IFRS 17 The Risk Adjustment
IFRS 17.37 “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 arise from non-financial risk”
In essence the compensation to the entity for being indifferent between settling a fixed liability or one subject to variable outcomes – an uncertain liability is worse than a known liability. Once the future cash flows have been discounted to present value, a Risk Adjustment needs to be made to reflect the compensation an entity requires for bearing the non-financial risk.
As the adjustment relates to non-financial risk, it is entity specific and will also need to take into consideration the entity’s own risk aversion.
The Standard expects that the calculations for the risk adjustment take into consideration:
- That risks with low frequency but high severity will result in higher adjustments than risks with high frequency and low severity;
- That for similar risks contracts with a longer duration will result in a higher adjustment than a shorter duration;
- That risks with a wider probability distribution will result in higher adjustments than risks with a narrower distribution;
- Where less is known about current estimates and trends, higher will be the adjustment; and
- That as experience emerges the uncertainty about the amount and timing of cash flows reduces and hence adjustments become smaller.
The IFRS 17 requirement for grouping of contracts will require one to consider how such adjustment is allocated to the groups. Alternatively, this could be done at a contract group level directly.
The adjustment will be particularly relevant to contracts that are marginally profit making as it could easily push the contract into loss making.
In addition, there is the need to consider the reinsurance contracts held separately.
IFRS 17.64 “Instead of applying para 37 an entity shall determine the risk adjustment for non-financial risk so that it represents the risk being transferred by the holder of the group of reinsurance contracts to the issuer of the contracts”
The risk adjustment needs to take into consideration the risk leaving the entity and hence such adjustment should be on a net basis and such difference is attributed to the reinsurance impact. An additional consideration would be whether such reinsurance is on a risks attaching basis or otherwise and would need to be considered as part of the calculations.
This is not necessarily a new concept, a risk adjustment for valuation purposes has been part of such calculations, most recently for Solvency II purposes in the guise of the Risk Margin and a common question has been can we use the same Risk Margin adjustment we have for Solvency II purposes.
In most practical cases, the answer is yes, but with amendments. This is because the Solvency II adjustment is driven by different objectives of the supervisory framework, is prescriptive (use of cost of capital method) and hence may adequately not reflect the expected entity’s internal view of non-financial risk.
So, a documented auditable thought process to arrive at an appropriate adjustment will be important to all stakeholders. Auditors will need to ensure that the inherent limitations of the Solvency II adjustment have been considered and dealt with by clients. Auditors will also need to review the entity’s assessment of non-financial risk themselves and conclude on its appropriateness.
Disclosure wise entities will be required to disclose the method and confidence level used for calculating the risk adjustment, amount of the adjustment and how it has changed over reporting period.
For any questions on this or other matters please contact Baqur Hossain.