How to calibrate the IFRS 17 risk adjustment to arrive at an economic value?

in Financial Services, 13.09.2017

A generic framework for the economic valuation of Insurance Liabilities allows companies to calibrate their risk margin to reflect a truly market-consistent value.

The role of the risk margin in economic valuations

Currently, the insurance industry uses a number of so-called economic valuations (a.k.a. market value balance sheets) including European Solvency II, the Swiss Solvency Test and Market Consistent Embedded Value. Life insurers, in particular, have a long history of producing economic valuations to provide more realistic market-consistent information for investors, management or in the context of a transaction.

The new IFRS 17 accounting standard for insurance provides a backbone for economic valuation with several accounting (non-economic) adjustments stacked on top such as the Contractual Service Margin – a mechanism for profit deferral. Although IFRS 17 requires a risk adjustment, the calculation  is not prescriptive, meaning companies are currently considering how to calibrate it. Some may try to reduce P&L volatility; whereas others may choose a calibration that ensures their IFRS accounts as economic as possible.

An economic valuation is fundamentally about valuing an insurance company in line with the market i.e. economic equity is the market capitalization of an insurer.  However in practice it is accepted that quoted insurance companies trade at either a discount or a premium to their reported “market-consistent value”. There are a number of reasons for this, for instance almost all economic valuations do not place value of future new business (known as the franchise value) and any attempt to do so is fraught with difficulties in observing the relevant parameters.

Components of the economic value of insurance liabilities and current issues

Leaving such practical difficulties aside, the question is whether current economic frameworks even conceptually allow for a market-consistent valuation of the in-force insurance business. This issue is explored in a new paper entitled “A Generic Framework for the Economic Valuation of Insurance Liabilities” co-authored with Paul Huber, Head of Balance Sheet Management at the Swiss Re Group. This paper derives a generic framework for determining the market value of insurance liabilities and shows that this comprises three components:

  1. Risk-free discounted value of the best estimate liability cashflows (Best Estimate Liability)
  2. Risk margin
  3. Deferred tax liability (DTL) representing tax on the difference between the market value and the taxable value of the insurance liabilities.

These components are common to all existing economic valuations, but there are number of issues concerning the specification of the risk margin and the DTL, which do not allow for a truly market-consistent valuation of the insurance business. For instance, the Solvency II risk margin uses a fixed 6% cost of capital charge specified in the Solvency II directive. Our paper shows that the cost of capital charge needs to be entity specific to arrive at the correct market value and depends on a number of factors, including the amount of debt financing used by the insurer, the rate of taxation and the outperformance above risk-free returns generated by the company’s investment portfolio.

A further example shown in the paper is that although the Swiss Solvency Test also uses a 6% cost of capital, differences in the specification of this solvency regime, in particular the fact the SST balance sheet is pre-tax, means that the resulting risk margin will differ from that of Solvency II. In General, the SST rate of 6% is more conservative than the Solvency II rate of 6%. In addition, the specification of the deferred taxes are often not consistent with that of the risk margin creating inconsistencies and leading to a non-market-consistent liability valuation.

Calibrating IFRS 17 for use as an economic performance framework

With the arrival of IFRS 17 and the gradual decline in usage of other standards such as MCEV, companies may well take the opportunity to further enhance their understanding of the market value of the insurance business and how different economic valuations are calibrated. In particular, some companies may want to use IFRS 17 for performance management on an economic basis. As depicted in the diagram below, this approach would target that IFRS Equity + Contractual Service Margin + Adjustment for Own Credit Risk = Market Capitalization – Franchise Value.

 

The accounting policy decisions generally selected to enable this approach would be:

  • General Measurement Model applied for all business
  • Calculations performed at a granular level
  • Bottom-up approach to setting the discount rate
  • Risk adjustment comprising of a margin for risk capital, a margin for residual capital and frictional tax with appropriately calibrated costs of capital.

A generic framework enables a meaningful interpretation of the risk margin

Use of a generic framework, such as the one presented in our paper, allows for a meaningful comparison and interpretation of the risk margin, as well as allowing companies to parameterize their economic valuation in such a way as to report a truly market-consistent value. It also lends itself to a multi-GAAP approach, such as that being developed at Swiss Re (read more here or here).

 

 

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