IAN 5

IAN 5 – Risk Adjustment

This 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 for non-financial risk required as part of the measurement approach set out in paragraphs 32 to 52 of IFRS 17, referred to as the Building Block Approach (BBA) in this chapter under IFRS 17. It is structured in the form of a series of questions and discussion about these questions.

1 What is a risk adjustment?

Under IFRS 17, insurance contract liabilities are principally measured as defined in para 32 below.

“32 On initial recognition, an entity shall measure a group of insurance contracts at the total of:(a) the fulfilment cash flows, which comprise:

(i) estimates of future cash flows (paragraphs 33–35);(ii) an adjustment to reflect the time value of money and the

financial risks related to the future cash flows, to the extent that the financial risks are not included in the estimates of the future cash flows (paragraph 36); and

(iii) a risk adjustment for non-financial risk (paragraph 37).(b) the contractual service margin, measured applying paragraphs

38–39.”

This IAN discusses the risk adjustment for non-financial risk. In other contexts, risk adjustments may be referred to as risk margins.

The “risk adjustment for non-financial risk” is a defined term in IFRS 17

Appendix A - “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”. A similar definition is also included in paragraph 37 of IFRS 17

In this IAN, the term “risk adjustment” refers to the “risk adjustment for non-financial risk”, as defined in IFRS 17. . In other contexts, risk adjustments may be referred to as risk margins

1

IAN 5

2 What is the purpose of the risk adjustment in IFRS 17 fulfilment cash flows?

“B87 The risk adjustment for non-financial risk for insurance contracts measures the compensation that the entity would require to make the entity indifferent between:

(a) fulfilling a liability that has a range of possible outcomes arising from non-financial risk; and

(b) fulfilling a liability that will generate fixed cash flows with the same expected present value as the insurance contracts.”

As such, it measures the (negative) value, or cost, that the entity places on the uncertainty and variability inherent in insurance cash flows.

3 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 17 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 users 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 communications 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 an actuary’s communication regarding the estimation of risk adjustment is to reflect the entity’s views with respect to the compensation it requires for bearing risk and uncertainty, based on an understanding of the entity’s views about risk aversion and risk diversification.

4 What are the IFRS 17 requirements for risk adjustment?

IFRS 17 does not provide guidance on appropriate techniques and methods to set the risk adjustment. It simply requires that

“37 An entity shall adjust the estimate of the present value of the future cash flows to reflect the compensation that the entity requires for bearing the uncertainty about the amount and timing of the cash flows that arises from non-financial risk.”

2

IAN 5

The application Application guidance Guidance Appendix B of IFRS 17 states, in para B91, that a risk adjustment should possess the following 5 characteristics:

(a) “risks with low frequency and high severity will result in higher risk adjustments for non-financial risk than risks with high frequency and low severity;

(b) for similar risks, contracts with a longer duration will result in higher risk adjustments for non-financial risk than contracts with a shorter duration;

(c) risks with a wider probability distribution will result in higher risk adjustments for non-financial risk than risks with a narrower distribution;

(d) the less that is known about the current estimate and its trend, the higher will be the risk adjustment for non-financial risk; and

(e) 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.”

[SE: These 5 characteristics emphasize that all aspects of deviation risk need to be considered, that is the

random deviation from the expected value which is inherent in any random variable (characteristics a and c)

deviation risk within the contract duration due to the possibility of changes of risk-triggering circumstances over time (characteristic b) and

deviation risk from the estimated expected value due to the risk of statistical error in the estimation of the expected value (characteristics d and e).]

It should be noted that the risk adjustment relates only to non-financial risks inherent in the insurance contract and its cash flows.

“B86 The risk adjustment for non-financial risk relates to risk arising from insurance contracts other than

financial risk. Financial risk is included in the estimates of the future cash flows or the discount rate used to adjust the cash flows. 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 (see paragraph B14).”

