FA Module 21: IFRS 17 discount rates
(The attached PDF file has better formatting.)
[This posting explains IFRS 17 discount rates: how they are selected and used. Final exam problems specify the discount rates; you must know how to apply them to insurance cash flows.]
Discount rates
The insurance contract liability to policyholders and other claimants is the present value of future cash flows. The discount rate for present values depends on the measurement model and the type of insurance contract.
● Variable fee approach: For insurance contracts with discretionary participation features, policyholders receive most of the yield from a specified pool of assets held by the insurer. The variable fee approach is separate from the general measurement approach and is explained in a separate section (not here).
● Asset-linked contracts: If the insurance cash flows vary with the returns on underlying assets, the yield on these assets is the discount rate.
○ The crediting rate for policyholder account balances may be less than the yield on the assets, but the discount rate is the asset yield, not the crediting rate.
● Non asset-linked contracts: If the insurance cash flows do not vary with the returns on underlying assets, the discount rate is the current (market) rate for assets with maturities, currency, and liquidity similar to those of the insurance cash flows.
● Premium allocation approach: For certain short duration contracts, insurers may use the simpler premium allocation approach. If the contracts have no significant financing component, insurers using the premium allocation approach have the option of not discounting the insurance cash flows.
The term “asset-linked contracts” is not used by IFRS 17, which instead says “groups of insurance contracts for which changes in assumptions that relate to financial risk have a substantial effect on the amounts paid to policyholders.” The IFRS 17 wording determines which discount rate is used; readers may better grasp the logic by thinking of asset-linked contracts. The difference between the two terms is important: for asset-linked contracts, the insurer holds the specified assets and their return is credited to policyholders’ account values. The IFRS 17 wording does not required the insurer to hold the specified assets, just that the assumed returns on certain assets substantially affect the cash flows to policyholders.
This section explains the discount rates for the general measurement approach (building block approach) for non-asset-linked contracts: the insurance cash flows do not vary with the returns on underlying assets. The same type of discount rate (but not the same determination date) is used for
● the premium allocation approach if the insurance cash flows have significant financing components (as for liability claims with long lags between occurrence and payment)
● the contractual service margin even if the insurance cash flows vary with the returns on underlying assets.
Discount rates may be current market rates, rates at initial recognition of the insurance contracts, or market rates when the claims are incurred:
● Present values of future cash flows use current market interest rates.
● The contractual service margin uses discount rates determined at initial recognition of the contracts.
● For the premium allocation approach, the discount rates are determined
○ at initial recognition for the liability for remaining coverage
○ when the claim is recognized for the liability for incurred claims
IFRS 17 lists three attributes of discount rates for insurance cash flows. Paragraph 36 says
An entity shall adjust the estimates of future cash flows to reflect the time value of money and the financial risks related to those cash flows … The discount rates … shall:
(a) reflect the time value of money, the characteristics of the cash flows and the liquidity characteristics of the insurance contracts;
(b) be consistent with observable current market prices; …
(c) exclude the effect of factors that influence such observable market prices but do not affect the future cash flows of the insurance contracts.
Currency
The discount rates should be for the same currency as the insurance cash flows. The nominal interest rate is the real interest rate plus the inflation rate. More precisely, it is (1 + the real interest rate) × (1 + the inflation rate) – 1, but the real interest rate plus the inflation rate is a close approximation when the rates are low.
● The time value of money is the real interest rate, which is little affected by the currency if the country’s economy is open and capital flows are unhindered.
● The currency affects the growth rate of the money supply, which affects the inflation rate.
Interest rates differ by maturity. The term structure of interest rates (the yield curve) is often upward sloping: interest rates are higher for longer maturities. IFRS 17 requires discount rates matched to the maturities of the cash flows, and insurers must disclose the yield curves underlying their discount rates.
IFRS 17 paragraph 120 says:
An entity shall disclose the yield curve (or range of yield curves) used to discount cash flows that do not vary based on the returns on underlying items… When an entity provides this disclosure in aggregate for a number of groups of insurance contracts, it shall provide such disclosures in the form of weighted averages, or relatively narrow ranges.
The effective duration of an asset is the change in its market price given a small change in interest rates. If the market price decreases 2% for a one percentage point increase in annual interest rates, the effective duration is two years. Market interest rates vary most closely with effective duration.
Fixed amount insurance claims, such as traditional death benefits, are like fixed amount bonds; their effective durations are easily measured. Estimating effective durations of other insurance claims is more difficult. Many insurance claims are inflation sensitive (not fixed), and their effective durations are similar to those of inflation sensitive assets, not to those of bonds with fixed payments. General insurance, health insurance, and some life insurance cash flows vary with inflation, loss cost trends, or nominal interest rates. The durations of these insurance contracts are debated.
The IFRS Board considered whether future inflation on non-life insurance contracts offset discount rates, so that estimates of claims not including loss cost trends are suitable proxies for the present values of the claims. The Board reasoned that claim inflation and the time value of money are different variables and may not offset one another. IFRS 17, Basis for Conclusions, paragraph BC190 says
Some stakeholders suggested that measuring non-life insurance contracts at undiscounted amounts that ignore future inflation could provide a reasonable approximation of the value of the liability, especially for short-tail liabilities, at less cost and with less complexity than measuring such contracts at explicitly discounted amounts. However, this approach of implicitly discounting the liability makes the unrealistic assumption that two variables (claim inflation and the effect of timing) will more or less offset each other in every case. As this is unlikely, the Board concluded that financial reporting will be improved if entities estimate those effects separately.
Determining the discount rate
Given the currency and maturity, the discount rates for insurance cash flows may be determined two ways:
● risk-free rates adjusted for liquidity (bottom-up approach)
● portfolio yields adjusted for credit risk (top-down approach)
Bottom-up approach
The bottom-up approach starts with the term structure of interest rates (the yield curve) for liquid, risk-free securities, such as government bonds of the same maturity and currency as the insurance cash flows.
