Navigating the intricacies of IFRS 17, a profound grasp of the 'Risk Adjustment' concept appears as an imperative endeavour, given its pivotal role as a fundamental parameter within the General Measurement Model for calculating insurance contract liability. While familiar notions like discount rates and estimated cash flows find resonance, the nuanced terrain of 'risk adjustment' often remains less understood.
In simple terms, the standard defines risk adjustment as the compensation sought by entities to accommodate the uncertainty surrounding the amount and timing of cash flows arising from non-financial risks, inherent as the entity fulfills its insurance contract. This article embarks on a mission to cast light on this concept, endeavouring to make it accessible to a broader audience, even the less technical ones.
First and foremost, let us delve into the concept of 'certainty equivalent cash flow,' also known as guaranteed cash flow or replacement cash flow, as it intertwines with the broader theme. The notion of certainty equivalent cash flow delineates the guaranteed monetary value that an investor would favour in the present, eschewing the risk of potentially greater returns in the future. This means that every future cash flow carries an embedded risk due to attendant uncertainties.
Further exploration brings to the fore three distinctive categories of investors: risk takers, risk-averse, and risk-neutral investors. The investment decisions of these categories pivot on their varying inclinations toward risk and their ability to embrace it. Consequently, these divergent investor profiles yield varying risk adjustment values, reflecting their respective certainty equivalents for future cash flows contingent upon their risk proclivities.
To crystallize this concept, consider a practical scenario: envision yourself as an investor, committed to an estimated cash flow of $100 in the next year due to your recent investment. Your certainty equivalent or guaranteed cash flow inherently falls short of the $100 benchmark, owing to your individual risk threshold. For a risk-taking investor, the approximated guaranteed cash flow might settle around $98 USD, acting as a surrogate for the anticipated $100 USD in a year. In contrast, a risk-averse investor might experience their guaranteed cash flow as $93 USD. Evidently, a higher affinity for risk propels the certainty equivalent cash flow closer to $100 USD, and vice versa.
Furthermore, this crucial question emerges: what exactly is the risk adjustment cash flow, as mandated by IFRS 17? As previously explained, both investor archetypes regard the present guaranteed cash flow as more valuable than the nebulous and uncertain $100 promised for the future year, tethered to multifaceted risks. Thus, the discrepancy between future cash flow and guaranteed cash flow encapsulates a cost the investor must bear, with this cost fluctuating in accordance with their risk preferences. In the aforementioned scenario, the risk-taking investor might bear a cost of $2 USD, while their risk-averse counterpart shoulders a cost of $7 USD. Consequently, the risk adjustment components to be integrated within the fulfillment cash flow calculation equate to $2 USD and $7 USD, respectively. This signifies a cost that the investor, in this case the insurer, warrants compensation for.
In an extreme scenario, envision an investment valuation deemed unworthy by the investor in a year's time. Here, the guaranteed cash flow could diminish to approximately $90 USD or even lower, consequently translating into a risk adjustment value of $10 USD or below. Conversely, if unwavering confidence in the investment's viability persists, leading to a guaranteed cash flow surpassing estimated future figures—say $105 USD—the resultant risk adjustment could manifest as -$5 USD.
This concept adheres to the principle of probability-weighted expected future cash flows. While this illustration simplifies the idea, its foundational principles extend to the domain of IFRS 17 risk adjustment. Consequently, when computing fulfillment cash flows, the inclusion of $2 USD or $7 USD is paramount to offsetting the cost associated with embracing a precarious contract, juxtaposed with the security afforded by a guaranteed cash flow.
It is noteworthy that IFRS 17 does not prescribe a specific method for computing risk adjustment, but it does provide certain recommendations to be considered. To ensure comparability in insurers' financial statements, the standard mandates disclosure of the method adopted, accompanied by a justification of the confident level in the adopted method. Other viable methods include the cost of capital method, tail VAR method, and value-at-risk method."
For further information, please contact the following to discuss these matters in the context of your particular circumstances.
Segun Adewumi
Advisory, Financial Modelling & Valuation Consultant
T: +234 0903 471 7589
E: sadewumi@bdo-ng.com