Risks reflected through the use ofpriced into market-consistent inputs are excluded. Other non-financial risks that may not arise directly from insurance contracts, such as asset-liability mismatch or general operational risks, should not be reflected in the risk adjustment for non-financial risks

3

IAN 5

This general guidance means that there is no single right way for an entity to set the risk adjustment. In general, there are other important considerations that will be relevant to how an entity determines its approach to estimating the risk adjustment:

consistency with how the insurer assesses risk from a fulfilment perspective

practicality of implementation and ongoing remeasurement translation of risk adjustment for disclosure of an equivalent

confidence level measure

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 or CTE, cost of capital techniques, or even potentially simple techniques such as direct techniques of adding margins to assumptions and subjective scenario modelling.

To support the selection of an approach or approaches for estimating the risk adjustment, an educational IAA Monograph: Risk Adjustments under IFRS has been produced. 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 17’s entity-specific approach may be incorporated into them.

5 What is the role of actuarial input on 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 four parts.

First, the actuary seeks to understand and assess the risk aversion of the entity (its attitude toward risk see questions 610 & 711), as it relates to the uncertainty and variability of insurance contractual cash flows, and to understand the extent to which the entity considers “the degree of diversification benefit the entity includes when determining the compensation it requires for bearing that risk” [B88(b)].

Next, the actuary seeks to understand and assess the uncertainty and variability inherent in the insurance contracts being valued.

Next, the actuary seeks to assess a value that reflects the entity’s risk aversion, in the context of those risks, and in the context of that diversification.

4

IAN 5

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.

6 What is risk aversion?

The term “risk aversion” only appears within the Standard itself in para B88, and it is also mentioned in BC215. There is no discussion as to its meaning, and the term does not appear in the Appendix A, defined terms. It is a vital concept behind the risk adjustment, and the IAA Monograph contains some useful discussion.

“Risk aversion” is intended to describe an entity’s reluctance to bear risk (variation and uncertainty), particularly unfavourable outcomes. The context for the risk adjustment component of the fulfilment cash flows is the provision required to meet the future liabilities, both earned and unearned. The greater the risk aversion, the greater the compensation required for bearing the uncertainty within the fulfilment cash flows.

7 How can the actuary assess and express an entity’s risk aversion?

The entity’s board is responsible for setting and operating its risk management policy as a whole. The essence of insurance is the acceptance of risks that serve the needs of its customers for a profit, and a term commonly used to describe the board’s strategy is its “risk appetite”, which conveys both its appetite to write risks for profit and its aversion to taking so much risk that the level of policyholder protection becomes unacceptable. Both the risk appetite, and the risk aversion, are hard to put clearly into words and numbers, and practice on these areas is continually evolving.

In some cases, there may be 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 to the person charged with estimating the risk adjustment for accounting. Topics and indications that may be found 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;

and the entity’s reinsurance policy and practices.

5

IAN 5

8 What is the role of judgement?

Judgement is needed for a variety of reasons.

To select the approach to risk adjustment to be adopted. In the assessment of the entity’s risk aversion; To a greater or lesser extent in the estimation and assessment of

variability and uncertainty, depending on the data available. To a greater or lesser extent in the assessment of diversification,

depending on the complexity of the business written. In assessing how risk aversion interacts with variability and

uncertainty in the determination of the risk adjustment.

In many cases, it is important that 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.

9 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 (the person or thing covered).

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.

6

IAN 5

The experience data will typically contain more or fewer extreme events than normal. Again, a comparison to a suitable probability distribution may assist in quantifying this.

Future circumstances may vary from those of the past, which may be drawn from differing circumstances over past periods. Environmental changes, technological changes and societal changes are all reasons why distributions based on past experience may need to be interpreted cautiously as guides to the future. Appropriate adjustments from past to future experience are a matter of judgement and introduce uncertainty into both the projected expected value and its variability.

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 on the result. At one extreme, it may be appropriate to analyse uncertainty as far as possible. More usually it may be appropriate to undertake more limited analysis of uncertainty and to base the response on 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.