IFRS 17 does not define risk-free rates. Financial economists estimate risk-free rates by yields on government bonds, yields inferred from interest rate swaps and interest rate derivatives, and prices of investment vehicles with minimal risk. These estimates differ from one another and they differ by country. Insurers must disclose the yield curves of risk-free rates from which they derive the discount rates for insurance contracts.
No standard model exists for liquidity, and financial economists do not agree how liquidity affects investment yields. IFRS 17 says that discount rates should be adjusted for liquidity but does not specify how. IFRS 17 conceives of liquid, risk-free securities as two parts: a non-liquid security of a given maturity plus a option to sell that security at its market price. Insurance cash flows are not liquid, so they lack the option to sell the liability at its market price.
IFRS 17 Basis for Conclusions paragraph BC193 explains:
Discussions of the time value of money often use the notion of risk-free rates. Many entities use highly liquid, high-quality bonds as a proxy for risk-free rates. However, the holder can often sell such bonds in the market at short notice without incurring significant costs or affecting the market price. This means that the holder of such bonds effectively holds two things:
(a) a holding in an underlying non-tradable investment, paying a higher return than the observed return on the traded bond; and
(b) an embedded option to sell the investment to a market participant, for which the holder pays an implicit premium through a reduction in the overall return.
In contrast, for many insurance contracts, the entity cannot be forced to make payments earlier than the occurrence of insured events, or dates specified in the contract.
Illustration: A 5% ten-year government bond that is actively traded may be viewed as a ten-year bond that can not be redeemed before its maturity and an option to sell this bond at its fair value at any time. This option is valuable: a ten-year bond that can not be traded or redeemed before its maturity may yield 6% per annum, not 5%. A ten-year insurance contract is like the illiquid ten-year bond: the insurer can not readily sell the contract (or the unpaid claim) to other parties, so it should use the 6% discount rate, not the 5% rate.
IFRS 17 Basis for Conclusions paragraph BC195 says that
it is not appropriate in a principle-based approach…to use an arbitrary benchmark (for example, high-quality corporate bonds) as an attempt to develop a practical proxy for measuring the specific liquidity characteristics of the item being measured, or to provide detailed guidance on how to estimate liquidity adjustments.
Liquidity may affect investment assets vs insurance claims in different ways:
● Less liquid investment assets are often assumed to have lower market prices because investors pay less for assets that they can not readily convert to cash.
● Less liquid insurance claims means the insurer has less need to convert its liabilities to cash, since claimants cannot demand immediate payment. The insurer may be willing to pay more (not to pay less) to meet these liabilities.
Liquidity adjustments depend on the risk aversion of investors. Adjustments that depend on the risk aversion of individual actors are hard to include in market prices. Investments have two parties: if the buyer of a bond demands a return 0.5% higher for illiquidity, the issuer of the bond accepts a return 0.5% lower for illiquidity.
Liquidity affects the market values of bonds through supply and demand, not just by risk aversion.
● Many investors prefer liquid investments that they can convert into cash if needed.
● Many borrowers (bond issuers) prefer illiquid investments that give them cash for fixed periods.
Supply and demand affects the bond yields.
● Highly liquid investments have more investors than issuers, so rates are lower than average.
● Highly illiquid investments have more issuers than investors, so rates are higher than average.
The relation between liquidity and yield is disputed. From market prices of bonds, we can derive yields to maturity by maturity, credit rating, and liquidity. Credit rating and liquidity are intertwined, and market prices of illiquid securities are less readily available, so published tables generally show yields by maturity and credit rating for publicly traded bonds.
[fn: The adjustment for liquidity gives insurers leeway in selecting discount rates. A large adjustment for illiquidity raises the discount rate, reduces the fulfilment cash flows, and speeds up the recognition of profits. Risk-free rates with no adjustment for illiquidity reduce the discount rate, raise the fulfilment cash flows, and slow the recognition of profit.]
Illustration: The risk-free rate on liquid investments is 4% for one year, 5% for two years, and 5.5% for 3 years. The insurer estimates that illiquid investments (with cash flows of the same liquidity as insurance claims) have yields 0.5% higher than those on liquid investments. The discount rates for the insurance cash flows are 4.5% for one year, 5.5% for two years, and 6.0% for 3 years.
The discount rates for insurance contracts have three attributes, as specified by IFRS 17 paragraph 36(a):
The discount rates shall reflect the time value of money, the characteristics of the cash flows, and the liquidity characteristics of the insurance contracts.
IFRS 17, paragraph B79 explains the liquidity adjustment:
… the discount rate reflects the yield curve in the appropriate currency for instruments that expose the holder to no or negligible credit risk, adjusted to reflect the liquidity characteristics of the group of insurance contracts. … Yield curves reflect assets traded in active markets that the holder can typically sell readily at any time without incurring significant costs. In contrast, under some insurance contracts the entity cannot be forced to make payments earlier than the occurrence of insured events, or dates specified in the contracts.
IFRS 17, paragraph B80, for the bottom-up approach, says that the insurer
… may determine discount rates by adjusting a liquid risk-free yield curve to reflect the differences between the liquidity characteristics of the financial instruments that underlie the rates observed in the market and the liquidity characteristics of the insurance contracts (a bottom-up approach).
Top-down approach
The top-down approach starts with the yields on a reference portfolio with cash flows similar to those of the insurance contracts. The reference portfolio has assets with characteristics similar to those of the insurance cash flows for maturity, currency, and liquidity. (IFRS 17 assumes that insurers try to minimize economic mis-match by holding assets with similar maturity, currency, and liquidity as those of the insurance cash flows.)
The yield on the reference portfolio covers also credit risk and market risk, which do not affect insurance cash flows. The yield on the reference portfolio is decreased for credit risk and market risk to give discount rates for insurance cash flows.
● Credit risk: corporate bonds may default, so the expected default losses (as a percentage) are subtracted from the corporate bond yield. In addition, investors are (perhaps) compensated for the uncertainty of defaults, so the reduction in the corporate bond yield may be slightly greater than the expected defaults.
