1 st Webinar on IFRS 17 16 July
1 st Webinar on IFRS 17 16 July 2020 Impact of IFRS 17 on insurance product design and pricing dominic. clark@milliman. com jeremy. kent@milliman. com
Contents 1 HOW TO CONSIDER THE IMPACT ON DESIGN/PRICING Basic methodology / S 2 NBV The potential for IFRS 17 to constrain distributable profits Rule of thumb and high-level conclusion 2 PRODUCT EXAMPLES Example: Unit-linked Example: Term assurance Example: Traditional savings with profit participation 3 CONCLUSIONS AND FURTHER READING
How to consider the impact on design/pricing The potential for IFRS 17 to constrain distributable profits
The impact of IFRS 17 on product design and pricing § IFRS 17 represents a fundamental change to accounting for insurance business § With such a fundamental change § What might be the likely impact on product design and pricing? § Differing views across informed parties § We present one specific way to define and address this question § Our approach § Is based around new business value (NBV) methodology § Focuses on the potential for IFRS 17 to constrain distributable profits § Allows detailed quantitative analysis § Proposes a rule of thumb for identifying when IFRS 17 constraint may apply in specific product cases
Product design and pricing – Basic methodology § We start by assuming that product design/pricing is based on maximising NBV § New business value (NBV) = discounted value of expected future net cashflows § Projection of expected future cashflows § Candidate product designs/pricing § Sample policies (with assumptions as to policy mix and volumes) § Assumptions as to future experience (best estimate, sensitivities)
Product design and pricing – S 2 NBV methodology § Decision-making by management (and analysis by shareholders) is often driven by consideration of real-world distributable profits § A methodology for NBV that aligns with this view is “S 2 NBV” § Focuses on “distributable profit” (rather than simply cashflows) § § Distributable profit = surplus cashflow after ensuring that S 2 capital requirement is satisfied § New business value = present value of expected future distributable profits Real-world approach § Investment returns projected in line with “real-world” assumptions § Risk discount rate = shareholders’ required rate of return § S 2 NBV is therefore sensitive to the timing of the emergence of distributable profit
Product design and pricing – Dividend constraints § In principle dividend amounts may simply follow the pattern of distributable profit implied by Solvency II (S 2 NBV) § In practice dividends will often be subject to outside constraints § § Dividend payouts may be restricted under local legislation § Supervisor views can influence dividend distribution practices § Companies themselves may prefer to avoid dividend payouts that exceed accounting profits Our analysis assumes that accounting rules (and hence IFRS 17 in the future) will form the basis for such constraints
Product design and pricing – IFRS 17 as constraint (1) § What is the potential for IFRS 17 to constrain the distributable profit of S 2 NBV? § On the “day-one” S 2 balance sheet, all future margins are brought forward § § But required capital will hold back the release of this available capital over time § § This is what S 2 NBV defines as the pattern of distributable profit For IFRS 17 we have a similar effect § § Recognised as “available capital” The CSM (via coverage units) holds back the release of profit over time The question that forms the basis for our analysis therefore becomes § Does the CSM do this relatively more so than S 2 required capital?
Product design and pricing – IFRS 17 as constraint (2) To investigate this our product design/pricing projection includes § Project S 2 NBV distributable profits § Project accounting profits implied by IFRS 17 § Check if IFRS 17 accounting profits constrain the distributable profits of S 2 NBV § This can give a potentially different pattern of profits: S 2 NBV constrained by IFRS 17 § § If so, S 2 NBV will reduce (as S 2 NBV is sensitive to the timing of emergence of profit) Where IFRS 17 does not act to constrain distributable profits, then S 2 NBV will be unchanged
Product design and pricing – Approx. rule for constraint (1) Profit to release A S S E T S L I A B I L I T I E S Assume same expected future cashflows (S 2 = IFRS 17) Empty balance sheet PV(in) MCNBV PV(out) S 2 Available Capital Assume same PV[expected future cashflows] (S 2 MCNBV = IFRS 17 MCNBV) IFRS 17 CSM S 2 Required Capital CSM holds back profit more than S 2 RC holds back profit more than CSM IFRS 17 constrains IFRS 17 won’t constrain (On the assumption that CSM and S 2 RC run off at same rate)