10 What risks should be considered?

IFRS 17 makes it clear that:

“B86 The risk adjustment for non-financial risk relates to risk arising from insurance contracts other than financial risk. Financial risk is included in the estimates of the future cash flows or the discount rate used to adjust the cash flows. 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 goes on to say that:

“B89 The purpose of the risk adjustment for non-financial risk is to measure the effect of uncertainty in the cash flows that arise from insurance contracts, other than uncertainty arising from financial risk. Consequently, the risk adjustment for non-financial risk shall reflect all non-financial risks associated with the insurance contracts. It shall not reflect the risks that do not arise from the insurance contracts, such as general operational risk.”.  

Furthermore, Financial Risk is defined as:

“Appendix A Definitions – Financial Risk    The risk of a possible change in one or more of a specified interest rate, financial instrument price, commodity price, currency exchange rate, index of prices or rates, credit

7

IAN 5

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.”

              

Under these definitions, the risk adjustment for non-financial risk would include the uncertainty created by the following risks to estimates of the future cash flows

claim occurrence, amount, timing and development (i.e. insurance risk);

Lapse, surrender, premium persistency and other policyholder actions;

Exercise of discretion and other insurer actions;

Expense risk, including inflation risk,  associated with costs of servicing the contract;

External developments and trends, to the extent that they affect insurance cash flows;

For the risk adjustment associated with reinsurance held, reinsurance disputes and defaults.

                               The risk adjustment for non-financial risk would NOT include the uncertainty created by the following

Operational risk Asset-liability mismatch risk  Price or credit risk on underlying assets

In some instances, there may be interactions between financial variables and non-financial variables that impact expected cash flows, making the distinction between financial risk and non-financial risk less clear. For instance, policyholder behaviour may be influenced by investment performance where there are linkages between investment returns and credited rates and/or contractual values. In this instance, the actuary would develop expected cash flows that reflect this influence.  The risk of policyholder behaviour being different than projected in the expected cash flows would be considered non-financial risk. A further example is spread compression risk due to earned/credited rate differences where crediting rates are discretionary. The risk of this discretionary spread compression being different than projected in the estimates of future cash flows would again be considered a non-financial risk.

The risk adjustment for non-financial risk would also reflect any risk associated with inflation risk in claim amounts or expenses, taking into account provisions designed to mitigate inflation risk.  Where there is benefit indexing, the risks associated with benefit indexing, primarily the uncertainty in the index versus expected index values, should also be reflected.    

8

IAN 5

11 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 adjustments for non-financial risk for a valuation under IFRS 17. It is not intended to be a detailed implementation guideline.

An actuary who assesses risk adjustments may find it useful to be familiar with

IFRS 17, including Appendices, Basis for Conclusions and Examples; any associated IASB and related guidance; ISAPs 1, 1A and 4; the IAA Monograph: Risk Adjustments under IFRS; 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 17 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.

12 What allowance should be made for risk diversification and what level of aggregation should be used?

The risk adjustment for non-financial risk reflects, inter alia, “the degree of diversification benefit the entity includes when determining the compensation it requires for bearing that risk” [B88(a)].

[The risk adjustment may reflect the impact of risk diversification across all of the insurance risks contracts that the entity regards as a common pool of contracts find another term. This may pool all risk contracts as one common pool to take account of all possible diversification benefits, or may be limited to sub-pools of specific portfolios or cohorts of business, where the entity considers it relevant that such sub-pools carry their own risks.

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

9

IAN 5

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 lower level entity’s 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.]

[SE substitutes for the above: IFRS 17 refers to “diversification” throughout instead of referring to the broader term “risk mitigation” for simplification without the intention of limitation to diversification (compare DP 2007, paragraph 190, AP 2D May 2010, AP 7C December 2011, particularly paragraph 9). Risk mitigation includes risk mitigation in a pool of similar but uncorrelated risks (pooling, based on the Laws of Large Numbers and the Central Limit Theorems), diversification of inhomogeneous uncorrelated risks, and off-setting of negatively correlated risks.

The risk adjustment should aim to fully reflect the impact of risk mitigation as the entity considers in determining the required compensation for bearing the risk. Limitations might be seen to exist only in that regard, that risk mitigation effects only from insurance contracts issued or reinsurance contracts hold should be considered, not from other economic activities of the entity.

