1. Sailing a Course through Risk Margins Will it be perilous?
Catherine Johnston
November 2010

2. Agenda IASB Exposure Draft measurement model
Development of Risk Adjustment
Risk Adjustment techniques
International views
The Future – will it be perilous?

3. Measurement Model Overview
Date
Measurement Model Overview
Fulfilment rather than an exit objective
Margin to ensure no profit emerges at outset
_____________________________________
Explicit estimate of the effects of uncertainty about the amount and timing of cashflows
Discount rate consistent with observable market prices
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Explicit, unbiased, probability weighted estimate of future fulfilment cashflows
Residual margin
Risk adjustment
Time value of money
The measurement model measures an insurance liability as the sum of the expected present value of the future cash outflows less future cash inflows that will arise as the insurer fulfils the insurance contract, adjusted for the effects of uncertainty about the amount and timing of those future cash flows (present value of the fulfilment cashflows) and a residual margin.
This model applies to all insurance contracts (life and non-life), although there is a simplified model for the pre-claims liability for short-duration contracts that we will consider later.
The model has a building block approach, first the estimated cashflows, then a discount rate, a risk adjustment and then a residual margin. It is a current model so the cashflows are based on current information and are discounted to their present value. The discount rate reflects the characteristics of the liability.
The present value of the fulfilment cash flows reflect the net position of cash outflows (e.g. claims) and inflows (premiums). Although the building blocks are calculated as separate components it is presented as one liability – the margins are not separately presented.
The model prohibits a day 1 gain so the residual margin eliminates any gain at inception. The FASB model is consistent for the first two building block but has one composite margin. We will go through the IASB model first and then look at the key differences between the two models.
One other point to note is that the ED notes that the insurance contract liability (including the short cut unearned premium method that we will consider later) in a foreign currency will be treated as a monetary item under IAS 21. This avoids some of the mismatches that have arisen under IFRS 4 when unearned premium balances were treated as non-monetary.
Current unbiased probability weighted estimates of future cash flow 3

4. Current unbiased probability weighted estimates of future cash flow
Date
Risk adjustment
Objective of risk margin to reflect the maximum amount that an insurer would rationally pay to be relieved of the risk that the ultimate fulfilment cash flows exceed those expected
Limited range of permitted techniques
Diversification at portfolio level
Residual margin
Risk adjustment
‘Subject to broadly similar risks and managed together as a single pool’
Time value of money
The IASB are proposing a separate risk adjustment to provide information about the effects of uncertainty about the amount and timing of the cash flows arising from insurance contracts. The objective of the risk adjustment is to reflect the maximum amount that an insurer would rationally pay to be relieved of the uncertainty that the ultimate cash flows will exceed the expected cash flows.
The guidance indicates some characteristics that should be reflected in an appropriate risk margin. These characteristics would result in higher risk adjustments for:
high severity/low frequency risks than from low severity/high frequency risks.
longer duration contracts than short duration contracts with similar risks
wide probability distribution rather than a risks with a narrow distribution
risks with lesser known estimates and trends
increased uncertainty due to experience
There are only three permitted techniques – confidence level, conditional tail expectation and cost of capital. However even where entities determine the risk adjustment using the conditional tail expectation or cost of capital approach, they must still disclose the corresponding confidence level of the risk adjustment.
The risk adjustment is determined at the level of a portfolio of insurance contracts that have broadly similar risks and that are managed together as a single pool. This means that diversification between portfolios will not be reflected in the measurement of the insurance contract.
Note that even where regulatory models include a risk margin the calculation or allowable methodologies may be different.
Current unbiased probability weighted estimates of future cash flow

5. Current unbiased probability weighted estimates of future cash flow
Date
Residual margin
Residual margin amortised in systematic way over coverage period
Passage of time; or
Expected timing of claims and benefits if different
Interest accreted at locked in rate
Residual margin cannot be negative
Residual margin
Risk adjustment
Time value of money
The final section of the building blocks is the residual margin. This is a derived number being the difference between the premium and the sum of the other three components. The residual margin cannot be negative either on initial recognition or subsequently.
The residual margin is recognised over the coverage period in a systematic way that reflects release from risk, which is passage of time or the expected timing of the incurred claims and benefits if that pattern differs significantly from the passage of time. The coverage period is defined as the period during which the insurer provides coverage for insured events.
Interest is accreted on the carrying amount of the residual margin using the discount rate at original recognition which is not re-measured.
It should be noted that the residual margin is not remeasured for subsequent changes in estimates but only reduced for contracts that are no longer in force.
Current unbiased probability weighted estimates of future cash flow 5