Product design and pricing – Approx. rule for constraint (2) § These assumptions, while broad, allow us to derive the following rule of thumb § If a contract generates surplus on a Solvency II basis at outset (i. e. available capital > required capital) § Then the introduction of IFRS 17 may broadly be expected to constrain distributable profits § However this is just a heuristic, i. e. it won’t work in all cases § More generally, the interplay of effects on profitability and effects on required capital may become even more important within the product design/pricing process § The chart on the next slide illustrates the position for some typical product examples
Profitability (MCNBV = CSM/S 2 AC) Product design and pricing – IFRS 17 as constraint on S 2 NBV RP term assurance product SP unit-linked savings product Likelihood of IFRS 17 decelerating profits relative to S 2 NBV Traditional savings product with profit sharing S 2 Required Capital
Examples Assumptions: § Yield curves, contract boundaries, assumptions etc the same for both Solvency 2 and IFRS 17 § Exclude risk margin / risk adjustment § Exclude tax § No onerous contracts § IFRS 17 constraint based on cumulative IFRS 17 profits less dividends rolled up at risk free § CSM run-off based on coverage units (numbers of policies in-force) § Required Capital run-off based on projections of SCR § These examples are for illustration only
Example: Unit-Linked § Single premium, no investment guarantees § CSM depends on level of profitability § SCR depends in particular, on asset mix (e. g. level of equities) and lapse risk (loss of VIF, surrender penalties) § Risk free: 0% pa; shareholders’ required rate of return 6% pa § Key details: § Term 10 years, premium 40, 000 § Initial charge 5%; AMC 0. 5% § Initial expenses + commission 5% § Renewal expenses + commission 0. 5% pa § Lapses 5% pa; surrender penalty 2% § Required capital: 150% * SCR § 100% invested in cash, assume no market SCR § Ignore insurance risk required to fall under IFRS 17
Example: Unit-Linked – base case Discounted @ shareholders’ required rate of return 400 250 230 210 190 170 150 300 200 100 0 S 2 NBV Initial CSM IFRS 17 Initial RC S 2 NBV limited to IFRS 17 Distributable profits 60 40 20 0 1 2 3 4 5 6 7 8 -20 S 2 NBV distributable IFRS 17 S 2 NBV limited by IFRS 17 9 10
Example: Unit-Linked – initial charge 5% to 15% Discounted @ shareholders’ required rate of return 5, 000 4, 000 3, 500 2, 000 1, 000 3, 000 0 2, 500 Initial CSM S 2 NBV Initial RC IFRS 17 S 2 NBV limited to IFRS 17 Distributable profits 5, 000 4, 000 3, 000 2, 000 1, 000 0 1 2 3 4 S 2 NBV distributable 5 IFRS 17 6 7 8 S 2 NBV limited by IFRS 17 9 10
Example: Unit-Linked – AMC 0. 5% to 1. 9% Discounted @ shareholders’ required rate of return 5, 000 4, 000 3, 000 2, 000 1, 000 0 4, 000 3, 500 3, 000 2, 500 Initial CSM S 2 NBV Initial RC IFRS 17 S 2 NBV limited to IFRS 17 Distributable profits 2, 500 2, 000 1, 500 1, 000 500 0 1 2 3 4 S 2 NBV distributable 5 IFRS 17 6 7 S 2 NBV limited by IFRS 17 8 9 10
Example: Unit-Linked – surrender penalty 2% to 29% Discounted @ shareholders’ required rate of return 5, 000 4, 000 3, 000 2, 000 1, 000 0 4, 000 3, 500 3, 000 2, 500 Initial CSM S 2 NBV Initial RC IFRS 17 S 2 NBV limited to IFRS 17 Distributable profits 1, 000 800 600 400 200 0 1 2 3 4 S 2 NBV distributable 5 IFRS 17 6 7 8 S 2 NBV limited by IFRS 17 9 10
Example: Term Assurance § Level annual premium, long contract boundary § High level of profitability => high CSM § SCR depends in particular, on proportion of premium providing risk cover § Risk free: 0% pa; shareholders’ required rate of return 6% pa § Key details: § Term 20 years § Premium 500 pa, Sum Assured 45, 000 § Commissions: 50% year 1, 20% thereafter § Expenses: initial 50 per policy, renewal 10 per policy pa § Lapses 5% pa § Required capital: 150% * SCR § No market risk
Example: Term Assurance – base case 1, 500 Discounted @ shareholders’ required of return 1, 000 950 900 850 800 750 1, 000 500 0 Initial CSM Initial RC S 2 NBV IFRS 17 S 2 NBV limited to IFRS 17 Distributable profits 400 300 200 100 0 1 2 3 4 5 6 7 8 S 2 NBV distributable 9 10 IFRS 17 11 12 13 14 15 S 2 NBV limited by IFRS 17 16 17 18 19 20
Example: Term Assurance – Required Capital 150% to 125% 1, 500 Discounted @ shareholders’ required rate of return 1, 000 950 900 850 800 750 1, 000 500 0 Initial CSM S 2 NBV Initial RC IFRS 17 S 2 NBV limited to IFRS 17 Distributable profits 600 500 400 300 200 100 0 1 2 3 4 5 6 7 8 S 2 NBV distributable 9 10 IFRS 17 11 12 13 14 15 S 2 NBV limited by IFRS 17 16 17 18 19 20
Example: Term Assurance – Required Capital 150% to 100% 1, 500 Discounted @ shareholders’ required rate of return 1, 000 950 900 850 800 750 1, 000 500 0 Initial CSM Initial RC S 2 NBV IFRS 17 S 2 NBV limited to IFRS 17 Distributable profits 800 600 400 200 0 1 2 3 4 5 6 7 8 S 2 NBV distributable 9 10 IFRS 17 11 12 13 14 15 S 2 NBV limited by IFRS 17 16 17 18 19 20
Example: Traditional savings with profit sharing Current low interest rates S 2 NBV considers “risky” assets Low “market consistent” margins / CSM High SCR (in some cases) Shareholder value from real-world “uplifts” Higher SCR (market risk) and hence Co. C IFRS 17 probably won’t constrain compared with SII Impact of IFRS 17 more complex. . .
