Blog
Grip on your EVE SOT
Over the past decades, banks significantly increased their efforts to implement adequate frameworks for managing interest rate risk in the banking book (IRRBB). These efforts typically focus
Find out moreOn 18 May 2017, the International Accounting Standard Board (IASB) issued the new IFRS 17 standards. The development of these standards has been a long and thorough process with the aim of providing a single global comprehensive accounting standard for insurance contracts.
The standard model, as defined by IFRS 17, of measuring the value of insurance contracts is the ‘building blocks approach’. In this approach, the value of the contract is measured as the sum of the following components:
IFRS 17 does not provide full guidance on how the risk adjustment should be calculated. In theory, the compensation required by the insurer for bearing the risk of the contract would be equal to the cost of the needed capital. As most insurers within the IFRS jurisdiction capitalize based on Solvency II (SII) standards, it is likely that they will leverage on their past experience. In fact, there are many similarities between the risk adjustment and the SII risk margin.
The risk margin represents the compensation required for non-hedgeable risks by a third party that would take over the insurance liabilities. However, in practice, this is calculated using the capital models of the insurer itself. Therefore, it seems likely that the risk margin and risk adjustment will align. Differences can be expected though. For example, SII allows insurers to include operational risk in the risk margin, while this is not allowed under IFRS 17.
Determining the impact of IFRS 17 is not straightforward: the current IFRS accounting standard leaves a lot of flexibility to determine the reserve value for insurance liabilities (one of the reasons for introducing IFRS 17). The reserve value reported under current IFRS is usually grandfathered from earlier accounting standards, such as Dutch GAAP. In general, these reserves can be defined as the present value of future benefits, where the technical interest rate and the assumptions for mortality are locked-in at pricing.
However, insurers are required to perform liability adequacy testing (LAT), where they compare the reserve values with the future cash flows calculated with ‘market consistent’ assumptions. As part of the market consistent valuation, insurers are allowed to include a compensation for bearing risk, such as the risk adjustment. Therefore, the biggest impact on the reserve value is expected from the introduction of the CSM.
The IASB has defined a hierarchy for the approach to measure the CSM at transition date. The preferred method is the ‘full retrospective application’. Under this approach, the insurer is required to measure the insurance contract as if the standard had always applied. Hence, the value of the insurance contract needs to be determined at the date of initial recognition and consecutive changes need to be determined all the way to transition date. This process is outlined in the following case study.
The impact of the new IFRS standards is analyzed for the following policy:
In the case of this policy, an insurer needs to capitalize for the risk that the policy holder’s life expectancy decreases and the risk that expenses will increase (e.g. due to higher than expected inflation). We assume that the insurer applies the SII standard formula, where the total capital is the sum of the capital for the individual risk types, based on 99.5 per cent VaR approach, taking diversification into account.
The cost of capital would then be calculated as follows:
At initiation (i.e. 2015 Q4), the value of the contract under the new standards equals the sum of:
The insurer will measure the sum of blocks 1, 2 and 3 (which we refer to as the fulfilment cash flows) and the remaining amount of the CSM at each reporting date. The amounts typically change over time, in particular when expectations about future mortality and interest rates are updated. We distinguish four different factors that will lead to a change in the building blocks:
Step 1. Time effect
Over time, both the fulfilment cash flows and the CSM are fully amortized. The amortization profile of both components can be different, leading to a difference in the reserve value.
Step 2. Realized mortality is lower than expected
In our case study, the realized mortality is about 10 per cent lower than expected. This difference is recognized in P&L, leading to a higher profit in the first year. The effect on the fulfilment cash flows and CSM is limited. Consequently, the reserve value will remain roughly the same.
Step 3. Update of mortality assumptions
Updates of the mortality assumptions affect the fulfilment cash flows, which is simultaneously recognized in the CSM. The offset between the fulfilment cash flows and the CSM will lead to a very limited impact on the reserve value. In this case study, the update of the life table results in higher expected mortality and increased future cash outflows.
Step 4. Decrease in interest rates
Updates of the interest rate curve result in a change in the fulfilment cash flows. This change is not offset in the CSM, but is recognized in the other comprehensive income. Therefore a decrease in the discount curve will result in a significant change in the insurance liability. Our case study assumes a decrease in interest rates from 2 per cent to 1 per cent. As a result, the fulfilment cash flows increase, which is immediately reflected by an increase in the reserve value.