● Market risk: bond yields and defaults vary with economic conditions: yields decrease and defaults rise during recessions. Asset returns that vary with overall market returns have market risk. Economists often assume that a positive correlation between an asset’s returns and the overall market returns raises the discount rate for that asset’s cash flows (as posited by the Capital Asset Pricing Model).
Insurance cash flows have no credit risk or market risk.
● The insurer’s own credit risk (non-performance risk) does not affect the insurance contract liability. If the expected claim is 100 but the insurer has a 10% probability of becoming insolvent and not paying the claim, the claim liability is 100, not 100 × (1 – 10%) = 90.
● Insurance cash flows have no material market risk. Claims are paid in recessions just as in boom years. The possible effects of economic conditions on mortality, morbidity, and accidents are slight.
The yields (by maturity and currency) on the reference portfolio are reduced for credit risk and market risk to give discount rates for insurance cash flows.
● The credit risk may be measured by market prices of credit derivatives.
● The market risk may be measured by asset pricing models, such as the Capital Asset Pricing Model. (The CAPM market risk for investment grade corporate bonds is generally small and often ignored.)
Illustration: The yields on a reference portfolio of investment grade bonds are 6% for one year maturities, 7.5% for two year maturities, and 9% for 3 year maturities. Market prices of credit derivative indicate that the credit risk on these bonds is 0.8% for one year maturities, 1% for two year maturities, and 1.5% for 3 year maturities. The discount rates for insurance cash flows are 5.2% for one year, 6.5% for two years, and 7.5% for 3 years.
The discount rates differ by insurer, depending on their chosen yield curves and liquidity adjustments for the bottom-up method and their reference portfolios and estimates of credit risk for the top-down method, and the two methods give different estimates even for the same insurer. The same variation affects many attributes of insurance cash flows. Estimates of mortality rates, claim frequency, claim severity, mortality improvement, and loss cost trends vary by insurer.
The top-down method is implied by paragraph 36(b,c):
The discount rates shall be consistent with observable current market prices … and exclude the effect of factors that influence such observable market prices but do not affect the future cash flows of the insurance contracts.
IFRS 17, paragraph B81, explains that the entity [the insurer]
… may determine the appropriate discount rates for insurance contracts based on a yield curve that reflects the current market rates of return implicit in a fair value measurement of a reference portfolio of assets (a top-down approach). An entity shall adjust that yield curve to eliminate any factors that are not relevant to the insurance contracts, but is not required to adjust the yield curve for differences in liquidity characteristics of the insurance contracts and the reference portfolio.
IFRS 17, Basis for Conclusions, paragraph 196, explains that the liquidity adjustment applies to the bottom-up approach, not the top-down approach.
… in response to feedback suggesting that it may be difficult to determine a liquidity premium in isolation, the Board observed that in estimating liquidity adjustments, an entity could apply either of the following:
(a) a ‘bottom-up’ approach based on highly liquid, high-quality bonds, adjusted to include a premium for the illiquidity.
(b) a ‘top-down’ approach based on the expected returns of a reference portfolio, adjusted to eliminate factors that are not relevant to the liability, for example market and credit risk. … a reference portfolio will typically have liquidity characteristics closer to the liquidity characteristics of the group of insurance contracts… an entity need not make an adjustment for any remaining differences in liquidity characteristics between the reference portfolio and the insurance contracts.
Exercise 21.1: Discount rate
An insurer is selecting discount rates for IFRS 17.
● The risk-free rate on liquid investments is 4% for one year, 5% for two years, and 5.5% for 3 years.
● Investments whose liquidity is similar to that of insurance cash flows add 0.5% to the discount rate.
● Investment grade bonds yield 6% for one year, 7.5% for two years, and 8.5% for 3 years
● The default risk part of high grade bond yields is 1% at one year, 1.5% at 2 years, and 2% at 3 years
The insurance contract has low cost (25%), medium cost (50%), and high cost scenarios (25%):
● low cost: claim in 1 year with 5% claim frequency and 200 claim severity
● medium cost: claim in 2 years with 10% claim frequency and 500 claim severity
● high cost: claim in 3 years with 15% claim frequency and 800 claim severity
A. What is the discount rate curve for insurance contracts using the bottom-up approach?
B. What is the discount rate curve for insurance contracts using the top-down approach?
C. What is the present value of future cash outflows for the bottom-up approach?
D. What is the present value of future cash outflows for the top-down approach?
Part A: The bottom-up approach adds the liquidity adjustment to the risk-free rate by maturity and currency:
● 1 year: 4% + 0.5% = 4.5%
● 2 years: 5% + 0.5% = 5.5%
● 3 years: 5.5% + 0.5% = 6.0%
Part B: The top-down approach subtracts the credit risk part from the yield on investment grade bonds.
● Investment grade bonds yield 6% for one year, 7.5% for two years, and 8.5% for 3 years
● The default risk on investment grade bonds adds 1% at one year, 1.5% at 2 years, and 2% at three years
The implied yield excluding the credit risk part is
● 1 year: 6% – 1% = 5%
● 2 years: 7.5% – 1.5% = 6%
● 3 years: 8.5% – 2% = 6.5%
Part C: We determine the present value of the claim cost by scenario for the bottom-up approach:
● low cost: 5% × 200 / (1 + 4.5%)1 = 9.57
● medium cost: 10% × 500 / (1 + 5.5%)2 = 44.92
● high cost: 15% × 800 / (1 + 6.0%)3 = 100.75
the present value of future cash outflows is 25% × 9.57 + 50% × 44.92 + 25% × 100.75 = 50.04
Part D: We determine the present value of the claim cost by scenario for the top-down approach:
● low cost: 5% × 200 / (1 + 5.0%)1 = 9.52
● medium cost: 10% × 500 / (1 + 6.0%)2 = 44.50
● high cost: 15% × 800 / (1 + 6.5%)3 = 99.34
the present value of future cash outflows is 25% × 9.52 + 50% × 44.50 + 25% × 99.34 = 49.47
Exercise 21.2: Discount rates
IFRS 17, paragraph 36, says:
The discount rates … shall reflect the time value of money, the characteristics of the cash flows, and the liquidity characteristics of the insurance contracts