In some cases, for statutory or other reasons, the entity might be required to limit the consideration of risk mitigation effects to particular sub-pools (such as statutory funds). Such requirements might not be seen as applicable under IFRS 17 applying the principle-based approach referring to the compensation which the entity requires.

When looking at the potential impact of risk mitigation, 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, risk mitigation benefits across the group can be considered in setting the risk adjustment across the consolidated group. However, where stand-alone IFRS accounts are being prepared at a lower level, e.g. a legal entity, for an IFRS reporting entity within a group, only risik mitigation benefits available to that entity can be considered. This may lead to situations where the same business has different risk mitigation benefits when reported within group accounts

10

IAN 5

versus within stand-alone entity accounts. However, some believe that the risk aversion of the ultimate risk bearer, if it is the holding of a large insurance group, may be seen as being influenced by the risk mitigation abilities within that insurance group and affect accordingly as well the risk adjustment of in the report of a legal entity within that insurance group.

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.

It should be noted that the risk adjustment refers to risks to be born in the partly far distant future and that the risk adjustment represents the present value of the compensation which the entity, from its current perspective, requires in the period of bearing the risk. This compensation depends on the risk mitigation effects which the entity considers to be present when the risk is to be born, not on the risk mitigation effects available at the reporting date. There is no guidance in IFRS 17 limiting the consideration of the entity to risk mitigation effects resulting from present obligations, existing contracts, contract boundaries etc. Accordingly, the entity might consider for each contract and there for each future risk to be born the risk mitigation effects to arise in future. Applying the going-concern principle, as far as the financial report is applied under the going-concern assumption, the entity may assume that it is able to upheld the current extent of risk mitigation effects for the risks to be born under the contract in future periods, except if supportable information indicate that this is not the case. As a consequence, it might not be a suitable approach to consider the future risk mitigation effects, simply to determine the risk adjustment for the aggregated effect of the currently existing business arising in future on a run-off basis. It might be more appropriate to determine for each cash flow the risk mitigation effect today and to apply the same effect as well to the measurement of the equivalent cash flow expected to incur in future.]

[13] With respect to the liability for future coverage (i.e. insured events that have not yet occurred), What allowance should be made for catastrophes and other large and/or infrequent and/or atypical events in the risk adjustments for future claims coverage and incurred claims?

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.

11

IAN 5

In suitable cases, for future coverage, 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.

Judgement is also needed in respect of events that are impending at the reporting date. Uncertainty about whether, for example, a hurricane will make landfall after the reporting date, or remain at sea, can have a substantial impact on overall uncertainty.

Similar considerations apply to incurred claims, particularly for IBNR claims in respect of storm damage close before the reporting date.

13[14] What allowance should be made for risk sharing mechanisms?

Risk sharing mechanisms for non-financial risk include:

participation; investment linkage; deductibles and excesses; profit sharing; retrospective experience rating; and prospective experience rating schemes, such as no-claim discounts.

[ question asked – what does this mean ???].

No allowance should be made for prospective experience rating outside the contract boundary, as this does not relate to current contracts and is better regarded as part of the underwriting process for subsequent 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.

14[15] 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;

12

IAN 5

a target rate of return or margin over risk-free on total (or net) assets, capital or equity;

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.

15[16] 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.

13

IAN 5

These bases are discussed in the IAA Monograph: Risk Adjustments under IFRS, along with the contexts in which each may be appropriate.

16[17] To what extent is it appropriate for the actuary use analyses and measurements made for other purposes, such as pricing, embedded value, regulatory reporting or capital modelling?

IFRS 17 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 for non-financial risk for insurance contracts measures the compensation that the entity would require to make the entity indifferent between:

(a) fulfilling a liability that has a range of possible outcomes arising from non-financial risk; and

(b) fulfilling a liability that will generate fixed cash flows with the same present value as the insurance contract.” (B87)

While it may often be desirable to make use of analyses conducted for other purposes, it 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. Risk adjustments are set in a 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 fulfilment, market, entry and exit values and of pricing are clearly different. This means that pricing and exit value assessments of the liability may not be appropriate ways to calibrate risk adjustments. Nevertheless, there may be some value in ensuring that the relationship between the fulfillment and pricing perspectives is reasonable.

