simply requires simply that fulfilment cash flows be “adjusted to capture the compensation that the entity requires for bearing the uncertainty about the amount and timing of those cash flows”, those cash flows being the unbiased expected cash flows. “When determining the fulfilment cash flows, an entity shall apply a risk adjustment to the expected present value of cash flows used.” [IFRS X 27]The implementation guideline for IFRS X simply re-states that:“The risk adjustment measures the compensation that the entity would require to make the entity indifferent between; fulfilling an insurance contract liability that has a range of possible outcomes; and fulfilling a liability that will generate fixed cash flows with the same present value as the insurance contract.” [IFRS X (B76]) It then lists 5 characteristics that a risk adjustment should possess to the extent possible:“risks with low frequency and high severity will result in higher risk adjustments than risks with high frequency and low severity;for similar risks, contracts with a longer duration will result in higher risk adjustments than contracts with a shorter duration;risks with a wide probability distribution will result in higher risk adjustments than risks with a narrower distribution;the less that is known about the current estimate and its trend, the higher the risk adjustment; andto the extent that emerging experience reduces uncertainty, risk adjustments will decrease and vice versa.” [IFRS X B81]As well, there are added comments on additional considerations relating to pooling of risksThis general guidance means that there is no single right way for an entity to set risk margins. In general, an entity should select a method that Meets the 5 characteristics aboveCan be shown to be consistent with how the insurer assesses risk from a fulfilment perspectiveCan be practically implementedCan be translated into a confidence level, directly or indirectly (necessary for disclosure)Therefore a variety of methods are potentially available, although their ultimate usage depends on whether they meet the criteria above, given the specific circumstances of the company. Potential methods includes, but are not limited to, quantile techniques such as confidence level of CTE, cost of capital techniques, or even potentially simple techniques such as direct additive techniques of margins to assumptions or subjective scenario modelling. How should risk and uncertainty be quantified?The methodology underlying the quantification of the risk adjustment should should be actuarially sound. To support this aim, an educational Monograph has been produced (reference to Deloitte work). The main intention of the Monograph is to provide focus on methodologies and approaches, to document and build on actuarial approaches that have been developed so far, and to explore ways in which IFRS X’s entity-specific approach may be incorporated into them.What is the value role of actuarial input on risk adjustment?As set out in IFRS X, the risk adjustment is intended to measure “the compensation that the entity would require to make the entity indifferent between:fulfilling an insurance contract liability that has a range of possible outcomes; andfulfilling a liability that will generate fixed cash flows with the same expected present value as the insurance contract.” (B76]It should be noted that the risk adjustment relates only to risks inherent in the insurance contract and its cash flows. Risks “reflected through the use of market consistent inputs” [[IFRS X B78] are excluded. Other risks undertaken by an entity, such as asset-liability mismatch or general operational risks, should also not be reflected in the insurance risk adjustment. In actuarial terms the risk adjustment is intended to be the value of the uncertainty inherent in the insurance cash flows under the contract. This is an area in which actuaries have been active for over 150 years. It is a reasonable assumption to expect that compliance with the standard will require strong actuarial input.This input falls into three four parts.First, the actuary seeks to understand and assess the risk aversion of the entity (its attitude toward risk see questions 10 & 11), as it relates to the uncertainty and variability of insurance cash flows, and to understand the extent to which the entity considers “diversification benefits … in setting the compensation it requires to bear risk” [[IFRS X B37(b)].SecondlyNext, the actuary seeks to understand and assess the uncertainty and variability inherent in the insurance contracts being valued.FinallyNext, the actuary seeks to assess a value that reflects that the entity’s risk aversion, in the context of those risks, and in the context of that diversification.Finally, the actuary seeks to communicate her or his understandings and judgements in arriving at that assessment, so that the entity’s board and management can have an appropriate appreciation of how the risk adjustment is derived.What is the role of actuarial judgement?Actuarial judgement is needed for a variety of reasons.It is needed to select the approach to risk adjustment to be adopted.It is needed in the assessment of the entity’s risk aversion.It is needed to a greater or lesser extent in the estimation and assessment of variability and uncertainty, depending on the data available.It