6. Subsequent measurement
Date
Subsequent measurement
Remeasurement 
Amount initially recognised is unwound but not remeasured
Residual margin 
Updated for current estimates
Risk adjustment 
Updated for market rates
Time value of money
The measurement model in the ED is a current model therefore except for the residual margin (which is a derived number on initial recognition) all components of the insurance contract liability are updated for current information at each reporting period. Therefore cash flow estimates must be updated based on all available information, current discount rates must be used and the risk margin is also updated. The impact of these adjustments to the carrying value of the liability is reflected directly in the income statement. 
Updated for current estimates
Current unbiased probability weighted estimates of future cash flow 6

7. Profit Signature – MoS vs Exposure Draft

8. Profit Signature – MoS vs Exposure Draft

9. Impact of Risk Adjustment on Profit
Increases potential volatility due to remeasurement
Important part of the ED methodology
Transition
No residual margin
Setting of initial risk adjustment important in profit emergence thereafter

10. Risk Adjustment definition
“The risk adjustment shall be the maximum amount that an insurer would rationally pay to be relieved of the risk that the ultimate fulfilment cashflows exceed those expected.” (ED paragraph 17) The aim is to make an adjustment to the discounted cashflows for the “effects of uncertainty about the amount and timing of those future cashflows”

11. IASB Conclusions: Risk Adjustment should ….
Provide useful information to users about risk inherent in insurance contracts
Reflect the insurer’s view of the economic burden of that risk
Ensure that the measurement of a risk liability includes allowance for risk (as opposed to being risk free)
Be conceptually consistent with the valuation of other assets and liabilities which include allowance for risk
Reduce the amount that that would be release to profit in an arbitrary manner (eg. residual margin)

12. Objections to the Risk Adjustment
Not possible to calculate an explicit risk adjustment objectively
Risk adjustment & residual margin likely to vary significantly by insurer for same underlying risk leading to differences in profit recognition
No single technique for calculation is universally used and accepted
Some techniques difficult to explain
Difficulties in back testing whether risk adjustment was appropriate
Cost of developing calculation systems
Inconsistency with IASB’s revenue recognition proposals
An increase in the risk adjustment will cause an initial loss which would reverse over time – this is likely to be confusing to users

13. Composite Margin
Pros
Not possible to calculate an explicit risk adjustment objectively
Risk adjustment & residual margin likely to vary significantly by insurer for same underlying risk leading to differences in profit recognition
Cons
Provides no information on risk
Implications for separation of embedded options & guarantees
Inconsistent with pricing of financial instruments & written options
Inconsistent with IAS 37 proposals
Lack of principle in run-off pattern

14. Risk Adjustment Calculation
Needs to cover all risks associated with insurance contract – mortality, morbidity, lapse, expense
Remeasured at end of each reporting period
Calculated at portfolio level – group of contracts that are subject to similar risks and managed together as a pool
Can allow for diversification within, but not between, portfolios
Calculate gross and reinsurance separately

15. Risk Adjustment Characteristics
The stated characteristics for the risk adjustment are:
Risks with low frequency and high severity will result in higher risk adjustments than risks with high frequency and low severity
For similar risks, contracts with a longer duration will result in higher risk adjustments than those of a shorter duration
Risks with a wide probability distribution will result in higher risk adjustments than those risks with a narrower distribution
The less that is known about the current estimate and its trend, the higher the risk adjustment shall be
To the extent that emerging experience reduces uncertainty, risk adjustments will decrease and vice versa.

16. Allowable techniques Confidence interval Conditional tail expectation
Cost of capital

17. Other techniques considered
Explicit assumption methods
factor based methods
judgement based on experience studies
Multiple of second and higher moments of risk distribution
Discount rates
Risk adjusted returns
Deflators
Stress/sensitivity testing
Stochastic modelling
Calibration to capital markets or insurance pricing
Implicit (but unspecified) confidence interval

18. Confidence Interval - methodology
Extra amount to be added to expected value so probability of outcome less than expected plus risk margin equals target confidence interval.
Familiar from general insurance context
Relatively complex and tends to be ad-hoc
To cover all risks related to insurance contracts – mortality, morbidity, lapse and expense
Can a probability distribution be determined for best estimate liability?
Or will a distribution be required for each risk?
What allowance to make for diversification?

