International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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(for example, prices of publicly traded securities and interest rates).
Estimates of market variables should be consistent with observable market prices at the
measurement date. An entity should maximise the use of observable inputs and should
not substitute its own estimates for observable market data except in the limited
circumstances as permitted by IFRS 13 (see Chapter 14 at 17.1). Consistent with IFRS 13,
if variables need to be derived (for example, because no observable market variables
exist) they should be as consistent as possible with observable market variables.
[IFRS 17.B44].
Insurance contracts (IFRS 17) 4489
Market prices blend a range of views about possible future outcomes and also reflect the
risk preferences of market participants. Consequently, they are not a single-point forecast
of the future outcome. If the actual outcome differs from the previous market price,
IFRS 17 argues that this does not mean that the market price was ‘wrong’. [IFRS 17.B45].
An important application of market variables is the notion of a replicating asset or a
replicating portfolio of assets. A replicating asset is one whose cash flows exactly
match, in all scenarios, the contractual cash flows of a group of insurance contracts in
amount, timing and uncertainty. In some cases, a replicating asset may exist for some
of the cash flows that arise from a group of insurance contracts. The fair value of that
asset reflects both the expected present value of the cash flows from the asset and the
risk associated with those cash flows. If a replicating portfolio of assets exists for some
of the cash flows that arise from a group of insurance contracts, the entity can use the
fair value of those assets to measure the relevant fulfilment cash flows instead of
explicitly estimating the cash flows and discount rate. [IFRS 17.B46]. 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 should satisfy
itself that a replicating portfolio technique would be unlikely to lead to a materially
different measurement of those cash flows. [IFRS 17.B47]. In practice, we believe that
the use of a replicating portfolio is likely to be rare as IFRS 17 refers to an asset whose
cash flows exactly match those of the liability.
Techniques other than a replicating portfolio technique, such as stochastic modelling
techniques, may be more robust or easier to implement if there are significant
interdependencies between cash flows that vary based on returns on assets and other
cash flows. Judgement is required to determine the technique that best meets the
objective of consistency with observable market variables in specific circumstances. In
particular, the technique used must result in the measurement of any options and
guarantees included in the insurance contracts being consistent with observable market
prices (if any) for such options and guarantees. [IFRS 17.B48].
In May 2018, the IASB staff responded to a submission to the TRG which asked
whether ‘risk neutral’ (i.e. based on an assumed distribution of scenarios that is
intended to reflect realistic assumptions about actual future asset returns) or ‘real
world’ (i.e. based on an underlying assumption that, on average, all assets earn the
same risk-free return, with a range of scenarios analysed reflecting the assumed
volatility of returns for an asset price consistent with volatility implied by option
prices) scenarios should be used for stochastic modelling techniques to project future
returns of assets. The IASB staff clarified that IFRS 17 does not require an entity to
divide estimated cash flows into those that vary based on the returns on underlying
items and those that do not (see 8.3 below) and, if not divided, the discount rate should
be appropriate for the cash flows as a whole. The IASB staff observed that any
consideration beyond this is actuarial (i.e. operational measurement implementation)
in nature and therefore does not fall within the remit of the TRG. The TRG members
did not disagree with the IASB staff’s observations.9
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8.2.3.B Non-market
variables
Non-market variables are all other variables (other than market variables) such as the
frequency and severity of insurance claims and mortality.
Estimates of non-market variables should reflect all reasonable and supportable
evidence available without undue cost or effort, both external and internal. [IFRS 17.B49].
Non-market external data (for example, national mortality statistics) may have more or
less relevance than internal data (for example, internally developed mortality statistics),
depending on the circumstances. For example, an entity that issues life insurance
contracts should not rely solely on national mortality statistics, but should consider all
other reasonable and supportable internal and external sources of information available
without undue cost or effort when developing unbiased estimates of probabilities for
mortality scenarios for its insurance contracts. In developing those probabilities, an
entity should give more weight to the more persuasive information. For example:
[IFRS 17.B50]
• Internal mortality statistics may be more persuasive than national mortality data if
national data is derived from a large population that is not representative of the
insured population. This might be because, for example, the demographic
characteristics of the insured population could significantly differ from those of the
national population, meaning that an entity would need to place more weight on
the internal data and less weight on the national statistics.