is needed to a greater or lesser extent in the assessment of diversification, depending on the complexity of the business written.It is needed in assessing how risk aversion interacts with variability and uncertainty in the determination of the risk adjustment.It is needed when the actuary is under pressure, to distinguish between reasonable flexibility and weakness.In many cases, it is important that actuarial judgement be communicated, so that the entity’s board and management can properly understand how the risk adjustment is derived and how their input contributes to this.What does “risk” mean in this IAN?The word “risk” can have a variety of meanings, in the context of insurance.It can mean the two-sided risk that an outcome be greater or less than the estimated expected value of that outcome, as a result of variability and uncertainty. This is the meaning intended in this IAN. To emphasize this, this IAN sometimes refers to “risk (variability and uncertainty)”.It can mean the one-sided risk that an outcome will be worse than its expected, anticipated, or perhaps hoped-for, value.It can refer to the subject of the insurance.It can refer to the insured perils.Variability refers to the statistical variation inherent in the insurance process. This is amenable to statistical analysis of experience data. Given enough data, it can be quantified in terms of the variance and higher moments of a suitable probability distribution.Uncertainty is a broader concept that has a number of aspects.Estimates of expected value, variance and higher moments of a probability distribution are themselves uncertain. This uncertainty can be quantified as part of the statistical analysis.The choice of probability distribution is also a source of uncertainty. Complex insurance processes seldom conform exactly to standard probability distributions. It may be possible to partially quantify this uncertainty by considering alternate distributions.The experience data will typically contain more of fewer extreme events than normal. Again, a comparison to a suitable probability distribution may assist in quantifying this.Future circumstances may vary from the past which may be drawn from differing circumstances over past periods. Appropriate adjustments from past to future experience are a matter of judgement and introduce uncertainty into both the projected expected value and its variability.There are also unknown unknowns.The appropriate response to these sources of variability and uncertainty depends on the extent of the data and the materiality of the potential impact of the result. At one extreme, it may be appropriate to analyse as far as possible. More usually it may be appropriate to undertake more limited analysis and to base the response to other aspects of uncertainty. At the other extreme, with limited data, it may be necessary to rely almost totally on judgement. In assessing the extent of analysis appropriate, it may not be worth undertaking deeper analysis that does not yield a material change in the estimate of risk and uncertainty.What risks should be considered?IFRS X makes it clear that “the risk adjustment shall reflect all risks associated with the insurance contract, other than those reflected through the use of market consistent inputs”. [[IFRS X B78] Market consistent inputs may include discount rates, replicating portfolios and, where based on derivative market data, other economic assumptions such as inflation rates.B78 also makes it clear that risks outside the contract (operational risk, asset-liability mismatch, etc., and investment risks that do not affect what is payable under the contract) are not considered in the risk adjustment.Risks that are considered include:claim occurrence, quantum, timing and development;lapse and other policyholder actions;investment risks when linked to policy outcomes;re-investment risks, where cash flows extend past market yield data;inflation and other economic risks, to the extent that they are not hedged;external developments and trends, to the extent that they affect insurance cash flows; and, for the risk adjustment in reinsurance assets,reinsurance disputes and defaults.What is risk aversion?Risk aversion is an entity’s reluctance to accept risk (variation and uncertainty), particularly unfavourable outcomes. To overcome this aversion, entities typically expect a reward or profit for bearing risk. The greater the risk aversion, the greater the expected reward required.How can the actuary assess and express an entity’s risk aversion?The entity’s board is responsible for its risk policy, including its policy on risk aversion. In some cases, the actuary may be able to draw on an explicit risk policy, developed by the entity’s Chief Risk Officer in consultation with the entity’s Board.In other cases, discussions with the entity’s board and management may prove useful. Topics and indications that the actuary may find useful include:comparison with similar entities in the market;discussion of stress scenarios, both short and long term;the entity’s underwriting and pricing policy and practices;the entity’s approach to risk-based capital and capital management; andthe entity’s reinsurance policy and practices.What other references are relevant to this topic?This IAN is designed to be a concise document to address key questions of approach / practice for an actuary in establishing risk margins for a valuation under IFRS X. It is not intended to be a detailed implementation guideline. An actuary who assesses risk adjustments may find it useful to be familiar withIFRS X, including Appendices, Basis for Conclusions and Examples;any associated IASB and related guidance;ISAPs 1, 1A and 4;tThe IAA Monograph: Risk Adjustments under IFRS [Risk Margin Monograph – use the proper title];as well as any applicable parts of IANs 8, 13, 14, 24, 25 and 26, depending on the nature of the business valued.The IAA Monograph: Risk Adjustments under IFRS is a highly informative and useful educational document that describes a variety of approaches and considerations for the actuary in setting risk adjustments for an IFRS X valuation.An actuary working on liabilities in a particular jurisdiction may also find any applicable equivalent local accounting and actuarial standards, and associated guidance, useful.What allowance should be made for risk diversification and what level of aggregation should be used?The risk adjustment incorporates “diversification benefits to the extent that the entity considers those benefits in setting the compensation it requires to bear risk” [[IFRS X B37(b)]. The risk adjustment should aim to fully reflect the impact of risk diversification across all of the insurance risks that the entity regards as a common pool. Typically, this pool will comprise all of the insurance risks underwritten by the entity. In some cases, for statutory or other reasons, the entity might limit diversification to particular sub-pools (such as statutory funds). When looking at the potential impact of diversification, it is important that only benefits that are available to the reporting entity for which the IFRS accounts are being prepared are reflected. For example, where IFRS accounts are being prepared for a consolidated group, diversification benefits across the group can be considered in setting the risk margins across the group. However, where stand-alone IFRS accounts are being prepared at a lower level for an IFRS reporting entity within a group, only diversification benefits available to that entity can be considered. This may lead to situations where the same business has different diversification benefits when reported within group accounts versus within stand-alone entity accounts.On the other hand, it may be open to an entity which is part of a group to allow for the support of the group in setting its risk tolerance policy, so that the entity risk adjustments match those in the consolidated accounts. If this support is provided explicitly in the form of intra-group reinsurances, the difference between entity and group risk tolerance required to match net risk adjustments may not need to be dramatic.What allowance should be made for catastrophes and other large and/or infrequent and/or atypical events?The risk adjustment is intended to fully reflect all of the uncertainty and variability in insurance cash flows, incorporating allowance for all possible outcomes in proportion to their respective probabilities. Where such events or combinations of events are not represented in the experience data, judgement may be needed as to how great an allowance is needed. Conversely, where such events are present, judgment may be needed as to whether they are over-represented.In suitable cases, it may be possible to fit a probability distribution that makes due allowance for extremes, based on observed experience, but the suitability of the chosen probability distribution is also a matter of judgement. It is often helpful to model catastrophes separately from other events.What allowance should be made for risk sharing mechanisms?Risk sharing mechanisms include:participation;investment linkage;deductibles and excesses;profit sharing;retrospective experience rating; andprospective experience rating.No allowance should be made for prospective experience rating outside the contract boundary, as this does not relate to current contracts.Risk sharing arrangements should be allowed for to the extent that they are expected to affect the risks (uncertainty and variability) in the insurance cash flows.What is the compensation that the entity requires for bearing risk?The compensation that the entity requires for bearing risk is a matter of judgement, which is ultimately exercised by the management of the entity and governed by the Board of the entity. In many cases, this will be informed by risk management expertise but, ultimately, the judgement is a Board responsibility, based on management (and possibly actuarial) advice.Such judgements about compensation and risk are perhaps made regularly by entities in relation to the profit margin priced into their insurance policies. Examples of how such profit margins are expressed can be observed in a variety of ways, such as:an overall required profit margin on business written;a target rate of return or margin over risk-free on total (or net) assets;different profit margins on different classes of business; depending on perceived risk;a target probability which may be used for solvency assessment that losses will not exceed a given percentage of net assets;an analysis of the net assets and margin over risk-free return required to support the total business, on a basis such as a target