29 July 2019
One of the trickier technical aspects of IFRS 17 is the risk adjustment, which exists because an uncertain liability is “worse” than a known liability. If an insurance company has an uncertain liability (which is, after all, the main point of its business) then IFRS 17 says that there is theoretically a higher but “certain” liability that it would be willing to swap it for. The risk adjustment is the difference between that higher liability and the expected value of the actual, uncertain liability.
But what if we have reinsurance in place? How does that affect our risk adjustment?
Paragraph 64 of the standard states: an entity shall determine the risk adjustment…so that it represents the amount of risk being transferred by the holder of the group of reinsurance contracts to the issuer of those contracts.
This seems to indicate that the correct measure of risk is the risk that is leaving the entity, rather than the standalone reinsurance recoveries. Therefore, a sensible approach may well be to reassess the risk adjustment on a net basis, and to attribute the difference to the impact of the reinsurance.
Imagine a portfolio of risks with best estimate liabilities of £100m, where the firm would be equally happy with a fixed liability of £110m. Let’s say there is a 40% quota share reinsurance contract. We would look at the net best estimate liabilities of £60m and hold a net risk adjustment of £6m (ie £10m less £4m). This is the intuitive answer that you might expect, and for most firms this seems to be as far as the thinking has gone.
However, some reinsurance contracts (such as “risks attaching” contracts) cover risks that are not yet written.
For this element of the contract, it is the future recoveries that are uncertain, and these count as an asset. If this is considered separately, you should be willing to swap this uncertain asset for a fixed asset of lower value, which would mean a further increase to the risk adjustment (which is an accounting liability)!
In other words, I might have a portfolio of risks with best estimate liabilities for future business of £100m.
I take out a 40% quota share, so my best estimate recoveries are £40m but this benefit is uncertain. In isolation the “known asset” I would swap it for might be £38m, giving a risk adjustment of a further liability of £2m. Until the business is written, there is no liability to offset against the expected reinsurance recoveries. However, once I have written the business, the reinsurance will act to offset the risk adjustment for the future claims for this business.
This makes the evaluation of this element of the risk adjustment particularly tricky.
Should the future transfer of risk be allowed for in full when the reinsurance contract is written? This would result in a reinsurance risk adjustment of £4m as if the business had already been written like the original example.
Or, should the accounts only reflect the change in risk in the contracts currently recognised in the accounts, including a potential increase for the uncertainty of the benefit of reinsurance coverage on future business? This would result in a risk adjustment of a liability of £2m in the second example.
To avoid unnecessary volatility in the bottom line it may be simplest to recognise no risk adjustment on the reinsurance asset initially and recognise the smaller net amount as the new contracts are written. This will be a point to watch as the details of the implementation and interpretation are finalised with auditors, and market practice begins to emerge.