In May 2018, the IASB staff responded to a submission to the TRG which asked whether, for
a group of insurance contracts for which changes in financial risk do not have a substantial
effect on the amounts paid to policyholders (and the entity chooses to disaggregate insurance
finance income or expenses between profit or loss and other comprehensive income) an
entity should use an effective yield rate or a yield curve. The IASB staff stated that, in using
4494 Chapter 52
the discount rate determined at the date of initial recognition to nominal cash flows that do
not vary based on returns from underlying items, IFRS 17 does not mandate the use of an
effective yield rate or a yield curve. In response to the IASB staff, a few TRG members
commented that using an effective yield compared to using a yield curve could result in a
significant difference to insurance finance income or expense to be included in profit or loss
over the reporting periods subsequent to initial recognition.10
Estimates of discount rates should be consistent with other estimates used to measure
insurance contracts to avoid double counting or omissions; for example: [IFRS 17.B74]
• cash flows that do not vary based on the returns on any underlying items should
be discounted at rates that do not reflect any such variability;
• cash flows that vary based on the returns on any financial underlying items should be:
• discounted using rates that reflect that variability; or
• adjusted for the effect of that variability and discounted at a rate that reflects
the adjustment made;
• nominal cash flows (i.e. those that include the effect of inflation) should be
discounted at rates that include the effect of inflation; and
• real cash flows (i.e. those that exclude the effect of inflation) should be discounted
at rates that exclude the effect of inflation.
However, discount rates should not reflect the non-performance (i.e. own credit) risk
of the entity. [IFRS 17.31].
As explained in the second bullet point above, cash flows that vary based on the returns
on underlying items should be discounted using rates that reflect that variability, or to
be adjusted for the effect of that variability and discounted at a rate that reflects the
adjustment made. The variability is a relevant factor regardless of whether it arises
because of contractual terms or because the entity exercises discretion, and regardless
of whether the entity holds the underlying items. [IFRS 17.B75].
Cash flows that vary with returns on underlying items with variable returns, but that are
subject to a guarantee of a minimum return, do not vary solely based on the returns on
the underlying items, even when the guaranteed amount is lower than the expected return
on the underlying items. Hence, an entity should adjust the rate that reflects the variability
of the returns on the underlying items for the effect of the guarantee, even when the
guaranteed amount is lower than the expected return on the underlying items. [IFRS 17.B76].
In May 2018, in response to a submission to the TRG which had asked whether minimum
guarantees are reflected through adjusting the discount rate (rather than through
adjustments to the cash flows) the IASB staff stated that although IFRS 17 requires the time
value of a guarantee to be reflected in the measurement of fulfilment cash flows, it does
not require the use of a specific approach to achieve this objective. Financial risk is
included in the estimates of future cash flows or the discount rate used to adjust the cash
flows. Judgement is required to determine the technique for measuring market variables
and that the technique must result in the measurement of any options and guarantees
being consistent with observable market prices for such options and guarantees. Any
consideration beyond this is actuarial (i.e. operational measurement implementation) in
nature. The TRG members did not disagree with the IASB staff’s observations.11
Insurance contracts (IFRS 17) 4495
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. If an entity does not
divide the estimated cash flows in this way, the entity should apply discount rates
appropriate for the estimated cash flows as a whole; for example, using stochastic
modelling techniques or risk-neutral measurement techniques. [IFRS 17.B77].
Discount rates should include only relevant factors, i.e. factors that arise from the time
value of money, the characteristics of the cash flows and the liquidity characteristics of
the insurance contracts. Such discount rates may not be directly observable in the
market. Hence, when observable market rates for an instrument with the same
characteristics are not available, or observable market rates for similar instruments are
available but do not separately identify the factors that distinguish the instrument from
the insurance contracts, an entity should estimate the appropriate rates. IFRS 17 does
not require a particular estimation technique for determining discount rates. In applying
an estimation technique, an entity should: [IFRS 17.B78]
• maximise the use of observable inputs and reflect all reasonable and supportable
information on non-market variables available without undue cost or effort, both
external and internal. In particular, the discount rates used should not contradict
any available and relevant market data, and any non-market variables used should
not contradict observable market variables;
• reflect current market conditions from the perspective of a market participant; and
• exercise judgement to assess the degree of similarity between the features of the
insurance contracts being measured and the features of the instrument for which
observable market prices are available and adjust those prices to reflect the
differences between them.