probability that those assets will prove adequate and a rate of return commensurate with that risk;etc.It is not, however, necessarily appropriate simply to apply the profit margin basis to insurance risk margins. It is first necessary to exclude any part of the profit margin that does not relate to the risks that relate to the insurance cash flows, such as operational and asset-liability matching and, usually, investment risks.How should the risk adjustment be determined?Conceptually, the risk adjustment may be thought of as the risk margin in the price that the entity would be indifferent between holding the outstanding liability and transferring the liability to another entity.How the risk adjustment is determined can be expressed in terms of the how the compensation that the entity requires for bearing risk might relate to the entity’s financial performance. For example, if the insurer averages a 5% profit margin, then an average risk adjustment might be calibrated in a way that is consistent with the 5% profit margin. More generally, it would be appropriate to reflect the entity’s financial structure and performance in calibrating the entity’s compensation for bearing risk.If, for example, an entity has determined an amount of capital that it requires to support the fulfillment obligations and the related cash flow risks at some level of aggregation, then that amount of capital (after allowance for risks other than insurance risks) could be apportioned to whatever level of aggregation is needed, and then the risk adjustment could be determined by applying an appropriate rate of return on the allocated capital. There are a variety of possible bases for this apportionment, including:in proportion to expected value;in proportion to standard deviation;in proportion to variance;value at risk;conditional value at risk;proportional hazard transform;etc.These bases are discussed in the Risk Margin Monograph, along with the contexts in which each may be appropriate.How should qualitative risk characteristics be reflectedThe IFRS X requires that “… the risk adjustment shall reflect all risks associated with the insurance contract …” [B78] and that “the less that is known about the current estimate and its trend, the higher the risk adjustment” [B81 (d)]. These imply that allowance for qualitative risk characteristics is to be incorporated into the risk adjustment. By their nature, incorporating such factors into the assessment of the overall level of risk requires judgement.The first step is to assign a value to the level of risk and to assess the degree of correlation with measurable risks. In simple cases, it may be appropriate to assume that they are orthogonal and combine standard deviations as the square root of the some of the squares. There will seldom be an adequate basis for more sophisticated adjustments but, if the qualitative risks are well enough understood, it may be possible to incorporate allowance for correlation and skewness effects. Not infrequently, actuaries are confronted with situations for which information to develop assumptions for risk, including probability models, is limited. This is most frequently the case with new markets / risks, long duration risks, and risks involving extreme or remote events, but unanticipated circumstances (“unknown unknowns”) can arise almost anywhere.There is no single appropriate approach to reflect qualitative considerations and it is up to the actuary to choose a technique that appropriately reflects the information and/or models available and the extent of the uncertainty. It is important that the technique used appropriately captures the potential compensation for bearing the risk. (For example, a simple technique, such as adding a margin based on the estimated standard deviation may not fully allow for the risk of very low frequency but high severity outcomes. A scenario testing approach might perform better, provided suitable extreme scenarios are included. Modelling using a suitably skew probability distribution is another approach.) Both simple and complex techniques may be appropriate, depending on the nature of the uncertainty, the materiality of the uncertainty, and the structure of the underlying modelling available to the actuary. For example, where uncertainty is material, and is characterized by a very low frequency and high severity risk profile and probability models are available, such a risk could be captured by introducing a state or regime switch into the model.Since, by their nature, qualitative risks cannot be measured, their quantification is based on judgement. Where the impact of qualitative risks could be material, and since responsibility for the provisions lies with the entity, it may be desirable for the actuary to discuss these risks with the entity.It should also be noted that qualitative risks are seldom symmetrical. Because of this, it may be appropriate to make an adjustment, for subjective risks, to any mean or expected value estimated solely on the basis of observed experience. How should reinsurance affect the risk adjustment?In principle, under IFRS X, the risk adjustment determined by an entity for the valuation of insurance contracts it has issued (assumed risks) is not impacted by the presence on its balance sheet of reinsurance contracts it has entered into to mitigate these