A. What is meant by the time value of money?
B. What is meant by the characteristics of the cash flows?
C. What is meant by the liquidity characteristics of the insurance contracts?
Part A: The discount rate depends on the time until the cash is paid. Insurers should use a set of interest sensitive that depend on the lag until the claim is paid (a term structure of interest rates), not an average discount rate applied to all cash flows. The term structure generally slopes upward, so an average discount rate overstates the present value of long duration cash flows and understates the present value of short duration cash flows. Insurers must disclose yield curves implied by their discount rates. Paragraph 120, says:
An entity shall disclose the yield curve (or range of yield curves) used to discount cash flows that do not vary based on the returns on underlying items …
IFRS 17, Basis for Conclusions, paragraph BC198 explains that different ways to determine the discount rate could give rise to different rates, so insurers
should disclose the yield curve or range of yield curves used to discount cash flows … disclosure of the yield curves used will allow users of financial statements to understand how those yield curves might differ from entity to entity.
Part B: The characteristics of the cash flows are magnitude, timing, and currency. Insurers should project the amount of claims paid at each future date and the currency in which it is paid. Each cash flow is discounted at the discount rate for its lag, using the term structure of interest rates for its currency. Currencies with higher inflation generally have higher (nominal) discount rates.
Part C: Cash flows for future claim payments are not liquid: the insurer can not readily transfer the claims to another firm. Insurance contracts and insurance claims can often be reinsured, but the reinsurance price includes mark-ups for expenses and risk.
IFRS 17 reasons that if the insurer had a replicating portfolio with cash inflows equal to the cash outflows for the insurance claims, the present value of the insurance claims would equal the market value of the replicating portfolio. For illiquid insurance claims, the replicating portfolio has illiquid cash inflows. Illiquid investments generally have higher discount rates than liquid investments, so the discount rates for insurance claims should use these higher discount rates.
No model for the effect of liquidity on discount rates is commonly used, and financial economists do not even agree that liquidity is the cause of differences in discount rates. IFRS 17 lets insurers decide how to modify discount rates for liquidity.
Exercise 21.3: Discount rates
IFRS 17, paragraphs 36(b) and 36(c), says that the discount rates … shall
● be consistent with observable current market prices for financial instruments with cash flows whose characteristics are consistent with those of the insurance contracts, in terms of, for example, timing, currency and liquidity.
● exclude the effect of factors that influence such observable market prices but do not affect the future cash flows of the insurance contracts.
A. What is meant by consistent with observable current market prices?
B. What is meant by exclude factors that do not affect the cash flows of the insurance contracts?
Part A: Insurance cash flows can rarely be replicated by financial portfolios, but the discount rates should be consistent with observed market prices. If the discount rate for an illiquid euro cash flow in three years is 5%, the discount rate for an illiquid euro-denominated claim to be paid in three years should also be 5%. IFRS 17 paragraph B47 explains:
IFRS 17 does not require an entity to use a replicating portfolio technique. However, if a replicating asset or portfolio does exist for some of the cash flows that arise from insurance contracts and an entity chooses to use a different technique, the entity shall satisfy itself that a replicating portfolio technique would be unlikely to lead to a materially different measurement of those cash flows.
Question: Why does IFRS 17 emphasize observable current market prices?
Answer: IFRS 17 paragraph B78(b) explains that the discount rates should reflect current market conditions from the perspective of a market participant. If the market discount rate is 5% but a highly risk averse insurer considers a 7% discount rate more appropriate, it should use the 5% market rate for insurance cash flows.
In contrast, the risk adjustment for non-financial risk takes the perspective of the insurer, not that of market participants. If a highly risk averse insurer prices its policies with a 7% risk adjustment for non-financial risk but the competitive market price uses (implicitly) a 5% risk adjustment, the insurer should use the 7% figure.
Part B: The credit risk of financial investments is not relevant to insurance claims. Most insurers back their liabilities with financial portfolios that are not risk-free. The discount rates on the financial portfolios cover credit risk, market risk, and expected defaults, in addition to maturity, liquidity, and currency.
Illustration: An insurer buys investment grade corporate bonds to back its claim payments. The bonds yield 6% per annum, of which 0.4% covers the expected default losses and 0.2% is a risk premium for the risk of future defaults. The bond yield excluding the credit portions is 6% – 0.4% – 0.2% = 5.4%.
Question: IFRS 17, paragraph 36(a), says:
An entity shall adjust the estimates of future cash flows to reflect the time value of money and the financial risks related to those cash flows …
What is the risk adjustment for financial risk?
Answer: The risk adjustment for financial risk is the added yield related to maturity, liquidity, and currency.
● Maturity: the yield curve generally slopes upward, with higher yields for bonds of longer maturities. The discount rate for insurance cash flows should be matched to the maturity of these cash flows.
● Liquidity: less liquid investments often have higher yields. Insurance claim payments are not liquid, so the discount rate should be matched with bonds of similar liquidity.
● Currency: interest rates differ by currency. Financial economists often divide the nominal interest rate into a real interest rate and an inflation rate: the real interest rate is similar across currencies (if the economies are open) and the inflation rate is varies with the growth rate of the money supply.
Insurance cash flows that vary with the returns on underling assets
For some life insurance contracts, the insurer increases policyholder account balances by a crediting rate that depends on the returns on underlying assets.
Illustration: The account balance may be
● decreased each year by a 1% annual fee for the insurer’s costs
● increased by a crediting rate equal to the return on a portfolio of investment grade bonds minus 1.5%
● increased for premiums received
● decreased for claims paid.
The return on the portfolio of investment grade bonds is net of defaults (credit losses). The discount rate is the return on the portfolio, not reduced for the insurer’s 1% annual fee or its 1.5% reduction to the crediting rate. If the net return (after defaults) on the portfolio is 6%, the crediting rate is 6% – 1% – 1.5% = 3.5% and the discount rate is 6%. If the net return is 6% in 20X1 and 7% in 20X2, the discount rates are 6% in 20X1 and 7% in 20X2.