For cash flows of insurance contracts that do not vary based on the returns on
underlying items, 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. That adjustment should
reflect the difference between the liquidity characteristics of the group of insurance
contracts and the liquidity characteristics of the assets used to determine the yield
curve. 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.B79].
IFRS 17 proposes two methods for determining discount rates for cash flows of
insurance contracts that do not vary based on the returns on underlying items as follows:
• a ‘bottom-up’ approach; and
• a ‘top-down’ approach.
The ‘bottom-up’ approach determines 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. [IFRS 17.B80].
4496 Chapter 52
The ‘top-down’ approach determines 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. An entity should 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.B81].
In theory, both the ‘top-down’ and ‘bottom-up’ approaches should give the same result
although in practice this is not necessarily the case. An example of the approaches giving
the same result is illustrated below where the overall liability discount rate is 2.5% in
each case. The ‘top down’ approach starts with a current asset yielding 4% and this rate
is reduced by 1.5% for expected and unexpected losses while the ‘bottom up’ approach
stats with a risk free rate of 2% which is increased by a liquidity premium of 0.5%.
Assume a current asset yield of a reference instrument of 4% composed of:
‘Top-down’
approach
1.0%
Market risk premium
expected losses of 1%
0.5%
Market risk premium
unexpected losses of 0.5%
Liquidity premium of 0.5%
0.5%
%
0
2.
Risk-free rate of return of 2%
2.0%
‘Bottom-up’
approach
In estimating the yield curve on a ‘top down’ basis an entity should use measurement
bases consistent with IFRS 13 as follows: [IFRS 17.B82]
• if there are observable market prices in active markets for assets in the reference
portfolio, an entity should use those prices;
• if a market is not active, an entity should adjust observable market prices for similar
assets to make them comparable to market prices for the assets being measured;
• if there is no market for assets in the reference portfolio, an entity should apply an
estimation technique. For such assets an entity should:
Insurance contracts (IFRS 17) 4497
• develop unobservable inputs using the best information available in the
circumstances. Such inputs might include the entity’s own data and, in the
context of IFRS 17, the entity might place more weight on long-term estimates
than on short-term fluctuations; and
• adjust the data to reflect all information about market participant assumptions
that is reasonably available.
In adjusting the yield curve, an entity should adjust market rates observed in recent
transactions in instruments with similar characteristics for movements in market factors
since the transaction date, and should adjust observed market rates to reflect the degree
of dissimilarity between the instrument being measured and the instrument for which
transaction prices are observable. For cash flows of insurance contracts that do not vary
based on the returns on the assets in the reference portfolio, such adjustments include:
[IFRS 17.B83]
• adjusting for differences between the amount, timing and uncertainty of the cash
flows of the assets in the portfolio and the amount, timing and uncertainty of the
cash flows of the insurance contracts; and
• excluding market risk premiums for credit risk, which are relevant only to the
assets included in the reference portfolio.
In principle, for cash flows of insurance contracts that do not vary based on the returns of
the assets in the reference portfolio, there should be a single illiquid risk-free yield curve
that eliminates all uncertainty about the amount and timing of cash flows. However, in
practice the top-down approach and the bottom-up approach may result in different yield
curves, even in the same currency. This is because of the inherent limitations in estimating
the adjustments made under each approach, and the possible lack of an adjustment for
different liquidity characteristics in the top-down approach. An entity is not required to
reconcile the discount rate determined under its chosen approach with the discount rate
that would have been determined under the other approach. [IFRS 17.B84].