risks (ceded risks) . Essentially, the risk adjustment associated with the insurance contracts it has issued is determined without reference to any reinsurance contracts that mitigate or offset the risks of the issued contracts. The risk adjustment for the reinsurance assets created by the ceded risks is separately determined and increases the value of the reinsurance asset. The quantum of the risk adjustment should reflect the compensation that would make the entity indifferent between entering into reinsurance contract(s) to mitigate these risks and retaining these risks without reinsurance. The risk adjustment for the ceded asset is therefore determined with reference to the difference in the risk position of the entity with (i.e. net position) and without (i.e. gross position) the reinsurance asset.Note that any uncertainty arising out of both the ability and the willingness of the reinsurer to pay claims that the direct insurer considers valid is likely to increase the direct insurer’s net risk and, therefore, decrease the ceded risk adjustment.In practice it may be difficult to directly assess an entity’s appetite for gross risk, if that risk is heavily reinsured. It may be necessary to work backward, assessing appropriate net risk adjustments, based on an appetite for net risk, and then extrapolating to determine gross risk adjustments, with reinsurance risk adjustments determined by difference.Even if gross risk adjustments can be determined directly, it is an essential control to consider the net risk adjustment, based on the entity’s appetite for net risk. If this is not equal to the difference between the assessed gross and reinsurance risk adjustments, then the reinsurance risk adjustment does not properly “represent the risk being transferred by the holder of the reinsurance contract” [para 41(b)(iv)].What is the role of Gross, Ceded and Net risk adjustments?There is no mention of a net risk adjustment in IFRS X because of the theoretical separate determination of the gross risk adjustment and ceded risk adjustment. Conceptually, however, insurers manage their net exposure to risk so, while the net risk adjustment is, in IFRS X terms, the gross risk adjustment less the ceded risk adjustment, it is the net risk adjustment that has most economic substance. It is, therefore, important that, subject to the constraints imposed by IFRS X, the gross and ceded risk adjustments combine to produce an appropriate net position.What disclosures and explanations are required in IFRS X.?“The objective of the disclosure requirements is to enable users of financial statements to understand the nature, amount, timing and uncertainty of future cash flows …” [69]The disclosures required by IFRS X are set out in paragraphs 69-72. The following paragraphs [(IFRS X 73-95)] set out the required explanations. For the most part, these disclosures relate to amounts that are inclusive of risk adjustments and are discussed in other IANs. The specific requirements in respect of risk adjustments are: “Subject to paragraph 77 [[i.e. unless the simplified approach (PAA) is used], an entity shall disclose a reconciliation that separately reconciles the opening and closing balances of: … (b) the risk adjustment; …” [[IFRS X 76];“An entity shall disclose the judgements, and changes in those judgements, that were made …” [[IFRS X 83], including “… the methods and inputs that are used to estimate the risk adjustment” [[IFRS X 83(b)(i)] along with “the effect of changes in the methods and inputs …, separately showing the effect of each change that has a material effect on the financial statements, together with an explanation of the reason for each change.” [[IFRS X 83(c)];“If the entity uses a technique other than the confidence level technique for determining the risk adjustment, it shall disclose a translation of the result of that technique into a confidence level” [[IFRS X 84].What explanations and disclosures should be included in the actuary’s report?The objectives of disclosures in the actuary’s report are to provide the necessary basis for the entity’s IFRS X disclosures and to enable the Board and management to better understand the way in which the actuary has undertaken his or her work. Key elements of this, relative to risk adjustments, may include:discussion of and background to the disclosures required by IFRS X;discussion of how the actuary has quantified the compensation the entity requires for bearing risk;discussion of how the actuary has assessed and incorporated the entity’s risk aversion in considering the entity’s required compensation for bearing risk;discussion of how the actuary has identified and quantified risk and uncertainty and translated this into a risk adjustment;discussion of how qualitative and unknown risks have been allowed for, including of their relative importance, within the risk adjustment;discussion of the impact of reinsurance and other risk transfer or mitigation considerations;discussion of any uncertainty in relation to recoverability of reinsured amounts;discussion of how risk diversification has been considered, within and across product lines, geographic divisions, etc.; anddiscussion of the insurer’s net risk profile and how this is appropriately reflected in the difference between the gross and reinsurance risk adjustments.What are appropriate