CIA.IFRS17-DR

Question 1

Define the IFRS 17 term: Discount Rate

Answer 1

Rate used to discount the estimates of future cash flows which is consistent with the timing, liquidity and currency of the insurance contract cash flows.

• May be a single rate, or a curve of rates varying by duration.
• Discount rate and yield curve are terms used interchangeably

Question 2

Define the IFRS 17 term: Estimates of future cash flows

Answer 2

Future undiscounted cash flows arising from the insurance/reinsurance contracts issued or reinsurance contracts held

Question 3

Define the IFRS 17 term: Fulfilment Cash Flow (FCF)

Answer 3

Present value of the estimates of future cash flows plus the risk adjustment for non-financial risk

Question 4

Define the IFRS 17 term: Liquidity/Illiquidity Premium

Answer 4

Adjustment made to a liquid risk-free yield curve to reflect differences between the liquidity characteristics of the financial instruments that underlie the (risk-free) rates observed in the market and the liquidity characteristics of the insurance contracts

Question 5

Define the IFRS 17 term: Reference Portfolio

Answer 5

A portfolio of assets used to derive discount rates based on current market rates of return, adjusted to remove returns related to risk characteristics embedded in the portfolio that are not inherent in insurance contracts

Question 6

Is the liquidity of a government bond high or low? What about a high-tech start up firm?

Answer 6

Government bond: High

High-Tech Startup: Low

This is based on the liquidity profile of the investment

Question 7

Insurer may calculate ceded cash flows by calculating gross minus net cash flows.

In doing so, the actuary may consider the following (3)

Answer 7

Data availability: If data is sparse or limited, may not be possible/appropriate to directly estimate the PV of ceded cash flows

Cash flow volatility: different approaches may be warranted for different segments of business depending on volatility of cash flows

Reinsurance held: consideration would be given to the type and consistency of an entity’s reinsurance held

Question 8

Identify considerations in segmenting data for selecting payment patterns (3)

Answer 8

• The business segments used for the analysis of the liabilities on an undiscounted basis, and which may not correspond to the entity’s insurance contract portfolios
• The payout period
• The existence of a predetermined schedule of payments for a segment of claims

Question 9

Identify characteristics an IFRS17 discount rate should possess (3)

Answer 9

(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 (if any) for financial instruments whose characteristics are consistent with those of the insurance contracts

(c) exclude the effect of factors that influence such observable market prices but do not affect the future cash flows of the insurance contracts

Question 10

Identify the two methods for selecting a discount rate for valuation of insurance contract liabilities under IFRS17

Answer 10

• Bottom-up approach
• Top-down approach

Question 11

Explain the bottom-up approach

Answer 11

A liquid risk-free yield curve is adjusted 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

Question 12

Explain the top-down approach

Answer 12

The YTM of a reference portfolio of assets is adjusted to eliminate factors that are not relevant to insurance contracts

Question 13

Is it possible for the bottom-up and top-down approaches to lead to the same discount rate?

Answer 13

Yes, but they may also result in different discount rates due to limitations in the way in which adjustments are calculated

Question 14

How would an actuary select either the bottom-up or top-down approach?

Answer 14

The selection of one approach over the other depends on a number of considerations, such as

• The characteristics of the liability cash flows
• The availability of suitable data
• The investment environment
• How frequently the discount rate is expected to be updated

Question 15

Identify another possible approach for determining IFRS17 Discount Rates & its advantage

Answer 15

Hybrid approach: derive illiquidity premium using a top-down approach, and use this illiquidity premium in a bottom-up approach to determine IFRS17 discount rates

Advantage: blends the use of a robust model for estimating illiquidity premiums, which can be updated periodically as appropriate, with the use of readily available Canadian risk-free yield curves, which are updated weekly

Question 16

Identify an advantage & a disadvantage of the bottom-up approach

Answer 16

Advantage: availability of risk-free yield curves

Disadvantage: need to derive an illiquidity premium if or when a non-zero illiquidity premium is required

Question 17

Identify potential sources of risk-free yield curves

Answer 17

Government of canada:
- Zero-coupon bond yield curves (is advantageous over the other two due to: timeliness of data, which is updated weekly & availability of the data at a reasonable level of granularity)
- Spot yield curves
- Forward 1-yr rates

Question 18

Briefly describe 2 ways of determining illiquidity premiums

Answer 18

1. Use a reference portfolio and determine its illiquidity premium using a top-down approach (this is the hybrid approach)
2. Comparing yields on illiquid and liquid assets, both with same or similar degree of credit risk

Question 19

Identify an advantage & a disadvantage of the top-down approach

Answer 19

Advantage: does not require the explicit derivation of an illiquidity premium

Disadvantage: potential complexity of the derivation of a reference portfolio and applicable adjustments, particularly if the discount rate is expected to be updated frequently

Question 20

Identify risk factors that may differ between a reference portfolio and insurance contracts (4)

Answer 20

• Liquidity
• Investment risk (e.g.: credit risk, market risk)
• Timing
• Currency Risk

Question 21

Identify examples of credit risk adjustments

Answer 21

• Default risk
• Downgrade risk

Question 22

There is a wide range of practice to estimate the required deduction for credit risk inherent in bond yields. Observed practices include:

Answer 22

• Market based approaches
• Structural model techniques
• Historical distribution techniques

Question 23

What is the market risk adjustment if the reference portfolio consists solely of bonds?

Answer 23

No adjustments required

Question 24

What is the formula for the liability liquidity premium when using the hybrid approach?