19. Confidence Interval – Setting confidence level
Very little guidance on how this should be determined.
In general:
The greater the uncertainty in the best estimate assumptions, the large should be the risk adjustment. Consideration should be given to the degree to which experience data is relevant, reliable and/or credible.
Margins should reflect fluctuation in historical experience
Changes in environment that might limit the applicability of past experience to future obligations would be another area of uncertainty
The methodology to determine the margin level should be applied consistently.

20. Confidence Interval – pros and cons
Easy to communicate
Best suited to distributions which are not highly skewed and do not vary significantly over time
Cons
Hard to apply when probability distribution not statistically normal
Difficult to apply to some risks/assumptions eg. expenses
Requires judgment in setting the confidence level
Difficulty in determining allowance that should be made for management actions that might mitigate risk
Difficulty in determining allowance for diversification

21. Confidence Interval - Conclusion
Seems simple but definite complexities involved in practice

22. Conditional Tail Expectation
Risk margin is calculated as the expected value of the outcomes in the extreme of the distribution less the mean. Thus a 75% confidence level is the expected value of all outcomes that are in the highest 25% of the distribution. It is most useful when more extreme events need to be considered.

23. CTE – pros and cons
Pros
Provides a better reflection of the potential extremes than the confidence interval approach and is more appropriate to use when the underlying distribution is heavily skewed
Particularly useful for insurance contracts with skewed payments – eg those with embedded options, interest guarantees, or covering low-frequency, high-severity risks, or where signification concentration of risk
Cons
However one of the practical issues is whether enough is actually known of the extremes of the underlying distribution of outcomes.

24. Cost of Capital
The rationale behind the cost of capital approach is that the insurer will need to hold a sufficient amount of capital (regardless of any regulatory requirement) to ensure that it can fulfil its obligation to policyholders. The risk adjustment then reflects the compensation the insurer will require for holding that capital.

25. Cost of Capital
Calculate the amount that the entity would need to hold with a high degree of certainty (say 99.5%) that the amount would be sufficient to cover its obligations to policyholders. Effectively this should capture nearly the entire tail of the distribution as per confidence interval approach.
The difference between the amount calculated and the expected value represents the capital required.
The risk adjustment is then calculated as the cost of holding the capital amount required in all future periods, and then discounted to the current period using the risk free rate of return.

26. Capital Amount Regulatory – eg Solvency II Economic Capital
New Zealand – could we use part of the new regulatory capital calculation – eg. Insurance Risk Capital Charge

27. Cost of Capital Charge
Should only reflect the return demanded above the risk free rate and only uncertainty relating to the insurance contract
Risks unrelated to the insurance contract liability such as asset risks, mismatch risks and operational risks should not be allowed
Solvency II and the Swiss Solvency Test – set by the regulator
IASB – will need to be determined by the insurer.
Recognised for further research

28. Cost of Capital – pros and cons
Implicitly takes into account diversification
Relatively easy to implement if economic capital models already exist
Stability of calculation across reporting periods
Consistent with how investors view the business
Cons
Difficulties in determining an appropriate cost of capital to use
Potential to be influenced by regulatory solvency capital requirements
Need to calculate the capital amount at each future reporting date
No clear and transparent feedback on appropriateness of resulting margin
Need to calibrate for disclosure to confidence interval probability of sufficiency

29. International use and view
Europe
Cost of capital used for Solvency II
European CRO Forum – favour cost of capital approach
Australia
Concern re risk adjustment and residual margin
Advocate residual margin as shock absorber
FASB
Composite margin
International Actuarial Association
Risk Margin Working Group paper

30. The Future? Submissions on ED due 30 November
IASB likely to move quickly due to members leaving
Unless clear steer away from explicit risk adjustment in submissions, highly likely to remain
More research and guidance required
Europe – Solvency II

31. Implications for New Zealand
Definite complexity involved
Clear computational advantages if could use cost of capital leveraging off regulatory capital calculations
Possible implications for company structures

32. Will it be perilous? Thoughts/comments/questions???
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