methods to allocate risk adjustments calculated at a more aggregated level to the contract level?Under IFRS X, it not necessary for the risk adjustment to be directly determined at the contract level, but it may need to be allocated to the contract level or another lower level of aggregation than the level at which it is initially determined, for various purposes (e.g., contractual service margins, liability adequacy testing). Any method that will lead to materially the same risk adjustment were the risk margin directly determined at the lower level of aggregation is appropriate to more finely allocate risk margins. Therefore the methods used to do such allocations should reflect the key drivers of the risk margin calculation. For example, if the risk margin reflects components separately determined for insurance risk, policyholder behavior risk, and financial market risk, the allocation methodology should use risk drivers that appropriately attribute the impact of each of these risks to the lower levels of aggregationWhat are appropriate ways to determine confidence levels for disclosure when not directly available from the risk adjustment calculations?In order to determine confidence levels, it is necessary to be able to locate the value of the FCF of a portfolio of insurance contracts on the probability distribution of the present value of the cash flows for that portfolio. If that probability distribution is not explicitly derived as part of the valuation process, some method or model might be needed to estimate the percentiles of that combined portfolio distribution at the amount that reflects the risk adjustment. The extent of the analysis needed for such estimation will likely require actuarial judgement.For large direct insurance portfolios, the actuary may have sufficient evidence about the tail of the probability distribution to support the assumption of log-Normality. Consequently, it may be sufficient to estimate the expected value and standard deviation of (the logarithms of) the distribution. For large portfolios which lack evidence of significant skewness, it may even be adequate to assume Normality.In other cases, the actuary may assume the form of the probability distribution and estimate the parameters for that probability distribution that he or she considers appropriate for the purpose of this disclosure. For excess-of-loss portfolios and other more extreme risks, distributions such as the Pareto have been suggested.It is important to note that the sensitivity of the resulting confidence level to the chosen probability distribution increases as the confidence level increases. For confidence levels up to perhaps 65%, this choice is seldom important. For confidence levels up to perhaps 90%, it is important to get the shape of the bulk of the distribution right. For purported confidence levels over 99%, the shape of the upper tail is both vital and, for fitted distributions, highly speculative.The actuary may define the relevant part of the probability distribution in terms of two of more quantiles that straddle the FCF based on evidence and judgements which the actuary would be able to explain for the values chosen for those quantiles.What other considerations should the actuary bear in mind when estimating and communicating confidence levels?The actuary should be aware that different actuaries providing advice on confidence levels for similar reserves for similar risks can reach very different conclusions depending on the assumptions and methodology followed and on the judgement applied.External users will likely scrutinize confidence level disclosure closely and compare entities to their peers. As a result, this is an area of significant reputational risk to the actuaryThe actuary may well find him or her-self under pressure to justify the highest possible confidence level for the lowest possible FCFs.Setting a confidence level depends on at least the first and second and often higher moments of the implied probability distribution. When such moments are estimated, it is important to understand that relative uncertainty increases with the order of the moment estimated. It is advisable to avoid highly precise answers and to provide significant qualitative disclosure around the subjectivity and judgement involved in the figures provided. Range estimates or rounded answers may be preferable to precise answers.Determining confidence levels using fitted distributions may give apparently precise answers, but the actuary should be aware of the subjectivity in fitting distributions to the full range of outcomes, and in determining whether the outcomes used to fit the distributions are stable and representative of ongoing conditions.As the degree of uncertainty (in the confidence level) increases, the need for actuarial judgement increases and, with it, the need to communicate, to the entity, both the uncertainty and the way in which judgement has been exercised.What is the appropriate granularity for disclosure of confidence levels?The appropriate degree of granularity is a matter of judgement and depends on the extent to which the confidence level varies across the entity’s business. If a consistent valuation approach is adopted across the whole entity, it is likely that the confidence levels implied by the gross and net of reinsurance FCFs will be similar