IFRS 4 Phase II

The proposed Solvency II and IFRS 4 phase II standards focus on risk measures to be introduced into insurance regulation/insurance accounting respectively.

IFRS 4 phase II has diverged from the proposed Solvency II standard in the Exposure Draft (2010), BC119 as the notion of "transfer of liabilities exit value" (liabilities fair value) has been deemphasised. However, similar risk measure concepts still exist in both proposed standards. Both standards require accurate estimation of cash flow distributions - not just means, but a measure of 'risk adjustment' (market value margin) which are then incorporated into the (economic) balance sheet.

Risk adjustment techniques, specified in the IFRS 4 phase II Exposure Draft, requires the measuring probability distributions by calendar year of the underlying cash flows. Cost of capital, Conditional Tail Expectation (T-VaR) and confidence levels (VaR) necessitate models that project distributions by calendar year.

"Each of the permitted techniques for measuring risk adjustments builds on a probability distribution of the underlying cash flows." (BC118)
ED_Insurance_contracts_BASIS_WEB.pdf

ICRFS-Plus™'s PTF and MPTF modelling frameworks provide the distributions required to compute the risk adjustment measures. For long-tail liability valuation calculations it is imperative to have ICRFS-Plus™.

Since Solvency II calculations also require the above distributions by calendar year, and both impact the balance sheet, ICRFS-Plus™ is the ideal tool to construct internal models that meet both Solvency II and IFRS 4 phase II requirements for long-tail liabilities; calculation of the core components of insurance liabilities can be sourced from the same model. The joint use of ICRFS-Plus™ internal models for both applications implicitly reduces implementation costs.

IFRS 4 Phase II, Solvency II, and ring fenced funds

In the exposure draft Exposure Draft (2010), BC119, the level of aggregation for risk margins are considered, with the recommendation of the board being to determine risk adjustments at the level of individual portfolios.

The question of aggregation over portfolios, or LOBs, is important for determining the risk fund as it unlikely to be appropriate to assume all LOBs within an entity are fully fungible (that is, a surplus (loss less than the reserved mean) in one LOB is fully available to cover a deficit (loss greater than the reserve mean) in another LOB).

'In the Board's view ... complete fungibility is rare in practice, for legal and regulatory reasons'

Ring-fenced funds where surpluses in one LOB do not supplement losses in another LOB are discussed in QIS 5, SCR 11.

A ring-fenced fund as referred to in the Level 1 text arises as a result of an arrangement where:
a) There is a barrier to the sharing of profits/losses arising from different parts of the undertaking's business leading to a reduction in pooling/diversification related to that ring fenced fund; or

b) Own funds (restricted own funds) can only be used to cover losses on a defined portion of the undertaking's (re)insurance portfolio or with respect to particular policyholders or in relation to particular risks such that those restricted own funds are only capable of fulfilling the criteria in Article 93(1) (a) and/or (b) in respect of that defined portion of the portfolio, or with respect to those policyholders or those risks; or

c) Both a) and b) apply. (11.2)

The determination of risk adjustments, or risk margins, at the LOB level (as recommended by the IFRS board), however, negates one of the fundamental principles of insurance - namely risk pooling, including of the risk fund. Calculating the risk margin at the LOB level prevents diversification credit of the risk fund since each adjustment is applied independently.

There are solutions which include diversification credit of the risk fund, while not diversifying losses below the means. Consider the structure where a risk fund is pooled for all LOBs written. Under this structure, a number of options for fungibility, or lack thereof, can be considered.

1) Full fungibility; a surplus in one line can supplement a deficit in another line.

2) No fungibility; surpluses in a line are retained in that line and do not supplement the risk fund.

3) Partial fungibility; surpluses in a portfolio are fungible within the LOBs comprising the portfolio, but not between portfolios. Here a portfolio refers to a group of LOBs, possibly in a cluster, that are ring-fenced as a whole. This is particularly appropriate for analysing data from multiple countries, where LOBs within a country may share surpluses, but typically surpluses would not be shared between LOBs in different countries.

The latter options can be broken down further.

In particular, surpluses and deficits arrive in calendar time. Should these surpluses supplement future losses, including across LOB, or can they be released as profit? Using ICRFS-Plus™ models, forecast scenarios, and simulations, we can consider all of the above situations.

The above discussion can be boiled down to a simple question: what is the aggregate distribution of losses requiring the risk fund?

Example: L_A and L_B

Consider two LOBs: L_A and L_B.

The aggregate loss distribution, L_A + L_B, assumes that L_A and L_B are fully fungible.

If L_A and L_B are restricted such that any loss less than then mean of L_A or L_B are retained by L_A, L_B respectively, then the aggregate distribution becomes:

L*_A + L*_B where:

L*_A = Max(L_A, mean(L_A)), and

L*_B = Max(L_B, mean(L_B))

The above implicitly implies that any loss less than the mean of either LOB does not contribute to the risk pool, and can be managed according to company policy (release or retention) without any loss of risk cover.

Simply put, this represents a loss of diversification credit for writing multiple lines. In the case of two independent lines, the loss of diversification is in the order of 10-20%. If the two lines are positive-correlated, then the loss of diversification is lower since it is more likely that both LOBs are above the mean when draws on the risk fund are made.

The above formulae consider all calendar years within a LOB are fully fungible, but it is trivial to consider fungibility adjustments by calendar year; within and across LOBs. Simulation results are compared to their respective calendar means and surpluses supplementing draws on the risk fund according to fungibility requirements: across/within LOB, and across Calendar Years or otherwise.

Applying the above reasoning, we can consider the following scenarios:

(1) No sharing of surpluses

In this case funds are treated as if already allocated to each calendar year according to the forecast estimates. If the losses for the next calendar year exceed the estimated mean the difference is made up by drawing from the risk pool. If the losses are below the allocated reserve the difference is released as profit, these surplus amounts are not rolled over into the reserve fund.

(2) Buffered diversification

In this case the accumulated surplus from previous calendar years is retained as a 'buffer' fund to be drawn on before calls are made on the risk fund. In this case pooling occurs only in relation to past years. The retention of funds allocated to future years retains a higher priority than drawing on the risk fund, so that funds allocated to future calendar years cannot be accessed.

The scenarios are readily extended to multiple LOBs where, as discussed above, fungibility between LOBs is readily limited.

We can unify the cases by thinking in terms of a buffer fund or funds which delay calls to the Risk Fund. There may be a single buffer fund or separate ones for each LOB. A buffer fund may have access to the unused reserve fund for that line, or only to the current aggregate surplus, or may be always set to zero.

In all of these cases the risk fund is held in common, but what changes is the trigger for a call on the risk fund.

The various combinations provide for a broad range of reserving policies, and be adapted to respond to different regulatory or prudential regimes. Present value accounting can also be adapted to the timing inherent in each set-up.

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