The contracts in the illustration above have crediting rates, not direct participation in a specified pool of assets, so they use the general measurement approach. Contracts with direct participation features use the variable fee approach, not the general measurement approach.
The yield on underlying assets is used only for future cash flows that depend on the asset return. The discount rate for the accretion of interest on the contractual service margin (which is unearned revenue that does not depend on the asset yields) is determined by the bottom-up or top-down methods discussed earlier, not by the yield on underlying assets.
Illustration: The insurer credits policyholder account balances by the yield on a specified asset portfolio (equal to 6% in 20X1) minus 1.5%. The risk-free rate is 3% and the liquidity adjustment is 1%. The insurance finance expense uses the 6% asset yield (not the 6% – 1.5% = 4.5% crediting rate) for the fulfilment cash flows and a 3% + 1% = 4% rate for the contractual service margin.
Current rates vs rates determined at initial recognition
Discount rates are either current interest rates or interest rates when the insurance contract began, referred to as discount rates determined at initial recognition.
● Fair value estimates use current interest rates.
● Amortized value uses the interest rates when the asset was bought.
Both approaches may be justified.
● GAAP discount rates for long duration contracts are frozen at initial recognition. Insurers often use the policy premium to buy bonds of similar durations as their estimated claim payments, so the discount rates for insurance cash flows remain stable, just as the yields to maturity on the bonds.
● IFRS uses fair value (current market) estimates for most financial assets, and current discount rates for insurance cash flows. The discount rate is updated valuation date (each year for annual returns).
IFRS 17 specifies when each method is used.
● Current discount rates are used for future cash flows (fulfilment cash flows), which may be for
○ future claims (liability for remaining coverage)
○ incurred claims that have not yet been paid (liability for incurred claims)
● The accretion of interest on the contractual service margin uses the discount rate at initial recognition.
IFRS 17 allows a premium allocation approach to measure the insurance contract liability for certain short duration contracts. If the premium allocation approach is used and the contracts have significant financing components (interest rates are high or the time between premium collection and claim payment is long), the future cash flows are discounted (just as for the general measurement approach), but the discount rate is
● the rate determined at initial recognition if the claim has not yet occurred
● the rate determined at the date the claim occurred if the claim has already occurred
The premium allocation approach is meant to reduce measurement complexity.
● Current discount rates require remeasurement of the claims whenever interest rates change.
● Discount rates determined at initial recognition accrete interest at a constant rate.
Most general insurers track incurred claims separately from the policies giving rise to the claims. They keep the accident date of the claim, not the policy effective date of the insurance contract giving rise to the claim. Accretion of interest on these claims is simpler using the discount rate from the accident date, not the discount rate from the policy effective date.
Income and expense when market rates change
The effect of discounting on income and expense depends on how the asset or liability is valued. IFRS 9 has three classes for bonds:
● Amortized value uses the yield to maturity when the bond is bought. Changes in market interest rates do not affect the carrying values of bonds held at amortized value.
● Fair value through profit or loss derives the income as the change in the fair value of the bond using current interest rates, with the entire change recognized in profit or loss.
● Fair value through profit or loss derives total comprehensive income as the change in the fair value of the bond using current interest rates, but only the accretion of interest at the initial yield to maturity is recognized in profit or loss. The rest of the income is reported as other comprehensive income.
○ If interest rates increase, the bond’s fair value decreases, so total comprehensive income is less than profit or loss and other comprehensive income is negative.
○ If interest rates decrease, the bond’s fair value increases, so total comprehensive income is more than profit or loss and other comprehensive income is positive.
● The bond’s fair value is its par value when it matures, so amortized value and fair value give the same total income for all years combined, and the accumulated other comprehensive income is zero at maturity.
Insurance finance income or expense is analogous to interest income on bonds.
● Accretion of interest on the contractual service margin and for the premium allocation approach uses the discount rate at initial recognition. Changes in market interest rates do not affect accretion of interest.
● Insurance finance expense is the change in the present value of the future insurance cash flows using current interest rates, analogous to the fair value of bonds.
● The insurer chooses for each portfolio of insurance contracts whether insurance finance expense is recognized entirely in profit or loss or is dis-aggregated between profit or loss and other comprehensive income.
○ If the insurer dis-aggregates, the expense in profit or loss is based on a systematic allocation, and the remaining expense is other comprehensive income.
○ The other comprehensive income is
- positive if the fair value expense is more than the expense based on a systematic allocation
- negative if the fair value expense is less than the expense based on a systematic allocation
○ The other comprehensive income for all years combined is zero when the claims are settled.
The systematic allocation is generally a constant yield amortization. If the payments to policyholders do not vary with the returns on underlying assets, and the insurance finance expense is dis-aggregated between profit or loss and other comprehensive income, the amount in profit or loss is the accretion of interest at the discount rate at initial recognition, so the yield the same each year.
Exercise 21.4: Discount rates when market rates change
On January 1, 20X1, an insurer issues a group of insurance contracts with three year contract periods:
● it collects premium of 800
● it expects one claim for 750 to be incurred and paid on December 31, 20X3
● the risk adjustment for non-financial risk is 40 and does not accrete interest
the annual discount rate for the fulfilment cash flows is
● 4% on January 1, 20X1
● 6% on December 31, 20X1
● 5% on December 31, 20X2
A. What is the insurance finance expense for the fulfilment cash flows in 20X1, 20X2, and 20X3?
B. What is the insurance finance expense for the contractual service margin in 20X1, 20X2, and 20X3?
C. If the insurer dis-aggregates insurance finance expense between profit or loss and other comprehensive income, what are profit or loss and other comprehensive income in 20X1, 20X2, and 20X3?
Part A: The premium is received at initial recognition and the risk adjustment for non-financial risk does not accrete interest here, so the insurance finance expense applies to the present value of the future claim.