and will be broadly constant across the whole entity. Material differences would call into question either the basis on which the risk adjustments have been calculated or the probability distributions adopted in estimating the corresponding confidence levels.From an actuarial perspective, the overall net risk adjustment for the entity is the key and the overall gross and net confidence levels should be disclosed to the entity, even if a more granular disclosure is required for IFRS X disclosure.Calibration: howTo what extent should is it appropriate for the actuary use other internal references (e.g. pricing requirements, ORSA frameworks) in setting the quantum and technique for the risk adjustment? (this may be a subset of question 8 but we believe it should be referenced specifically in a question somewhere)analyses and measurements made for other purposes, such as pricing, embedded value, regulatory reporting or capital modelling?IFRS X does not mandate particular technique(s) to determine risk adjustments, nor does it specifically limit the techniques that may be used, or provide examples of appropriate techniques.The primary requirement in the application guidance is that” “The risk adjustment measures the compensation that the entity would require to make the entity indifferent between; fulfilling an insurance contract liability that has a range of possible outcomes; and fulfilling a liability that will generate fixed cash flows with the same present value as the insurance contract.” (B76) While it may often be desirable to make use of analyses conducted for other purposes, itIt must be emphasized that the conclusions drawn from such analyses may not be so readily transferrable. Such conclusions depend on the perspective and purpose for which they are required. the rRisk adjustments are set from in a FULFILLMENT fulfilment perspective and in the context of central estimates that are required to be unbiased expected values. This is not necessarily true of measurements set in other contexts. The underlying rationales of market, entry and exit values, and of pricing are clearly different.the risk adjustments do not therefore represent an exit or sale/pricing perspective. This means that the pricing or and exit value assessments of the liability are not appropriate ways to calibrate risk adjustments. Nevertheless, there may be some value in understanding and assessing the drivers of initial CSM for new contracts and ensuring that the relationship between the fulfillment and pricing perspectives is reasonable.Internal capital models that are developed within ORSA (Own Risk and Solvency Assessment)regulatory frameworks (and/or pricing) may provide a good reference for how the entity views and assesses risk. Therefore the techniques used to measure risk and develop risk adjustments under the IFRS X framework can be compared and assessed against the techniques and measurements used under the ORSA regulatory framework for reasonableness, and potentially leveraged to be used for both purposes should , but they also satisfy the additionalthe resulting risk adjustments need to reflect the (usually different) IFRS X criteriaRegulatory solvency capital adequacy models that align well with how an entity views and assesses risk may, similarly, be potentially leveraged in the development of appropriate IFRS X techniques to measure and assess risk. However, it must be emphasized that IFRS principles for the valuation of insurance contract liabilities are that these are not based on the solvency requirements of an insurer, so they can only be leveraged to the extent they reflect how the entity views and assesses risk. Having said this, regulatory capital adequacy requirements do place constraints on the entity, and are likely to influence its views. A further complication is that both internal and regulatory capital requirements are there to cover all of the risks faced by the entity, while the risk adjustment in the Fulfilment Cash Flows excludes risks outside the insurance contract (such as operational, asset and asset-liability mismatch risks) and risks reflected through the use of market consistent inputs (see question 97).. Even where regulatory minimum capital is built up in an additive structure, it does not necessarily follow that the insurance components of such a structure fully represent the insurance risks, since the underlying relationships are unlikely to be fully additive.It should also be notedAnother consideration is that, subject to certain limitations imposed when separate statutory funds cover specific portfolios, the whole of an entity’s net risk adjustments are available in respect of the whole of the entity’s risks. This is recognized, from another perspective, in IFRS X, which notes that “… the risk adjustment also reflects … the degree of diversification benefit that the entity considers when determining the compensation it requires …” [[IFRS X B77]Professional, role and relationship questions:Risk adjustment owned by board, as all accounting numbers?As with all accounting and other governance matters, the Board of the entity is responsible for the risk adjustment and the FCF, of which it is part. In carrying this responsibility, the Board will typically rely heavily on management and may delegate, but does not have the right to thereby avoid its responsibility. The