The impact of each step on the reserve value and underlying blocks is illustrated below.
The policy will evolve over time as expected, meaning that mortality will be realized as expected and discount rates do not change anymore. The reserve value and P&L over time will evolve as illustrated below.
The profit gradually decreases over time in line with the insurance coverage (i.e. outstanding notional of the mortgage). The relatively high profit in 2016 is (mainly) the result of the realized mortality that was lower than expected (step 2 described above).
As described before, under the full retrospective application, the insurer would be required to go all the way back to the initial recognition to measure the CSM and all consecutive changes. This would require insurers to deep-dive back into their policy administration systems. This has been acknowledged by the IASB by allowing insurers to implement the standards three years after final publication. Insurers will have to undertake a huge amount of operational effort and have already started with their impact analyses. In particular, the risk adjustment seems a challenging topic that requires an understanding of the capital models of the insurer.
Zanders can support in these qualitative analyses and can rely on its past experience with the implementation of Solvency II.
Over the past decades, banks significantly increased their efforts to implement adequate frameworks for managing interest rate risk in the banking book (IRRBB). These efforts typically focus
Find out moreWhile SAC is a planning tool to be considered, it requires further exploration to evaluate its fit with business requirements and how it could unlock opportunities to potentially streamline
Find out moreAfter the collapse of Credit Suisse and the subsequent orchestrated take-over by UBS, there are widespread calls for increasing capital requirements for too-big-too-fail banks to prevent
Find out moreThis article provides a thorough comparison of the Survival Analysis and Migration Matrix approach for modeling losses under the internal ratings-based (IRB) approach and IFRS 9. The optimal
Find out moreThe Zanders purpose Our purpose is to deliver financial performance when it counts, to propel organizations, economies, and the world forward. Recently, we have embarked on a process
Find out moreTo fully leverage the benefits of this technology, it’s essential to understand and address security threats when implementing blockchain solutions. As a decentralized distributed
Find out moreThe start of the migration from the SWIFT FIN format to the new ISO 20022 XML format, which is a banking industry migration that must be completed by November 2025. Whilst at this stage
Find out moreIn today’s world, supply chain disruptions are consequences of operating in an integrated and highly specialized global economy. Along with affecting the credit risk of impacted
Find out moreLarge systemic financial institutions have to show that they are resolvable during times of great stress. In this article, we discuss a specific requirement for resolution planning: the
Find out moreA 19th century book on Indian proverbs1 contains a story about a man who went on a journey with his son: “He came to a stream. As he was uncertain of its depth, he proceeded to sound
Find out moreWith the potential of Blockchain technology to transform businesses, we aim to guide our clients through the complexities of this technology and help them leverage it to improve their
Find out moreLate last year, ChatGPT emerged online as the next phase in this fast-growing and exciting technological space. Many of us tried it out already, and I have yet to meet anyone who is not left
Find out moreThis article may help SAP system owners re-think or change their approach towards bespoke custom solutions in the system. Over the past 14 years, my colleagues and I
Find out moreThe Federal Council in Switzerland wants to make sure that the Swiss financial sector will play a leading role in sustainability. To help accomplish this, it published an action plan in
Find out moreAn increasing number of policy makers and regulators have embedded the recommendations in industry guidance and laws. In this article we summarize the TCFD recommendations, taking into account
Find out moreToday’s interest rates are positive, the yield curve relatively flat and, in some currencies, even (slightly) inverse. The rise in interest rates poses a significant challenge for banks.
Find out moreWith every improvement, fraudsters look for and find new opportunities to exploit. When the opportunity arises, some people see a big incentive or pressure to commit fraud, and most will be
Find out moreMore simply put, the EBA was asked to investigate whether the current prudential framework properly captures environmental and social risks. In response, the EBA published a Discussion Paper
Find out moreThese risks stem from the transition towards a low carbon economy and from the physical risks of damages due to extreme weather events. To address climate-related financial risks within the
Find out moreIn the below overview, we present an overview of the main ESG-related publications from the European Commission (EC), the European Central Bank (ECB), and the European Banking Authority (EBA).
Find out more