Internal capital models that are developed within 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 17 framework can be compared and assessed against the techniques and measurements used under the regulatory framework for reasonableness, and potentially leveraged to be used for both purposes, but the resulting risk adjustments need to reflect the (usually different) IFRS 17 criteria

Regulatory 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 17 techniques to measure and assess risk. However, it must be emphasized that IFRS principles for the valuation of insurance contract liabilities are not based on the solvency requirements of

14

IAN 5

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 10). 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.

Another 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 17, which notes that

“… the risk adjustment also reflects … (a) the degree of diversification benefit the entity includes when determining the compensation it requires for bearing that risk…” [B88]

17[18] How should qualitative risk characteristics be reflected

The IFRS 17 requires that “… the risk adjustment shall reflect all non-financial risks associated with the insurance contract …” [B89] and that “the less that is known about the current estimate and its trend, the higher will be the risk adjustment …” [B91 (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 sum 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.

15

IAN 5

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, includingin the context of the risk strategy of the management, 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.

18[19] How should reinsurance affect the risk adjustment?

In principle, under IFRS 17, 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 held 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 held 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

16

IAN 5

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 “represent the risk being transferred by the holder of the group of reinsurance contracts to the issuer of those contracts.” [para 641(b)(iv)].Further discussion of reinsurance and risk adjustment is provided in the reinsurance section of this IAN.

19[20] What is the role of Gross, Ceded and Net risk adjustments?

There is no mention of a net risk adjustment in IFRS 17 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 17 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 17, the gross and ceded risk adjustments combine to produce an appropriate net position.See discussion of reinsurance and risk adjustment in the reinsurance section of this IAN. Briefly, the net effect of the gross risk adjustment minus the ceded risk adjustment should appropriately reflect the net risk borne by the entity.

20[21] What disclosures and explanations are required in IFRS 17?

“93 The objective of the disclosure requirements is for an entity to disclose information in the notes that, together with the information provided in the statement of financial position, statement(s) of financial performance and statement of cash flows, gives a basis for users of financial statements to assess the effect that contracts within the scope of IFRS 17 have on the entity’s financial position, financial performance and cash flows. …”

17

IAN 5

The disclosures required by IFRS 17 are set out in paragraphs 93-96. The following paragraphs [IFRS 17 97-109] set out the required “explanation of recognised amounts”. 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:

“For insurance contracts other than those to which the premium allocation approach described in paragraphs 53–59 or 69–70 has been applied, an entity shall also disclose reconciliations from the opening to the closing balances separately for each of:: … (b) the risk adjustment for non-financial risk; …” [101].

Where the premium allocation approach has been applied, the applicable paras requiring explanation of recognised amounts are 98-100 and 102-105. Of these, risk adjustment for non-financial risk is mentioned in each of paras 100 and 104

“An entity shall disclose the significant judgements, and changes in those judgements, that were made … (c)(ii)to determine the risk adjustment for non-financial risk …” [117]

“An entity shall disclose the confidence level used to determine the risk adjustment for non-financial risk. If the entity uses a technique other than the confidence level technique for determining the risk adjustment for non-financial risk, it shall disclose the technique used and the confidence level corresponding to the results of that technique.” [119].

[22] What explanations and disclosures should be included in the actuary’s reportcommunications?

An importantThe objectives of disclosures in the actuary’s communicationsreport isare to assistprovide the necessary basis for the entity’s in developing its IFRS 17 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 17; 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;

18

IAN 5

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.; and

discussion of the insurer’s net risk profile and how this is appropriately reflected in the difference between the gross and reinsurance risk adjustments.

21[23] What are appropriate methods to allocate risk adjustments calculated at a more aggregated level to the contract level?

Under IFRS 17, it is 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 total risk adjustment, were the risk margin directly determined at the lower level of aggregation, is appropriate to more finely allocate risk margins. Therefore theSuch 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 would use risk drivers that appropriately attribute the impact of each of these risks to the lower levels of aggregation.