Answer 24

Liability liquidity premium = r * asset portfolio illiquidity premium + constant illiquidity premium difference

• In the source text, r = 100% and the constant = 0

Question 25

Identify contract attributes that may influence the liquidity of an insurance contract (3)

Answer 25

Exit value: all else being equal, a contract where upon exit, all (or a large part) of the value build-up is paid out is more liquid than one that pays out none (or a small part) of the value build-up

Exit costs: all else being equal, a contract with high exit costs is likely to be more illiquid than one without

Inherent value: represents the contract holder’s perceived value of the contract. Contract would therefore be more liquid if it has a low inherent value vs a high one.

Question 26

Which set of insurance contract liabilities is more liquid: LIC or LRC? Explain

Answer 26

LRC is more liquid than LIC
- Since LRC covers events that have yet to occur, it’s easier to cancel or otherwise get rid of the contract

Question 27

Briefly describe the basis of the liquidity of insurance/reinsurance contracts issued, with respect to both LRC and LIC

Answer 27

LRC (liquid): liquidity will be based on the insured’s ability to exit from the contract prior to the contract’s expiry date and to receive value without incurring significant exit costs

LIC (illiquid): liquidity will be based on the insured’s ability to obtain the exit value of the contract in advance of “normal” payment dates

Question 28

Briefly describe the liquidity of reinsurance held contracts, with respect to both LRC and LIC

Answer 28

LRC: liquidity is evaluated on the basis of the ability of the purchaser of the reinsurance to cancel the reinsurance contract before it’s expiry date & receive value.

LIC: likely considered illiquid based on the inability of the purchaser of reinsurance to influence the timing of claim payments

Question 29

Can a single yield curve be used for LIC and LRC?

Answer 29

Yes.

However, LIC and LRC usually display different liquidity characteristics (LIC = illiquid vs LRC = liquid). Therefore, would be up to the judgment of the actuary (since IFRS17 refers to liquidity characteristics of the insurance contracts and not of the LIC or LRC)

Question 30

An approach with a single liquidity yield curve applied to both LIC and LRC could provide the following benefits:

Answer 30

• Fewer yield curves to manage: operationally simpler to reduce the number of calculations
• Single view of the profitability of the portfolio: valuation of the FCFs of the portfolios and groups would be more consistent when transitioning from the LRC to LIC.

Question 31

Under IFRS17, what is a reference curve?

Answer 31

A “standardized” yield curve to facilitate comparison among entities in the unobservable period

Question 32

Reference curves are defined based on:

Answer 32

• The length of the observable period
• The risk-free rate and illiquidity premiums for the observable period
• The ultimate risk-free rate, the ultimate liquidity premiums
• The approach used to interpolate between the last observable point and the ultimate point

Question 33

To discount the estimates of future cash flows, four assumptions are required:

Answer 33

• The undiscounted liability amount
• The expected payment pattern of the undiscounted liability amount
• The expected timing of future payments
• The yield curve consistent with the characteristics of future cash flows

Question 34

Under IFRS17, what is a locked-in curve?

Answer 34

A yield curve determined at the initial recognition of the group of contracts

Question 35

Under IFRS17, what are the 3 purposes for which locked-in yield curves are used?

Answer 35

• Adjusting and accreting interest on the CSM
• Systematic allocation of insurance finance income or expense to the income statement if the entity chooses to disaggregate the insurance finance income or expense between profit and loss and OCI
• The entity uses the PAA and there is a significant financing component

Question 36

In the context of financial reporting for P&C insurance contracts, locked-in yield curves are typically not used unless:

Answer 36

• The entity uses the GMA to determine the LRC for some or all groups of insurance contracts
• The entity selects the OCI option for some or all portfolios of insurance contracts

Question 37

Under IFRS17, identify 2 lines on the Income Statement where insurance expenses are reported

Answer 37

• Insurance service expense
• Insurance finance expense

Question 38

Under IFRS17, what does “insurance finance expense” (or income) refer to

Answer 38

Refers to the change in the carrying amount of the group of insurance contracts arising from:
- The effect of the time value of money and changes in the time value of money
- The effect of financial risk and changes in financial risk

Question 39

Briefly explain the “effect of the time value of money”

Answer 39

Referred to as the unwinding of the discount and represents the release of the effect of discounting at a subsequent measurement date due to the passage of time

Question 40

Briefly explain the “effect of changes in the time value of money”

Answer 40

Referred to as the effect of changes in discounting assumptions and represents the variation in the insurance contract liabilities due to changes in the yield curve relative to prior expectations

Question 41

Under IFRS17, what is meant by the “unwinding of discounts”

Answer 41

Conceptually can be thought of as the difference between discounting the cash flows to the beginning of the period and discounting to the end of the period

Question 42

Under IFRS17, identify methods for calculating the unwinding of discounts

Answer 42

Constant yield curve:
- Uses the same discount curve at the beginning and end of the period
- Corresponds to a priori assumption that the discount curve will remain the same at the end of the period

Unwinding spot rates:
- Uses an end of period discount curve that is equal to the beginning discount curve shifted by one period
- The equivalent unwinding rates are the beginning of period spot rates

Expectations hypothesis:
- Proposes that the term structure of interest rates is solely determined by market expectations of future interest rate changes
- A priori ending discount curve is equal to forward rate between each period’s spot rate

Question 43

Under IFRS17, what level of aggregation should be used for calculating FCFs?

Answer 43

Any level of aggregation provided estimates of LIC and/or LRC can be allocated back to portfolios and groups