IFRS on Discounting Rate of Insurance Contracts

The Globe & Mail published an article today, Insurers cry foul over pending rule changes, highlighting a problem that I’m not sure exists:

A key sticking point is the “discount rate,” or interest rate, that insurers use to calculate the current value of payments that they will have to make to customers in the future.

The rate that Canadian insurers are using basically allows them to take credit now for investment performance that they hope to achieve in the future, the IASB argues. Instead, it says, they should be using a current risk-free rate (essentially measured by the return on government bonds). Since that rate is lower, the Canadian insurers’ liabilities will rise when the change kicks in, and it will be especially painful in areas such as life annuities or whole life non-participating insurance, when the insurers value payments that they owe customers decades from now.

That hasn’t been lost on the IASB. Both Julie Dickson, the head of Canada’s banking and insurance regulator, and Jim Flaherty, the Finance Minister, wrote to the international accounting body earlier this year asking it to consider the impact on the Canadian sector.

To my total lack of surprise, I was unable to find the letters from Dickson or Flaherty published anywhere. So much nicer to do things in private, doncha know.

However, the issue has been bubbling for a while. A presentation by Rubenovitch in April 2008 (about six months before they nearly blew up), Manulife decried:

Asymmetrical accounting for asset and liability and earnings volatility that is not relevant and that will not ultimately be realized

which would result if long-term obligations were to be discounted at the risk-free rate, stating, quite rightly that this:

Assumes liquidity required and overstates liability

The problem is, of course, that government bonds do not simply reflect the “risk free rate”. They also represent the liquidity premium. You cannot get a risk-free rate without also losing the liquidity premium and attempts to disentangle the two aspects of corporate bond pricing came to grief during the Panic of 2007 (see chart 3.16 of the BoE FSR of June 2010 and note the amusing little gap in the x-axis).

But I can’t see that the rules actually require insurers to use government rates as their discounting rate. The relevant portion of the IFRS exposure draft states (emphasis added):

30 An insurer shall adjust the future cash flows for the time value of money, using discount rates that:
(a) are consistent with observable current market prices for instruments with cash flows whose characteristics reflect those of the insurance contract liability, in terms of, for example, timing, currency and liquidity.
(b) exclude any factors that influence the observed rates but are not relevant to the insurance contract liability (eg risks not present in the liability but present in the instrument for which the market prices are observed).

31 As a result of the principle in paragraph 30, if the cash flows of an insurance contract do not depend on the performance of specific assets, the discount rate shall reflect the yield curve in the appropriate currency for instruments that expose the holder to no or negligible credit risk, with an adjustment for illiquidity (see paragraph 34).

34 Many insurance liabilities do not have the same liquidity characteristics as assets traded in financial markets. For example, some government bonds are traded in deep and liquid markets and the holder can typically sell them readily at any time without incurring significant costs. In contrast, policyholders cannot liquidate their investment in some insurance contract liabilities without incurring significant costs, and in some cases they have no contractual right to liquidate their holding at all. Thus, in estimating discount rates for an insurance contract, an insurer shall take account of any differences between the liquidity characteristics of the instruments underlying the rates observed in the market and the liquidity characteristics of the insurance contract.

I don’t see anything unreasonable about this.

The Globe & Mail had reported earlier:

Despite their disappointment in the rules, at least some Canadian insurance executives say they are still optimistic that they will succeed in making their case as it appears that the draft is very preliminary and that the IASB is open to feedback. The insurers intend to present the accounting board with figures that demonstrate the impact the rules will have on their results.

I will be most interested in seeing those figures, particularly their derivation of the discount rate. Detail please!

KPMG comments:

Aspects of the proposed insurance model which are likely to attract debate include determining a discount rate for obligations based on their characteristics as opposed to the return on invested assets, and the treatment of changes in assumptions driving the measurement of the insurance obligation. The effects of changes in assumptions, whether financial such as interest rates or non-financial such as mortality and morbidity rates, would be required to be recognised in the statement of financial position and the statement of comprehensive income each reporting period.

Neil Parkinson, KPMG’s Insurance Sector Leader for Canada, emphasized the implications for Canadian insurers: “The IASB’s proposals would affect how all insurers measure their profitability and their financial position, and would likely result in greater volatility in many of the key measures they report. This volatility would be magnified for longer term insurance products, and is of particular concern for Canadian life insurers.”

I don’t see anything on the insurance companies’ websites themselves.

One way or another, this is an issue well worth following. Volatility in key measures? Great! Lets have a little more volatility in key measures and a little less “Whoopsee, we need $6-billion and a rule-change TODAY, came out of nowhere, honest!”

Update: Reaction in the UK is soporific:

Peter Vipond, director of financial regulation and taxation at the Association of British Insurers, said current insurance accounting methods have been inconsistent and haven’t adequately captured “the economics of the industry.”

“We are pleased that the IASB aims to offer a modern approach based on current measures that may offer investors a clearer view of insurers’ obligations and performance,” Vipond said in an e-mailed statement.

I believe – but am not sure! – that UK insurers use gilts to hedge annuities much more than corporates, in which case this change won’t make too much difference to them.

Update, 2010-8-4: Price-Waterhouse highlights the volatility issue:

Gail Tucker, partner, PricewaterhouseCoopers LLP, added:

“Industry reaction will be divided on these proposals. They will create increased volatility in insurer’s reported results going forward, as market movements will now affect reported profit. There will also be significant changes to the presentation of the income statement which stakeholders will need to take the time to understand. Today’s developments will also cast their net wider than the insurance industry, affecting all companies that issue contracts with insurance risk, such as financial guarantee contracts.

“Given the profound impact of these proposed changes, it is vital insurers work closely with industry analysts to make sure they fully understand the changes and what insurers’ accounting will look like going forward. As there is only a small window during which the industry has an opportunity to influence the final outcome of these proposals, insurers need to act now in assessing the implications of the new model on both their existing contracts and business practices.”

Update 2010-8-9: The MFC Earnings Release 2Q10 sheds some light (a little, anyway) on their objections:

We determine interest rates used in the valuation of policy liabilities based on a number of factors, as follows:
(a) we make assumptions as to the type, term and credit quality of the future fixed income investments;
(b) to reflect our expected investable universe, we adjust the publicly available benchmarks to remove the issues trading extremely tight or wide (i.e., the outliers);
(c) we assume reinvestment rates are graded down to average long-term fixed risk free rates at 20 years; and
(d) consistent with emerging best practices we limit the impact of spreads that are in excess of the long-term historical averages.

In other words. they are making an implicit assumption that they are always perfectly hedged.

5 Responses to “IFRS on Discounting Rate of Insurance Contracts”

  1. […] that they are highly interested in the IFRS exposure draft on Insurance Contracts, which has been previously discussed: On July 30, 2010 the International Accounting Standards Board issued an exposure draft for […]

  2. […] might be expected, they are not very supportive of the IFRS Exposure Draft on Insurance Contracts: As indicated above, the IFRS standard for insurance contracts is currently being developed and is […]

  3. […] proposed new standard has been discussed on PrefBlog. The CLHIA letter does not appear to have been made public by the CLHIA but has been published by […]

  4. […] are worried by the IFRS Exposure Draft on Insurance Contracts (see also commentary on SLF 3Q10) and are busily sleazing around the regulators and politicians to […]

  5. […] Dickson spoke against the IFRS Exposure Draft on Insurance Contracts in a speech at the 2010 Life Insurance Invitational Forum: On the “positive side”, the new […]

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