22[24] What 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 Financial Cash Flows 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 issued 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

19

IAN 5

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 FCFFinancial Cash Flows based on evidence and judgements which the actuary would be able to explain for the values chosen for those quantiles.

23[25] 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 place significant importance on thescrutinize confidence level disclosure closely and compare entities to their peers. As a result, this is an area of significant reputational risk towhere the actuary can help management understand and communicate the issues and challenges related to this important estimate and the appropriate explanation associated with this disclosure.

Estimating the The actuary may well find him or her-self under pressure to justify the highest possible confidence level for the lowest possible FCFFINANCIAL CASH FLOWs.

Setting a confidence level disclosure will depends on how well the aggregated at least the first and second and often higher moments of the implied probability distribution is understood. When the such moments of the probability distribution can beare estimated, theit is important to understand that relative uncertainty related to such estimates increases with the order of the moment estimated. Consequently, It is advisable to avoid highlythere are risks associatedis a risk of interpreting the confidence level

20

IAN 5

disclosure with a false sense of precisione in such estimates. This risk can be mitigated by providinganswers a better understandingand to provide significant qualitative disclosure around the qualitative considerations involving the level of subjectivity and judgement involved in the estimating the confidence levelfigures provided. Range estimates or rounded answers may be preferable to precise answers.

In Ddetermining the confidence levels using a particular technical methodfitted distributions there are additional considerations related may give apparently precise answers, but the actuary should be aware of the subjectivity in fitting distributions to how well the method reflects the full range of outcomes, and in determining whether the methodoutcomes used to fit the distributions areis stable over time, is fairly and representative of ongoing conditions, and can be replicated.

As the degree of uncertainty (in the confidence level estimate) increases, the need for actuarial judgement increases and, with it, the need to better understand and communicate, to the entity, both the uncertainty and the way in which judgement has been exercised.

24[26] 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 Fulfilment Cash Flows 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 disclosedare key information for to the entity, even if a more granular disclosure is required for IFRS 17 disclosure.

[27] Calibration: how should 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)?

IFRS 17 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”

21

IAN 5

“The risk adjustment measures the compensation that the entity would require to make the entity indifferent between;

[(c)] fulfilling an insurance contract liability that has a range of possible outcomes; and

[(d)] fulfilling a liability that will generate fixed cash flows with the same present value as the insurance contract.” (B76)

It must be emphasized that the risk adjustments are set from a FULFILLMENT perspective, and the risk adjustments do not therefore represent an exit or sale/pricing perspective. This means that the pricing or exit value assessment 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) 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 17 framework can be compared and assessed against the techniques and measurements used under the ORSA framework for reasonableness, and potentially leveraged to be used for both purposes should they also satisfy the additional IFRS 17 criteria

Regulatory 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 17techniques 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 FCF excludes risks reflected through the use of market consistent inputs (see question 10).. 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 noted that, subject to certain limitations imposed when separate statutory funds cover specific portfolios, the whole of an entity’s net

22

IAN 5

risk adjustments are available in respect of the whole of the entity’s risks. This is recognized, from another perspective, in IFRS 17, which notes that

“… the risk adjustment also reflects … (a) the degree of diversification benefit the entity includes when determining the compensation it requires for bearing that risk…” [B88]

[28] Professional, role and relationship questionsissues:

[a.] Risk adjustment is owned by the board, as are all accounting numbers?.As with all accounting and other governance matters, the Board of the entity is responsible for the risk adjustment and the Financial Cash Flows, 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 would 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 beis presented to the Board directly. This would typically include any formal reporting of valuation results.

[b.] Board understanding, setting, communicating, relevant risk appetite principles and measures? . Role of the actuary in facilitating, educating, assisting with communications, internally and externally as a, member of a 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.

[c.] Does it stop with an the actuary’s report or is the 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 17 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.

23

IAN 5

[29] 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 large insurers issuing complex products that require rigorous analysis. For smaller and simpler insurers, it may not be necessary, or not 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

24

IAN 5

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.

25