• Conversely, if the internal statistics are derived from a small population with
characteristics that are believed to be close to those of the national population, and
the national statistics are current, an entity should place more weight on the
national statistics.
Estimated probabilities for non-market variables should not contradict observable
market variables. For example, estimated probabilities for future inflation rate scenarios
should be as consistent as possible with probabilities implied by market interest rates.
[IFRS 17.B51].
In some cases, an entity may conclude that market variables vary independently of non-
market variables. If so, the entity should consider scenarios that reflect the range of
outcomes for the non-market variables, with each scenario using the same observed
value of the market variable. [IFRS 17.B52].
In other cases, market variables and non-market variables may be correlated. For
example, there may be evidence that lapse rates (a non-market variable) are correlated
with interest rates (a market variable). Similarly, there may be evidence that claim levels
for house or car insurance are correlated with economic cycles and therefore with
interest rates and expense amounts. The entity should ensure that the probabilities for
the scenarios and the risk adjustments for the non-financial risk that relates to the
market variables are consistent with the observed market prices that depend on
those
market variables. [IFRS 17.B53].
Insurance contracts (IFRS 17) 4491
8.2.4
Using current estimates
In estimating each cash flow scenario and its probability, an entity should use all
reasonable and supportable information available without undue cost or effort.
[IFRS 17.B54]. Undue cost and effort is discussed at 17.3 below. [IFRS 17.B54].
An entity should review the estimates that it made at the end of the previous reporting
period and update them. In doing so, an entity should consider whether: [IFRS 17.B55]
• the updated estimates faithfully represent the conditions at the end of the reporting
period; and
• the changes in estimates faithfully represent the changes in conditions during the
period. For example, suppose that estimates were at one end of a reasonable range
at the beginning of the period. If the conditions have not changed, shifting the
estimates to the other end of the range at the end of the period would not faithfully
represent what has happened during the period. If an entity’s most recent estimates
are different from its previous estimates, but conditions have not changed, it should
assess whether the new probabilities assigned to each scenario are justified. In
updating its estimates of those probabilities, the entity should consider both the
evidence that supported its previous estimates and all newly available evidence,
giving more weight to the more persuasive evidence.
The probability assigned to each scenario should reflect the conditions at the end of the
reporting period. Consequently, applying IAS 10 – Events after the Reporting Period,
an event occurring after the end of the reporting period that resolves an uncertainty that
existed at the end of the reporting period does not provide evidence of the conditions
that existed at that date. For example, there may be a 20 per cent probability at the end
of the reporting period that a major storm will strike during the remaining six months of
an insurance contract. After the end of the reporting period but before the financial
statements are authorised for issue, a major storm strikes. The fulfilment cash flows
under that contract should not reflect the storm that, with hindsight, is known to have
occurred. Instead, the cash flows included in the measurement include the 20 per cent
probability apparent at the end of the reporting period (with disclosure applying IAS 10
that a non-adjusting event occurred after the end of the reporting period). [IFRS 17.B56].
Current estimates of expected cash flows are not necessarily identical to the most recent
actual experience. For example, suppose that mortality experience in the reporting
period was 20 per cent worse than the previous mortality experience and previous
expectations of mortality experience. Several factors could have caused the sudden
change in experience, including: [IFRS 17.B57]
• lasting changes in mortality;
• changes in the characteristics of the insured population (for example, changes in
underwriting or distribution, or selective lapses by policyholders in unusually
good health);
• random fluctuations; or
• identifiable non-recurring causes.
An entity should investigate the reasons for the change in experience and develop new
estimates of cash flows and probabilities in the light of the most recent experience, the earlier
4492 Chapter 52
experience and other information. The result for the example above when mortality
experience worsened by 20% in the reporting period would typically be that the expected
present value of death benefits changes, but not by as much as 20 per cent. However, if
mortality rates continue to be significantly higher than the previous estimates for reasons that
are expected to continue, the estimated probability assigned to the high-mortality scenarios
will increase. [IFRS 17.B57].
