IFRS 17 Discount Rates

Study guide: Exam 6C

IFRS 17 Discount Rates are the rates used to convert insurance cash flows to present value. They must reflect the time value of money, the characteristics of the cash flows, and the liquidity characteristics of the insurance contracts — and they must be consistent with observable current market prices for instruments with similar characteristics. They must not reflect factors that do not affect the insurance cash flows, notably the insurer's own credit standing or the performance of its investment portfolio.

r_{\text{IFRS 17}} = r_{\text{risk-free}} + \text{Illiquidity premium}

• Two permitted construction methods, and candidates should be able to describe both:
  • Bottom-up — start from a liquid risk-free yield curve and add an illiquidity premium reflecting how illiquid the insurance liability is.
  • Top-down — start from the yield on an actual or reference asset portfolio and remove the components not relevant to the liability: expected and unexpected credit losses, and any market risk premium not reflecting liquidity.
• The two need not reconcile, and IFRS 17 expressly does not require them to. In practice the illiquidity premium is the hardest judgement in either direction, and it is where two insurers' curves most differ.
• Current, not locked in — with one exception. The liability is measured at current rates each period. The exception is CSM accretion, which uses the rate locked in at initial recognition.
• Where the effects go. The unwind of discount and the effect of changes in discount rates are Insurance Finance Income or Expenses, not Insurance Service Expenses. This is what keeps the Insurance Service Result free of interest-rate noise, and it is the single most important presentation consequence of discounting.
• The OCI option lets an insurer put the effect of discount rate changes in OCI rather than profit or loss, with the locked-in-rate portion staying in profit. Combined with fair-value-through-OCI assets, this reduces accounting mismatch — but it is an irrevocable choice by portfolio.
• Canadian practice is shaped by CIA guidance on constructing the curve and on the illiquidity premium, and by the fact that Canadian P&C liabilities are relatively short — so the discount effect is a few percent of the liability, against far more for a life insurer.

Bottom-Up Versus Top-Down The risk-free curve at the liability's duration yields 3.4\%. The insurer's supporting bond portfolio yields 4.9\%, comprising 0.35\% expected credit loss, 0.45\% unexpected credit risk premium, and the remainder liquidity and term. The insurer assesses the illiquidity premium appropriate to its claim liabilities at 0.5\%.

Compute the rate under each method and explain the gap.

Answer Bottom-up:

\begin{align*}
r &= 3.4\% + 0.5\% \\
&= 3.9\%
\end{align*}

Top-down: remove from the asset yield the components that do not belong in a liability discount rate — expected and unexpected credit risk:

\begin{align*}
r &= 4.9\% - 0.35\% - 0.45\% \\
&= 4.1\%
\end{align*}

The 20 basis point gap is the difference between the illiquidity premium the insurer assessed for its liabilities (0.5\%) and the liquidity-plus-term component embedded in its assets (4.9\% - 3.4\% - 0.35\% - 0.45\% = 0.7\%).

IFRS 17 does not require reconciliation, so either rate is permissible provided the method is applied consistently and disclosed. But the gap is worth explaining internally: the insurer's assets are less liquid than the liabilities they support, and the top-down rate carries that extra illiquidity into the liability measurement.

The magnitude matters. On a \$500 million liability with a duration of three years, 20 basis points is roughly \$3 million — small enough to be a judgement rather than a misstatement, large enough that the method choice must be disclosed. On a long-tail book with a duration of eight years, the same 20 points would be four times as consequential, which is why liability duration determines how much attention the curve deserves.