The present value of the future claim payment use the current market interest rate:
● January 1, 20X1: 750 / 1.043 = 666.75
● December 31, 20X1: 750 / 1.062 = 667.50
● December 31, 20X2: 750 / 1.051 = 714.29
● December 31, 20X3: 750
The insurance finance expense on the fulfilment cash flows is
● 20X1: 750 / 1.062 – 750 / 1.043 = 0.75
● 20X2: 750 / 1.051 – 750 / 1.062 = 46.79
● 20X3: 750 – 750 / 1.051 = 35.71
Part B: We use the discount rate determined at initial recognition for the contractual service margin:
● The contractual service margin at initial recognition is 800 – 750 / 1.043 – 40 = 93.25.
● The insurance finance expense on the contractual service margin in 20X1 is 93.25 × 4% = 3.73.
(We use the 4% rate at initial recognition, not the current 6% rate at December 31, 20X1.)
● The contractual service margin allocated to profit or loss in 20X1 is (93.25 + 3.73) / 3 = 32.33.
● The contractual service margin on January 1, 20X2, is 93.25 + 3.73 – 32.33 = 64.65.
● The insurance finance expense on the contractual service margin in 20X2 is 64.65 × 4% = 2.59
(We use the 4% rate at initial recognition, not the current 5% rate at December 31, 20X2.)
● The contractual service margin allocated to profit or loss in 20X2 is (64.65 + 2.59) / 2 = 33.62
● The contractual service margin on January 1, 20X3, is 64.65 + 2.59 – 33.62 = 33.62
● The insurance finance expense on the contractual service margin in 20X3 is 33.62 × 4% = 1.34
Part C: IFRS 17 specifies several attributes of a systematic allocation of insurance finance income or expense to dis-aggregate between profit or loss and other comprehensive income:
● based on the characteristics of the insurance contracts, not on the characteristics of the assets if their returns do not affect the cash flow of the insurance contracts) (paragraph B130(a)).
● results in no other comprehensive income over the life of the insurance contracts (paragraph B130(b)).
● uses discount rates determined at initial recognition if the changes in interest rates do not substantially affect the payments to policyholders (paragraph B72(e)(i)).
Most insurers will allocate all insurance finance expense to profit or loss (at current discount rates) or allocate a constant yield to profit or loss (using discount rates determined at initial recognition). If the insurer allocates a constant yield, the insurance finance expense on the fulfilment cash flows allocated to profit or loss is
● 20X1: 750 / 1.042 – 750 / 1.043 = 26.67
● 20X2: 750 / 1.041 – 750 / 1.042 = 27.74
● 20X3: 750 – 750 / 1.041 = 28.85
The insurance finance expense on the fulfilment cash flows allocated to other comprehensive income is
● 20X1: 0.75 – 26.67 = (25.92)
● 20X2: 46.79 – 27.74 = 19.05
● 20X3: 35.71 – 28.85 = 6.86
The other comprehensive income for all years combined is zero.
The insurance finance expense from accretion of interest on the contractual service margin is recognized in profit or loss, not in other comprehensive income.
For other types of insurance contracts, the rules for discount rates may differ:
● If changes in interest rates substantially affect payments to policyholders, as for crediting rates based on an index, the discount rates should allocate the finance income or expenses over the remaining duration of the contracts at a constant rate (paragraph B72(e)(ii)).
● If the insurer uses the premium allocation approach, the discount rates are determined when the claim occurs, not at initial recognition of the group of insurance contracts (paragraph B72(e)(iii)).
The IFRS 17 systematic allocation for these other scenarios is covered in other exercises.
Exercise 21.5: Changes to the discount rate
An insurer writes an insurance contract on December 31, 20X0, with a two year policy term.
● Premium of 100 is collected on December 31, 20X0, and acquisition cash flows are zero.
● One claim of 110 is expected to be incurred and paid on December 31, 20X2.
● The annual discount rate is 8% on December 31, 20X0, and is 6% on December 31, 20X1.
● The risk adjustment for non-financial risk is zero.
The acquisition cash flows and the risk adjustment for non-financial risk are zero to focus on discount rates.
A. What are the fulfilment cash flows at initial recognition?
B. What are the fulfilment cash flows right after the premium is collected?
C. What is the contractual service margin on December 31, 20X0?
D. What is the insurance contract liability on December 31, 20X0?
E. What are the fulfilment cash flows on December 31, 20X1?
F. What is the insurance finance expense for 20X1?
G. What is the contractual service margin on December 31, 20X1?
H. What is the insurance contract liability on December 31, 20X1?
I. What is the insurance revenue for 20X1?
Part A: The fulfilment cash flows at initial recognition = 110 / 1.082 – 100 = (5.69)
Part B: The fulfilment cash flows right after the premium is collected = 110 / 1.082 = 94.31
Part C: The contractual service margin on December 31, 20X0, is the negative of the fulfilment cash flows at initial recognition = 5.69
Part D: The insurance contract liability on December 31, 20X0, is the fulfilment cash flows + the contractual service margin = 94.31 + 5.69 = 100.00. At inception of the policy, the insurance contract liability for a non-onerous contract is the increase in the cash asset, which is the premium received minus any acquisition cash flows paid. For onerous contracts, the insurance contract liability at initial recognition is more than the premium received.
Part E: The fulfilment cash flows on December 31, 20X1, use the current discount rate, not the discount rate at initial recognition: 110 / 1.061 = 103.77
Part F: The insurance finance expense for 20X1 has two parts.
● The fulfilment cash flows increased from 94.31 to 103.77 because of the time value of money, so the insurance finance expense on the liability for remaining coverage = 103.77 – 94.31 = 9.47.
○ The fulfilment cash flows use the current discount rates at each valuation date.
● The contractual service margin accretes interest at the discount rate determined at initial recognition:
○ 8% × 5.69 = 0.46
The insurance finance expense is 9.47 + 0.46 = 9.92
If the discount rate changes, the insurer selects for each portfolio of insurance contracts whether to
● recognize the insurance finance expense (on the present value of future cash flows) in profit or loss or
● dis-aggregate the insurance finance expense between profit or loss and other comprehensive income
If the insurer chooses to dis-aggregate, it must systematically allocate the portion in profit or loss by year and the portion in other comprehensive income must be zero for all years combined (for each group of contracts).