role of the actuary is that of an adviser to both management and the Board. Ideally, the actuary should have the right of direct access to the Board. (This is mandated under many supervisory regimes in respect of statutory reporting.) Where such access is available, it is a matter of actuarial judgement as to what advice should be presented to the Board directly. This would typically include any formal reporting of valuation results.Board understanding, setting, communicating, relevant risk appetite principles and measures? Role of actuary in facilitating, educating, assisting with communications, internally and externally, member of larger and multi-disciplinary team?In addition to formal reporting of valuation results, it is important that the actuary should communicate closely with the entity, so that Board and management can have a sound and sufficient understanding of the actuary’s work and, in return, that the actuary should have a sound and sufficient understanding of the entity, particularly, in the context of risk adjustments, of its risk appetite. It is also highly desirable that the actuary should be involved in the way in which his or her work is communicated outside the entity.Does it stop with an actuary’s report or is role ideally broader? Scope of IAN in relation to this – being clear about that scope within the IAN, professional development questions more generally?While the formal requirements for IFRS X reporting of risk adjustments are limited, it is highly desirable that the actuary should have a closer and broader relationship with the management (and Board) of the entity, to provide a more complete background to that work, and to enable a clearer understanding of the actuary’s work.To wWhat extent are “simple and sufficient” solutions approaches to implementation of risk adjustment might be utilizedappropriate? Is the monograph OTT re validation, etc.? Should the actuary avoid creating excessive but not really useful or value-for-money work?The IAA Monograph: Risk Adjustments Under IFRS goes into considerable depth on how risk adjustment can be carried out. Such a painstaking approach is appropriate for insurers issuing complex products that require rigorous analysis. For simpler insurers, it may not be necessary, or always be necessary to go to so much effort. The key concepts are statistical significance, materiality and cost/benefit. More complex models are not necessarily better. Unless adequately supported by data, more complexity simply adds noise. If simpler approaches give materially the same results they are acceptable, even preferable.There is no need to use a single model for all the business or all the risks. An entity may mix methods to set risk adjustments across different businesses provided this mixed approach makes due allowance for diversification and is done in a way that can be reasonably disclosed and explained to external users (which is likely the biggest hurdle to a mixed model approach).More complex models may be run in the background at a higher level of aggregation (and perhaps more periodically) and then translated into factor matrixes to use at a more granular level in the valuation. This would be particularly useful for risks that would not normally use stochastic approaches.Internal models used to assess risk for ORSA or other purposes can be used as the basis for IFRS X risk adjustments provided they meet the criteria laid out in the IFRS guidance. Similarly, regulatory models may also be usable in some instances. An important consideration is that the total of all risk adjustments, across the whole of the entity should fairly reflect the value of all of the insurance risk (uncertainty and/or variability) carried by the entity. Since this total includes both positive (gross) and negative (reinsurance) adjustments, this is essentially a net view, though it may also be helpful to also confirm that the total gross (direct) adjustment makes sense. While it will often the case that these totals are built up from adjustments determined for component portfolios, it may sometimes be helpful to start from the (net) total and apportion this between portfolios and within portfolios, as may be required for sector reporting.The reference to mixed models for different businesses presumes that the typical approach is to add risk adjustments from different models. Also, there is no need under IFRS to report risk adjustments at any granular level other than the reporting segment level for financial statements. While there may be a need for allocating risk adjustments in order to compute and re-measure CSM, the complexity of multiple models is a challenge and cannot really be simplified with respect to CSM. Several of the risk adjustment techniques are inherently non-additive and therefore present additional challenges. This discussion is lacking in making appropriate distinctions between the measurement objectives of IFRS adjustments versus ORSA or other solvency models for capital adequacy. The latter would consider investment risk, asset-liability matching and other considerations which are clearly excluded from IFRS risk adjustments. It would be necessary to decompose other risk models if there might be some carry over from other models to IFRS. ................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download