Frequently Asked Questions—Indirect Par Contracts Under IFRS 17
By Bruce Rosner and Kyle Stolarz
The Financial Reporter, June 2021
One of the areas of IFRS 17 that has generated some of the more complex questions is the approach to valuing indirect participating products. By way of background, IFRS 17 provides us with three models for measuring a group of insurance contracts—the general measurement model (GMM), the variable fee approach (VFA), and the premium allocation approach. Within the GMM, the standard provides a variation in technique for policies that have some market participation, but do not qualify for the VFA, affectionately known as “Indirect Par.” While less common in Europe, there are a large number of Indirect Par products in the U.S. and Canada, as well as in Asia. We will focus on these products and share emerging industry practices related to actuarial modeling and accounting for Indirect Par products under IFRS 17 via frequently asked questions.
Question 1: What types of products do we expect to be classified as Indirect Par under IFRS 17?
Any insurance product with market-sensitive cash flows that is not classified as insurance contracts with direct participation features (and required to apply the VFA) is expected to be classified as Indirect Par. In this context, “market-sensitive” refers to financial risks related to interest rates, equities, or inflation indices, to name a few.
In North America, companies are typically classifying fixed and indexed deferred annuities, and fixed and indexed universal life insurance contracts as Indirect Par. These products have some market participation via a crediting mechanism; however, there are typically interest guarantees present that limit market participation, and/or there may not be a clearly identified pool of underlying items that determine the amounts to be paid to the policyholder. The standard outlines three requirements for applying the VFA in IFRS 17.B101. The two examples mentioned above are two common (but not the only) reasons a product does not meet VFA eligibility requirements and would be classified as Indirect Par.
Excluded from the list of Indirect Par contracts are variable universal life and variable annuities in the U.S., as well as segregated fund products in Canada, where companies are typically applying the Variable Fee Approach because these products meet the requirements in IFRS 17.B101 and are classified as insurance contracts with direct participation features. The main differentiators for these products are the presence of a clearly identified pool of underlying items and limited guarantees.
Specific facts and circumstances need to be considered, particularly when products offer guarantees and the company expects policyholders to primarily leverage the insurance features over the investment features. For example, a minimally funded fixed universal life policy with significant no-lapse guarantees may have no, or very few, cash flows with sensitivity to changes in interest rates.
Question 2: What are some of the implications on actuarial modeling that companies should consider for Indirect Par products?
Companies will need to consider:
- Whether a stochastic model is required;
- if it is, whether to use real-world or risk-neutral scenarios;
- the level of the illiquidity premium in the discount rate; and
- how to apply locked-in discount rates and locked-in scenarios for purposes of determining the contractual service margin (CSM) adjustment (see question 6 below for detailed response).
We expect that stochastic modeling will be required in most cases in order to capture the time value of options and guarantees embedded in these types of products. Other approaches are available, e.g., replicating portfolio techniques are mentioned in IFRS 17.B47 and B48, but we have not seen this in common use.
The logical next question is whether scenarios should reflect real-world or risk-neutral probabilities. IFRS 17 does not prescribe a single method, and either are appropriate so long as a market-consistent valuation is performed. However, IFRS 17.B77 does state that risk-neutral projections may be used where appropriate, and most companies are taking this view. From our experience, companies in North America have not opted for real-world scenarios, which would require calibrating real-world deflators.
Most companies are also taking the view that the illiquidity premium should be incorporated in both the asset growth rates and the discount rate, within the risk-neutral valuation. Note that it may take some period of time until projected credited rates fully align with the reduced expectation of asset yields. This is due to product mechanics and the way that companies set credited rates. If projected credited rates do immediately drop to the risk free rate in the current period, then companies may see some undesirable volatility in profit and loss (P&L) or other comprehensive income (OCI) as expected returns and cash flows are risk neutral but actual returns and cash flows are real world. We expect this P&L or OCI volatility to be less common in North America given product mechanics, investment strategies, and modeling approaches for these types of products.
Because the illiquidity premium is being applied to all cash flows, and policyholders are typically able to withdraw funds in these products, companies are expecting to apply a relatively low illiquidity premium compared with many nonparticipating products.
An alternate approach that has been discussed is to only apply the illiquidity premium to the cash flows that are deemed to be truly illiquid—such as the guaranteed cash flows in excess of the account value. In this case, the risk-neutral projection would use risk free rates for expected asset growth, and the illiquidity premium included in the discount rate would be set to a higher level corresponding more closely to fully illiquid products.
Regardless of the approach taken, companies will need to justify the level of illiquidity premium per IFRS 17.B78. Some considerations when setting the level of illiquidity premium include the ability to surrender, surrender charges, and guarantees or insurance benefits that are lost on surrender. The level of illiquidity premium is a robust topic not just for Indirect Par contracts, but for all insurance contracts, and is worthy of its own discussion.
Question 3: Do groups of insurance contracts need to meet any criteria, or eligibility tests, to apply IFRS 17.B132(a) and be considered Indirect Par?
Most companies are not applying an eligibility test to qualify as Indirect Par. Paragraph B132(a) includes the following language: “for which changes in assumptions that relate to financial risk have a substantial effect on the amounts paid to the policyholders” (emphasis added). Paragraph B101 also uses “substantial” when referring to insurance contracts with direct participation features (VFA contracts). However, the standard is silent on testing and any additional criteria for indirect participating contracts, unlike paragraphs B101-B108 for VFA, which go on to further explain the criteria for these types of contracts. Therefore, most companies are interpreting the word “substantial” in IFRS 17.B132(a) to mean that there is a change to cash flows that is not immaterial.