Example: Traditional savings with profit sharing Timing of recognition of real world uplifts (investment in risky assets) S 2 NBV Recognized upfront (based on discounted real world distributable profits) Emergence of distributable profits may be slow at first if high SCR (e. g. from market risk) MCNBV Not recognized (but form part of MCEV in future when they occur) IFRS 17 Recognized in future when they occur If VFA then uplifts increase CSM (change in variable fee). Impact spread over current and future service periods, thus deferred Current accounting Speed of profit emergence generally depends on prudence in reserving basis May not be so prudent in current low interest rate environment Real-world uplifts recognized in future when they occur
Example: Traditional savings with profit sharing § Single premium 1, 000 § Term 10 years § Profit sharing: Max [i – 1% ; 0. 35%] § Maturity value = single premium + accumulated profit sharing § No other costs or loadings § No exits before maturity § CSM coverage units: coverage provided evenly over term § VFA applies § Required capital: 3% of accumulated assets, % running off linearly over term § Risk-free: 0. 5% pa; real-world returns 2. 5% pa
Example: Traditional savings with profit sharing Without real-world uplifts: 5 40 0 0 1 2 3 4 5 6 7 8 9 10 -5 30 20 -10 10 -15 0 0 -20 Distributable profits (S 2 NBV) IFRS 17 profits 1 2 3 4 5 Required capital 6 7 CSM 8 9 10
Example: Traditional savings with profit sharing With real-world uplifts: 40 40 30 30 20 10 20 0 10 -10 0 1 2 3 4 5 6 7 8 9 10 0 0 -20 Distributable profits (S 2 NBV) IFRS 17 profits 1 2 3 4 5 Required capital 6 7 CSM 8 9 10
Example: Traditional savings with profit sharing § Savings products with guarantees may rely on real-world uplifts, particularly in current low interest rate environment § Real-world uplifts can influence view of product when comparing S 2 NBV and MCNBV § Savings products depending heavily on real-world uplifts may be significantly affected under VFA of IFRS 17 § MCNBV effectively ignores real-world returns and cost of capital for market risk § S 2 NBV allows for both => MCNBV could be negative, but S 2 NBV positive § => could have economically profitable product which is onerous under IFRS 17
Conclusions and Further reading
Conclusions § Our approach has focused on the comparable impact of the IFRS 17 CSM and S 2 required capital in slowing the emergence of distributable profit § This analysis suggests that the impact within European markets may not be as pronounced as might be imagined § Some products will however see IFRS 17 constrain the distributable profits of S 2 NBV § As a broad rule of thumb § If a contract generates surplus on an S 2 basis at outset (i. e. S 2 available capital > S 2 required capital) § Then the introduction of IFRS 17 may broadly be expected to constrain distributable profits § More generally, the interplay of effects on profitability and effects on required capital may become even more important within the product design/pricing process § This is, of course, a complex topic and the position may evolve
Further reading Our recent Milliman white paper forms the basis for this presentation and provides more detail: § Impact of IFRS 17 on insurance product pricing and design Our methodology for considering projected distributable profits under Solvency II is described in the following Milliman white papers: § S 2 AV: A valuation methodology for insurance companies under Solvency II § Measuring new business profitability under Solvency II (S 2 NBV) § Shining new light on European insurance M&A
Annex – Reliances and Limitations
Reliances and Limitations (1) The views expressed in this presentation are those of the presenters, and not those of the presenters’ employer. Nothing in this presentation is intended to represent a professional opinion or be an interpretation of actuarial standards of practice. This presentation is intended solely for educational purposes and presents information of a general nature. It is not intended to guide or determine any specific individual situation and persons should consult qualified professionals before taking specific actions. Neither the presenter nor the presenter's employer shall have any responsibility or liability to any person or entity with respect to damages alleged to have been caused directly or indirectly by the content of this presentation. This presentation must not be relied upon for any purpose. All numerical examples are purely illustrative. The content of the presentation is based on our current view of IFRS 17, and cannot be seen as giving definitive opinions. This is in part because the treatment of some items may be dependent on the view, approach and attitude of auditors and regulators, how best practice emerges at both a local and international level, and how distinct parties may consider the pros and cons of different approaches. Responding to questions asked during the presentation is not a substitute for consulting advice. The framework for, and interpretation of, IFRS 17 continues to be under some development and changes are likely. Therefore any comments relate only to the position as at today and cannot anticipate what future changes may occur. Furthermore we have not necessarily made any allowance for ongoing discussions by relevant interested parties which may or may not be in the public domain, although of course we have attempted to allow for anything relevant which we are aware of. We note that IFRS 17 is a principle-based accounting system and so correct interpretation of the rules can be subject to alternative views.
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