How to Calculate Risk Adjustment under IFRS 17

In any insurance contract, uncertainty is inevitable. But how can you price that uncertainty? This question leads directly into the heart of Risk Adjustment under IFRS 17, a critical component for calculating insurance liabilities. Risk adjustment is the amount an entity requires for bearing the uncertainty of future cash flows. It's the margin needed to reflect the risk an insurer is exposed to, in a structured, comparable way across the industry.

What’s the core of the risk adjustment calculation under IFRS 17? It's not just about market volatility or high-level risk. It's about measuring uncertainty in fulfillment cash flows for insurance contracts—what remains after a company considers all possible future scenarios.

So how do insurers actually calculate it? Let's walk through the key pieces, and by the end, you'll be clearer about how to align with regulatory standards, all while keeping the complexity manageable. But to get there, we'll jump into some technical and practical aspects.

Risk Adjustment: The Key Elements

Risk adjustment takes into account several factors, primarily the uncertainty over the amount and timing of cash flows from insurance contracts. Here are the key factors in calculating risk adjustment:

1. Non-financial Risks: These are risks unrelated to market-driven factors such as interest rate movements or currency fluctuations. They include:

   • Mortality risk
   • Morbidity risk
   • Lapse risk
   • Catastrophe risk

2. Time Horizon: The longer the time period until the uncertainty is resolved, the higher the risk adjustment. This links to the duration of the insurance contracts and the length of time before the liabilities become clearer.

3. Diversification: Companies must assess their exposure to a broad range of risks across products, geographic regions, and even business segments. A diversified portfolio can reduce overall risk, thereby lowering the required risk adjustment.

4. Risk Aversion: Different entities have different levels of risk tolerance. Some insurers may be more conservative, preferring to build a higher margin into their risk adjustment to cover uncertainties, while others may take a more aggressive approach.

Now, let’s see how these components translate into the formula used to calculate the risk adjustment. However, IFRS 17 doesn’t mandate a specific method for determining the risk adjustment, giving insurers some leeway to align with their internal risk management policies. This flexibility comes with responsibility.

Common Methods to Calculate Risk Adjustment

1. Cost of Capital Approach: This method focuses on how much capital is required to support the insurance liabilities, factoring in the cost to hold this capital. Essentially, the risk adjustment is based on the idea that capital is needed to cover risk, and insurers charge for holding that capital.

   • Formula:
   $\text{Risk Adjustment}=\text{Capital at Risk}\times \text{Cost of Capital Rate}$Risk Adjustment=Capital at Risk×Cost of Capital Rate

   The Cost of Capital Approach is widely used, especially by insurers with advanced risk management frameworks.

2. Confidence Level Approach: In this method, the risk adjustment is the amount required to bring the total liabilities to a specified confidence level, which reflects the probability that the actual outcomes will not exceed a certain threshold.

   • Example: A company might decide to hold enough margin to cover 95% of future outcomes, meaning there is only a 5% chance that liabilities will exceed the estimate.

3. Conditional Tail Expectation (CTE) Method: This method is similar to the confidence level approach but focuses more on extreme tail events. It estimates the average of the worst outcomes (e.g., the worst 10% of possible results). This is useful for scenarios like catastrophe insurance, where severe outlier events are the main source of risk.

4. VaR (Value at Risk): A statistical technique used to measure the risk of loss in value of an asset or a portfolio. Under IFRS 17, VaR can be adapted to reflect the risk adjustment for insurance liabilities, particularly when managing catastrophic events.

Steps in the Calculation Process

1. Identify All Risks: Break down the risks inherent in the portfolio, both financial and non-financial. Focus on those that could materially affect future cash flows.

2. Determine the Approach: Decide on a calculation method—Cost of Capital, Confidence Level, or another appropriate model based on the insurer’s risk profile.

3. Quantify Uncertainty: Use historical data, actuarial models, and scenario analysis to estimate the uncertainty in future cash flows.

4. Apply the Chosen Model: Once the risks and uncertainties are quantified, apply the chosen calculation method (such as the Cost of Capital Approach). For example, if using the Confidence Level Method, ensure you're setting the confidence level that reflects your company’s risk tolerance.

5. Adjust Regularly: Update the risk adjustment calculation regularly as market conditions and company-specific factors evolve. This is crucial for maintaining compliance with IFRS 17 and ensuring that the calculation remains relevant to the actual risks.

Risk Adjustment in Practice: A Numerical Example

Let’s consider an insurer with a portfolio that has non-financial risks, such as mortality risk, that can lead to variations in expected future cash flows. Assume the following:

Item	Value
Expected cash flows	$1,000,000
Capital at risk	$50,000
Cost of capital rate	6%
Confidence level	95%
CTE for worst 10% losses	$20,000

1. Cost of Capital Approach Calculation:

   $\text{Risk Adjustment}=50,000\times 6\%=3,000$Risk Adjustment=50,000×6%=3,000

   The risk adjustment here would be $3,000, reflecting the cost of holding the capital to cover the risk.

2. Confidence Level Approach:

   • Assume that at a 95% confidence level, the estimated margin required to cover future liabilities is $4,000.

3. Conditional Tail Expectation:

   • The average of the worst 10% of outcomes adds an extra $2,000, leading to a total risk adjustment of $6,000.

The final risk adjustment could vary depending on which approach is selected, but in all cases, it reflects the cost or margin that the insurer needs to ensure it can meet future liabilities under uncertain conditions.

Why is Risk Adjustment Critical in IFRS 17?

IFRS 17 aims to bring transparency and comparability to the accounting of insurance contracts. Risk adjustment plays a crucial role in ensuring that the financial statements of insurers reflect the true risk of their liabilities. This transparency helps stakeholders—whether they are investors, regulators, or policyholders—make informed decisions based on the real risk the company is bearing.

Moreover, regulatory bodies require that insurers demonstrate how they arrived at their risk adjustment, ensuring that companies don't understate their risks or overstate their solvency positions.

Risk adjustment also impacts the profitability of insurance contracts. If the risk adjustment is set too high, the profit margins of these contracts may shrink, affecting both the pricing strategy and overall financial health.

Key Takeaways on IFRS 17 Risk Adjustment

• Flexibility: IFRS 17 does not prescribe a specific method for calculating the risk adjustment, allowing insurers to align their risk adjustment with internal models.
• Transparency: The aim is to reflect the true risk of insurance liabilities, increasing the transparency of financial statements.
• Judgement: Insurers must use judgement when determining their risk adjustment, including the method and assumptions used in the calculation.
• Ongoing Monitoring: It is essential to regularly review and adjust the risk margin as market conditions and risk exposures evolve.

As you continue to navigate IFRS 17, understanding the nuances of risk adjustment will not only ensure compliance but also provide a clearer view of the financial impact of the risks your business faces.