Insurers who dis-aggregate will generally use the discount rate determined at initial recognition for the portion recognized in profit or loss. For this exercise
● the portion recognized in 20X1 profit or loss is 94.31 × 8% = 7.54
● the 20X1 other comprehensive income is 9.47 – 7.54 = 1.93
In 20X2, the increase in other comprehensive income reverses:
● the insurance finance expense (on the present value of future cash flows is 110 – 103.77 = 6.23
● the portion recognized in 20X2 profit or loss is 94.31 × 1.08 × 8% = 8.15
● the 20X2 other comprehensive income is 6.23 – 8.15 = (1.92)
Part G: The contractual service margin on December 31, 20X1, is the contractual service margin at the previous valuation date + the accretion of interest – the allocation of profit for the year.
The contractual service margin after accretion of interest = 5.69 + 0.46 = 6.15
The coverage units at the same for 20X1 and 20X2, so the allocated profit in 20X1 is 6.15 / 2 = 3.07
The contractual service margin at December 31, 20X1, is 6.15 – 3.07 = 3.07
Part H: The contractual service margin on December 31, 20X1, is the fulfilment cash flows plus the contractual service margin = 103.77 + 3.07 = 106.85
Part I: The insurance service revenue for 20X1 is the contractual service margin allocated to 20X1 = 3.07.
Exercise 21.6: Timing of income
The profit or loss over the life of the insurance contracts depends on the cash received and paid, not on the accounting system. IFRS 17 determines
● when revenue and expenses are recognized
● how revenue and expenses are divided between insurance services and insurance finance expense
● whether income is reported in profit or loss vs other comprehensive income
On January 1, 20X1, an insurer issues a group of insurance contracts with three year contract periods and
● it collects premium of 100 on 1/1/20X1
● it expects one claim for 100 × 1.103 = 133.10 on 1/1/20X4
● the discount rate for the fulfilment cash flows is 10% per annum
● the risk adjustment for non-financial risk is zero
The difference between GAAP for long duration contracts and IFRS 17 is explained below.
A. What are the fulfilment cash flows at initial recognition, after the premium is received, and at December 31, 20X1, 20X2, and 20X3?
B. How does GAAP show the revenue and expense from the insurance contracts?
C. How does IFRS 17 show the revenue and expense from the insurance contracts?
D. How does IFRS 17 show the accretion of interest on the future cash flows?
E. What are the insurance revenue and insurance service expense on 1/1/20X4?
Part A: The fulfilment cash flows are
● at initial recognition: 133.10 / 1.103 – 100 = 0.00
● after premium is received: 133.10 / 1.103 = 100.00
● at December 31, 20X1: 133.10 / 1.102 = 110.00
● at December 31, 20X2: 133.10 / 1.101 = 121.00
● at December 31, 20X3: 133.10 / 1.100 = 133.10
Part B: GAAP show insurance revenue for long duration contracts when the premium is due (initial recognition here) and an expense for policy reserves on the same day. If the discount rate for the policy reserves is 10% per annum, GAAP shows premium revenue of 100 and an expense for the change in policy reserves of 100.
Part C: IFRS 17 does not show any revenue or expense at initial recognition if the contracts are not onerous.
Question: What about the cash received of 100 and the insurance contract liability of 100?
Both GAAP and IFRS 17 show a cash inflow of 100 at initial recognition and an insurance contract liability (or policy reserve) of 100 at initial recognition, for zero net revenue. For long duration contracts
● GAAP shows revenue and expense of 100 each at initial recognition.
● IFRS 17 shows insurance revenue and insurance service expense of 133.10 each when the claim occurs.
Part D: IFRS 17 shows the insurance finance expense (accretion of interest) year by year:
● In 20X1, the present value of the future cash flows increases from 100 to 110, and the insurer shows insurance finance expense of 10.
○ The investment income on the cash is covered by IFRS 9, not by IFRS 17.
○ If the investment yield on cash equals the discount rate for insurance liabilities, the insurer shows zero net profit or loss in 20X1 (or 20X2 or 20X3).
● In 20X2, the present value of the future cash flows from 110 to 121, and the insurer shows insurance finance expense of 11.
● In 20X3, the present value of the future cash flows from 121 to 133.10, and the insurer shows insurance finance expense of 12.10.
Part E: On January 1, 20X4, the claim is incurred and paid for 133.10.
● The insurer shows insurance revenue of 133.10 and insurance service expense of 133.10.
● The insurance contract liability decreases from 133.10 to zero and the insurer’s cash decreases 133.10.
IFRS 17 says in paragraph 88:
… an entity shall make an accounting policy choice between:
(a) including insurance finance income or expenses for the period in profit or loss; or
(b) disaggregating insurance finance income or expenses for the period to include in profit or loss an amount determined by a systematic allocation of the expected total insurance finance income or expenses over the duration of the group of contracts …
Paragraph 88(a) is the method used to solve the exercise here. Paragraph 88(b) is the alternative method that allocates the (nominal) insurance finance income or expenses systematically over the contract period.
Changes in estimates vs changes in discount rates
IFRS 17 distinguishes changes in estimates of future claims from change in the discount rate for future claims.
● Changes to the contractual service margin offset changes to the fulfilment cash flows that stem from changes in estimates of future claims if these changes relate to future service, not current service.
● Changes in current market rates relate to current service, not future service, so they affect fulfilment cash flows and are not offset by changes to the contractual service margin.
Changes to claim payments may stem from several sources:
● Changes unrelated to interest rate changes, such as changes in mortality rates, claim frequency, or claim severity that relate to the liability for remaining coverage, are offset by changes to the contractual service margin (subject to the restriction that the contractual service margin may not be negative).
○ An increase in a claim estimate increases the fulfilment cash flows, decreases the contractual service margin an equal amount (subject to a lower bound of zero), and does not directly affect profit or loss.
- The decrease in the contractual service margin reduces the allocation to profit or loss over the current and subsequent years of the contract period.
