C37 CIA IFRS 2

Purpose of RA

Adjusts PV of future CFs to reflect compensation entity requires for bearing uncertainty ab amount & timing of CFs from non-financial risk

RA is higher for risks with:

• Low freq / high sev

• Longer duration contracts

• Wide prob distr

• Less known ab current estimate & its trend

RA is lower for risks with:

Emerging experience → more aware ab timing & amt of CFs

RA → Level of Aggregation

IFRS 17 Principles

• Measurement → requires unit of account level

• Presentation & Disclosure → requires aggregated level

Possible RA granularities

• Aggregate → allocate back to unit of account level to satisfy Measurement

• Unit of Account level → sum to get aggregate RA to satisfy Presentation & Disclosure

RA → Diversification Benefit

If units of account are diversified → lower aggregate RA

• If RA calculated @ aggregate lvl

  • Benefit factored in

• If RA calculated @ unit of acount lvl then sum

  • Diversification benefit might not be accurately reflected

Is reinsurance credit risk reflected in the RA?

NO

• Reflected thru reduction in expected CFs

4 Methods for Calculating RA

• Quantile methods

• Cost-of-Capital method

• Margin method

• A combination of methods

Calculating RA → Quantile Method

Use distr of FCFs to determine RA for a given prob

• Ex: VaR, CTE

• Generate distr using Monte Carlo, bootstrap, etc

Pro: satisfies IFRS17 Disclosure req → gives CI for RA

Con: inaccurate if distr misrepresented

Calculating RA → Cost of Capital (CoC) Method

RA based on compensation required to meet target return on capital

• 3 Components

  • Projected capital amts

  • CoC rates

  • Discount Rates

Pro: conceptually close to def’n of RA

Con: operationally complex bc need projection of capital requirements

Calculating CoC Rate

CoC Rate = Target ROE - Investment Rate

Note: If Target ROE is after tax → remove tax first!

• CoC Rate = Target ROE/(1-Tax%) - Investment Rate

Calculating RA → Margin Method

Select margins that reflect compensation entity requires for uncertainty of non-financial risk

RA for Reinsurance Held → Granularity

Pick 2 of gross, net, or ceded

• Then add/subtract to get the third

4 Methods for Calculating RA for Reinsurance Held

• Quantile methods

• Cost of Capital methods

• Catastrophe models

• Proportional scaling

specific to reinsurance held

Calculating RA for Reinsurance → Catastrophe Models

• Use output from cat model tailored to entity’s book of business

• Select percentile directly from given distr

Calculating RA for Reinsurance → Proportional Scaling

• Best for quota share

• Use RA for direct business → scale to ceded portion

  • i.e. use same RA as % of PV(future CFs)

• Can be modified to consider ceding commissions, expense allowances, etc.

RA for Catastrophe Reinsurance

May need to calculate net RA & ceded RA separately

Reason:

• Low freq, high sev events

• Standard Quantile method may product RA that’s too small

Method for Calculating: CoC method

• w/ assumption for required capital set at higher percentile

Calculating RA → Ex of combining methods

Unit of account level combination

• For groups w/ less skewed distr → VaR quantile method

• For groups w/ highly skewed distr → CoC

Calculating RA → Aggregate/entity-level approach

Primarily use Quantile or CoC method

Simplified CoC Method

IDEA: Target profit margin allocated between

• Reserve risk

• UW risk

• Other risks not relevant to RA

Given:

• Profit Margin %

• Capital Allocation % → Reserve / UW / Other risks

RA for LIC = EP x (Profit margin %) x (Capital % for Reserve risk)

RA for LRC = UEP x (Profit margin %) x (Capital % for UW + Reserve risks)

Quantile Method → Methods to generate Distribution

• Monte Carlo

• Bootstrap

  • Pro: recognizes heavy tails & other observations that departs from theoretical distr

  • Con: Bad for small samples → assumes each sampled variable is indep from another

    • May not adequately represent low freq/high sev events

• Scenario Modelling

  • Ex: FCT

  • But may not meet materiality threshold for RA

Calculating RA using CoC Method

CoC Rate

• r = Target ROE/(1-Tax Rate) - Investment Rate

Undiscounted Capital

• Unpaid Loss x Liability/Surplus Ratio

Undiscounted Capital for non-financial risk

• Remove other risks → market, operational

RA → IFRS17 Disclosure Requirements

Need CI for RA

• Use quantile method