Question 4: When electing to disaggregate insurance finance income or expense (IFIE) to OCI for Indirect Par contracts, what options do companies have to systematically allocate IFIE to P&L? Do we expect companies to favor one approach over the other?
Per paragraph 88 of the standard, companies are required to make an accounting policy choice at the portfolio level between including insurance finance income or expense in P&L, or disaggregating to OCI. For Indirect Par contracts where OCI is elected, the standard provides two methods of systematic allocation: effective yield and projected crediting rate (IFRS 17.B132(a)). We’re seeing both methods being applied in practice.
Companies may look to the effective yield method first, as it is relatively simple to understand and captures the entire current period impact of financial risk. This method is implemented by solving for a single effective rate that results in an unchanged value of the fulfillment cash flows after updating financial impacts. The systematic allocation to P&L is then done over the life of the contracts. The financial implication of this method is that the level discount rate wipes out the alignment between projected credited rates and discount rate (while preserving the current value), and where the discount rate curve is non-level this results in an altered P&L profile.
In our experience, the projected crediting rate method provides a more level P&L result, as the systematic allocation generates discount rates that are intended to be aligned with projected crediting rates. The projected crediting rate method achieves this outcome by basing the systematic allocation on the amounts credited in the period and expected to be credited in future periods. The main drawback is that it is often more challenging to implement which could lead companies to the effective yield method instead.
Paragraphs IE152-IE172 in the illustrative examples that accompany the standard provide an illustration of both the effective yield and projected crediting rate method.
Question 5: Which changes in the fulfillment cash flow over a period are included and excluded in both the effective yield and projected crediting rate methods?
The following elements are typically included:
- All financial risks, including interest rate changes and equity movements; and
- the impact of inflation on inflation-indexed benefits.
Changes in inflation assumptions affecting projected expenses would typically be excluded. In addition, the standard states in paragraph B98 that discretionary changes to credited rates are excluded, and they are treated similar to nonfinancial assumption changes and adjust the CSM. This is important to keep in mind as any communication breakdown between rate setting and actuarial modeling may result in the impact of a change in discretion being captured in IFIE instead of the CSM.
IFRS 17 does not explicitly state whether policyholder behavior should be included or excluded. However, because (a) the dynamic behavior is a direct consequence of the market movement, and (b) it may, in fact, be impossible to accurately split the dynamic behavior from market movements, companies typically include the impact of future dynamic policyholder behavior within financial risks.
Question 6: How is the CSM adjusted for changes in fulfillment cash flows that relate to future service?
This question can be complex both with respect to the discount rate and the cash flow projection that is used for this purpose.
With regard to the discount rate, IFRS 17 B72(c) points you to the original locked-in rate, regardless of OCI election or application of paragraph B132(a). There are potentially poor financial outcomes from the use of locked-in rates in this context. For any product, unless OCI is elected, the disconnect between the change in fulfillment cash flows at the current rate versus the locked-in rate means that the CSM will not perfectly offset the change in the fulfillment cash flows. Furthermore, in the case of indirect participating products, this issue is exacerbated because of the relationship between the discount rate and the credited rate. The use of a current credited rate in the projection with a locked-in discount rate can result in unusual, even negative, pricing margins, and in such a case, the CSM offset may have no intuitive relationship to the change in the fulfillment cash flows. To address this issue, a company may want to consider IFRS 17.B97(a), which outlines the changes that do not adjust the CSM for groups of insurance contracts applying the GMM.
Most companies are taking the view that the cash flow projection should be aligned with the discount rate, necessitating an additional cash flow projection on a locked-in basis, i.e., with financial assumptions locked in as of the inception of the group of contracts, solely for CSM purposes. Among these companies, there are a variety of approaches being considered, based on interpretations of IFRS 17.B97(a) and based on materiality and operational considerations. Some of the options considered are:
- Lock in the parameters of the scenario generator and roll those forward for each valuation period.
- Lock in the scenarios directly.
- Perform this calculation on a deterministic basis and roll forward each of the deterministic parameters at each valuation period.
A minority will use the current cash flow projection and accept the disconnect described above. In this case, there is additional work needed to connect current cash flows to locked-in discount rates (these products normally use path-specific discounting, which wouldn’t follow sound actuarial principles if the projection and discount rates were not connected at the scenario level). Two options that have been considered are:
- Adjusting the cash flows using a set of weights that equates the average present value with path-specific discounting to the present value with a deterministic discount rate.
- Using the same set of random seeds as the current economic scenario generator (ESG) run to perform a second ESG run with the original locked-in curve rolled forward to the current date. As the random seeds correspond between the two sets, the path-specific locked-in discount rates can be applied to the current cash flow projection.
This cash flow methodology decision is brought about because the adjustment to the CSM is measured at locked-in discount rates. This adds a layer of complexity to actuarial modeling that companies need to consider.
Application of IFRS 17 to products with indirect participation features is one of the most complex areas of the standard. Companies may need to rethink risk-neutral modeling, and create new systems that are capable of handling the unique calculations required to support OCI and CSM for these products. Actuaries will want to take the remaining time before the standard takes effect to test their methodology decisions and uncover any hidden implications of those decisions in this complex area.
The views expressed by the authors are not necessarily those of Ernst & Young LLP or other members of the global EY organization, the Society of Actuaries, or the newsletter editors.
Bruce Rosner, FSA, MAAA, is a managing director at Ernst & Young LLP. He can be reached at email@example.com.
Kyle Stolarz, FSA, MAAA, is a senior manager at Ernst & Young LLP. He can be reached at firstname.lastname@example.org.