Estimates of non-market variables should include information about the current level
of insured events and information about trends. For example, mortality rates have
consistently declined over long periods in many countries. The determination of the
fulfilment cash flows reflects the probabilities that would be assigned to each possible
trend scenario, taking account of all reasonable and supportable information available
without undue cost or effort. [IFRS 17.B58].
In a similar manner, if cash flows allocated to a group of insurance contracts are sensitive
to inflation, the determination of the fulfilment cash flows should reflect current
estimates of possible future inflation rates. Because inflation rates are likely to be
correlated with interest rates, the measurement of fulfilment cash flows should reflect
the probabilities for each inflation scenario in a way that is consistent with the
probabilities implied by the market interest rates used in estimating the discount rate
(see 8.2.3.B above). [IFRS 17.B59].
When estimating the cash flows, an entity should take into account current expectations
of future events that might affect those cash flows. The entity should develop cash flow
scenarios that reflect those future events, as well as unbiased estimates of the probability
of each scenario. However, an entity should not take into account current expectations
of future changes in legislation that would change or discharge the present obligation or
create new obligations under the existing insurance contract until the change in
legislation is substantively enacted. [IFRS 17.B60].
8.3 Discount
rates
The second element of the building blocks in the general model discussed at 8 above is
an adjustment (i.e. discount) to the estimates of future cash flows to reflect the time
value of money and the financial risks related to those cash flows, to the extent that the
financial risks are not included in the estimates of cash flows.
The discount rates applied to the estimates of the future cash flows should: [IFRS 17.36]
• reflect the time value of money, the characteristics of the cash flows and the
liquidity characteristics of the insurance contracts;
• be consistent with observable current market prices (if any) 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; and
• exclude the effect of factors that influence such observable market prices but do
not affect the future cash flows of the insurance contracts.
The discount rates calculated according to the requirements above should be
determined as follows: [IFRS 17.B72]
Insurance contracts (IFRS 17) 4493
Insurance liability measurement component
Discount rate
Fulfilment cash flows.
Current rate at reporting date.
Contractual service margin interest accretion for contracts
Rate at date of initial recognition of group.
without direct participation features (including insurance
and reinsurance contracts issued and reinsurance
contracts held).
Changes in the contractual service margin for contracts Rate at date of initial recognition of group.
without direct participation features (including insurance
&nbs
p; and reinsurance contracts issued and reinsurance
contracts held).
Changes in the contractual margin for contracts with A rate consistent with that used for the allocation
direct participation features.
of finance income or expenses.
Liability for remaining coverage under premium Rate at date of initial recognition of group.
allocation approach.
Disaggregated insurance finance income included in Rate at date of initial recognition of group.
profit or loss for groups of contracts for which changes in
financial risk do not have a significant effect on amounts
paid to policyholders (see 15.3.1 below).
Disaggregated insurance finance income included in Rate that allocates the remaining revised finance
profit or loss for groups of contracts for which changes in income or expense over the duration of the group
financial risk assumptions have a significant effect on at a constant rate or, for contracts that use a
amounts paid to policyholders (see 15.3.2 below).
crediting rate, uses an allocation based on the
amounts credited in the period and expected to be
credited in future periods.
Disaggregated insurance finance income included in Rate at date of incurred claim.
profit or loss for groups of contracts applying the
premium allocation approach (see 15.3.2 below).
For insurance contracts with direct participation features, the contractual service
margin is adjusted based on changes in the fair value of underlying items, which includes
the impact of discount rate changes (see 11.2 below).
To determine the discount rates at the date of initial recognition of a group of contracts
described above an entity may use weighted-average discount rates over the period that
contracts in the group are issued, which cannot exceed one year. [IFRS 17.B73]. As
explained at 6 above, this can result in a change in the discount rates during the period
of the contracts. When contracts are added to a group in a subsequent reporting period
(because the period of the group spans two reporting periods) and discount rates are
revised, an entity should apply the revised discount rates from the start of the reporting
period in which the new contracts are added to the group. [IFRS 17.28]. This means that
there is no retrospective catch-up adjustment.