○ A decrease in a claim estimate decreases the fulfilment cash flows, increases the contractual service margin an equal amount, and does not directly affect profit or loss.
- The increase in the contractual service margin raises the allocation to profit or loss over the current and subsequent years of the contract period.
● Changes stemming from movements in market interest rates are changes related to current services, not to future services. A change in the current market interest rate from 5% to 6% is a change in the current market rate, not a re-estimate of a future contingent event. Changes related to current services are not offset by changes to the contractual service margin.
○ An increase in the current market interest rate decreases fulfilment cash flows but does not increase the contractual service margin.
- The insurer recognizes a profit in profit or loss or in other comprehensive income, depending on its accounting policy choice for the portfolio of insurance contracts.
○ A decrease in the current market interest rate increases fulfilment cash flows but does not decrease the contractual service margin.
- The insurer recognizes a loss in profit or loss or in other comprehensive income, depending on its accounting policy choice for the portfolio of insurance contracts.
○ Changes in interest rates do not affect the insurance finance expense for all years combined or the profit or loss for all years combined.
- Other comprehensive income for all years combined is zero.
Discretionary cash flows
Many life insurance contracts have an account balance that
● increases as the policyholder pays premiums
● decreases by an annual fee for the insurer’s expenses
● increases by a crediting rate for the accretion of interest.
The crediting rate may be fixed or may be tied to an interest rate index, such as investment grade bond yields.
Some insurance contracts allow the insurer discretion over the crediting rate applied to policyholder account balances. The crediting rate may be related to certain asset returns, such as the return on a specified pool of assets minus a charge (such as 2%), but the insurer may raise or lower the charge to offset increases or decreases in the asset returns.
Illustration: If the asset return increases (decreases) 1%, the insurer may raise (lower) the charge 0.5%, so that fluctuations in the crediting rate are dampened.
Changes stemming from the exercise of discretion relate to future services and are offset by changes to the contractual service margin.
● Changes to crediting rates stemming from changes in market interest rates do not affect the contractual service margin.
● Changes to crediting rates based on the insurer’s exercise of discretion are changes to the claim estimate (future service) and are offset by changes to the contractual service margin.
● A higher crediting rate based on the exercise of discretion raises the fulfilment cash flows (more money is paid to policyholders) and reduces the contractual service margin (but not below zero).
○ The decrease in the contractual service margin reduces the allocation to profit or loss over the current and subsequent years of the contract period.
● A lower crediting rate based on the exercise of discretion reduces the fulfilment cash flows (less money is paid to policyholders) and raises the contractual service margin.
○ The increase in the contractual service margin raises the allocation to profit or loss over the current and subsequent years of the contract period.
Exercise 21.7: Changes to crediting rates
An insurer issues an insurance contract on January 1, 20X1, with a starting account balance of 800 from the initial premium received.
● The account balance increases each year by the yield on a pool of investment grade bonds minus D.
○ D is the discretionary reduction in the asset return to derive the crediting rate.
● The insurer specifies D at initial recognition, but it may change this figure at its discretion.
At initial recognition, the mortality rate is 3%, the investment yield is 7%, and D is 2%.
For simplicity, we assume constant mortality rates throughout the policy life. In practice, the insurer has a mortality table, which it updates every few years. We assume a constant, flat yield curve, though the insurer may have priced the policy with a non-flat yield curve and perhaps rising or falling long-term interest rates.
At December 31, 20X1, the insurer re-estimates the mortality rate and the investment yield. The mortality rate is an estimate related to future services.
● If the insurer re-estimates the mortality rate as 2%, the reduction in the fulfilment cash flows is offset by an increase in the contractual service margin.
● If the insurer re-estimates the mortality rate as 4%, the increase in the fulfilment cash flows is offset by a decrease in the contractual service margin (but not below zero).
The market interest rate relates to current services.
● If the current investment yield changes to 6%, the reduction in the fulfilment cash flows is related to current services and is not offset by an increase in the contractual service margin.
● If the current investment yield changes to 8%, the increase in the fulfilment cash flows is related to current services and is not offset by a decrease in the contractual service margin.
The discretionary parameter D is the offset to the investment yield to derive the crediting rate in future years.
● If the insurer changes the discretionary parameter D to 3%, the reduction in the fulfilment cash flows is related to future services and is offset by an increase in the contractual service margin.
● If the insurer changes the discretionary parameter D to 1%, the increase in the fulfilment cash flows is related to future services and is offset by a decrease in the contractual service margin.
An insurer may use its discretion to smooth changes in the crediting rate. If the crediting rate is the investment yield minus D, and the investment yield decreases 1%, the insurer may decrease D 0.4%, so the crediting rate decreases only 0.6%. The change in the investment yield is not offset by a change in the contractual service margin, but the change in the value of D is offset by a change in the contractual service margin. A separate exercise shows how to compute the contractual service margin when the change is the investment yield is accompanied by a change in the exercise of discretion.
Question: A discretionary parameter is not known at initial recognition, so how does the insurer quantify the change in this parameter and the effect on the contractual service margin?
Answer: IFRS 17 paragraph B98 explains that the insurer specifies at inception of the contract how it intends to determine the discretionary parameter.
The terms of some insurance contracts … give an entity discretion over the cash flows to be paid to policyholders. A change in the discretionary cash flows is regarded as relating to future service, and accordingly adjusts the contractual service margin. To determine how to identify a change in discretionary cash flows, an entity shall specify at inception of the contract the basis on which it expects to determine its commitment under the contract; for example, based on a fixed interest rate, or on returns that vary based on specified asset returns.
The specification at inception of the contract enables us to distinguish changes in the investment yield or the interest rate from changes in the exercise of discretion. Paragraph B99 says:
An entity shall use that specification to distinguish between the effect of changes in assumptions that relate to financial risk on that commitment (which do not adjust the contractual service margin) and the effect of discretionary changes to that commitment (which adjust the contractual service margin).
“Changes in assumptions that relate to financial risk” refers to changes in investment yields or market interest rates. The insurer estimates investment yields for future years, so a re-estimate is a change in assumptions.