No restrictions are specified on the reference portfolio of assets used in the top-down
approach. However, fewer adjustments would be required to eliminate factors that are
not relevant to the insurance contracts when the reference portfolio of assets has similar
characteristics. For example, if the cash flows from the insurance contracts do not vary
based on the returns on underlying items, fewer adjustments would be required if an
entity used debt instruments as a starting point rather than equity instruments. For debt
instruments, the objective would be to eliminate from the total bond yield the effect of
credit risk and other factors that are not relevant to the insurance contracts. One way
to estimate the effect of credit risk is to use the market price of a credit derivative as a
reference point. [IFRS 17.B85].
Some insurance contracts will have a contract boundary which extends beyond the period
for which observable market data is available. In these situations, the entity will have to
determine an extrapolation of the discount rate yield curve beyond that period. IFRS 17
provides no specific guidance on the estimation techniques for interest rates in these
circumstances. The general guidance above for unobservable inputs is that an entity
should use the best information available in the circumstances and adjust that data to
reflect all information about market participant assumptions that is reasonably available.
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8.4
The risk adjustment for non-financial risk
The third element of the building blocks in the general model discussed at 8 above is
the risk adjustment for non-financial risk.
The risk adjustment for non-financial risk is the compensation that the entity requires
for bearing the uncertainty about the amount and timing of cash flows that arises from
non-financial risk. [IFRS 17.37]. Non-financial risk is risk arising from insurance contracts
other than financial risk, which is included in the estimates of future cash flows or the
discount rate used to adjust the cash flows. The risks covered by the risk adjustment for
financial risk are insurance risk and other non-financial risks such as lapse rate and
expense risk. [IFRS 17.B86].
In theory, the risk adjustment for non-financial risk for insurance contracts measures
the compensation that the entity would require to make the entity indifferent between:
[IFRS 17.B87]
• fulfilling a liability that has a range of possible outcomes arising from non-financial
risk; and
• fulfilling a liability that will generate fixed cash flows with the same expected
present value as the insurance contracts.
In developing the objective of the risk adjustment for non-financial risk, the Board
concluded that a risk adjustment for non-financial risk should not represent:
[IFRS 17.BC209]
• the compensation that a market
participant would require for bearing the non-
financial risk that is associated with the contract. This is because the measurement
model is not intended to measure the current exit value or fair value, which reflects
the transfer of the liability to a market participant. Consequently, the risk
adjustment for non-financial risk should be determined as the amount of
compensation that the entity, not a market participant, would require; and
• an amount that would provide a high degree of certainty that the entity would be
able to fulfil the contract. Although such an amount might be appropriate for some
regulatory purposes, it is not compatible with the Board’s objective of providing
information that will help users of financial statements make decisions about
providing resources to the entity.
To illustrate the objective, the Application Guidance explains that a risk adjustment for
non-financial risk would measure the compensation the entity would require to make
it indifferent between fulfilling a liability that, because of non-financial risk, has a 50%
probability of being CU90 and a 50% probability of being CU110, and fulfilling a liability
that is fixed at CU100. As a result, the risk adjustment for non-financial risk conveys
information to users of financial statements about the amount charged by the entity for
the uncertainty arising from non-financial risk about the amount and timing of cash
flows. [IFRS 17.B87].
In addition, because the risk adjustment for non-financial risk reflects the compensation
the entity would require for bearing the non-financial risk arising from the uncertain
amount and timing of the cash flows, the risk adjustment for non-financial risk also
reflects: [IFRS 17.B88]
Insurance contracts (IFRS 17) 4499
• the degree of diversification benefit the entity includes when determining the
compensation it requires for bearing that risk; and
• both favourable and unfavourable outcomes, in a way that reflects the entity’s
degree of risk aversion.
The purpose of the risk adjustment for non-financial risk is to measure the effect of
uncertainty in the cash flows that arise from insurance contracts, other than uncertainty
arising from financial risk. Consequently, the risk adjustment for non-financial risk
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 889
