Margin for Adverse Deviations

Study guide: Exam 6C

A Margin for Adverse Deviations (MfAD) is a provision added to a best-estimate assumption to allow for the possibility that experience is worse than expected. Under the pre-IFRS 17 Canadian regime, MfADs on claims development, reinsurance recovery and interest rate were the mechanism by which conservatism entered policy liabilities. They have been replaced by the risk adjustment, and the contrast between the two is regularly examined.

$\text{Policy liability}_{\text{old}} = \text{Best estimate} \times (1 + \text{MfADs})$

The three MfADs under the old CIA standards: claims development (a percentage load on the best estimate of unpaid claims), reinsurance recovery (a load reflecting the risk that ceded amounts are not collected), and investment return rate (a deduction from the discount rate). Each had a prescribed range within which the actuary selected.
What changed under IFRS 17:
- MfADs applied assumption by assumption, in ranges set by standards; the risk adjustment is a single, entity-specific amount for non-financial risk with a disclosed confidence level.
- The reinsurance MfAD covered collectability; under IFRS 17 that is non-performance risk on the reinsurance asset — a credit adjustment, explicitly not part of the risk adjustment.
- The interest rate MfAD reduced the discount rate; under IFRS 17 the discount rate is market-consistent with no prudence in it, because financial risk is excluded from the risk adjustment.
Why the change was made. Prescribed ranges made margins comparable but arbitrary, and mixing prudence into the discount rate confused financial and non-financial risk. Disclosing a confidence level makes an entity-specific margin comparable in a way a list of MfADs never was.
What was lost: the old ranges gave a floor. A risk adjustment is the insurer's own judgement, and while the confidence-level disclosure constrains it, a low disclosed confidence level is permitted so long as it is disclosed.
MfADs remain relevant on the exam as the basis of comparison — candidates are asked to explain what replaced them and why.

Old Margins Versus the New Risk Adjustment An insurer's best estimate of unpaid claims is $\$400$ million undiscounted, discounting at $4\%$ reduces it to $\$370$ million, and reinsurance recoverable is $\$90$ million.

Under the old regime the actuary selected a claims development MfAD of $8\%$ , a reinsurance MfAD of $2\%$ , and an interest rate MfAD of $50$ basis points (which increases the discounted liability by $\$4$ million). Under IFRS 17 the actuary sets a risk adjustment at the $70\text{th}$ percentile, computed as $\$26$ million, with non-performance risk on the reinsurance asset of $\$1.5$ million.

Compare.
Answer Old regime, gross policy liability:
 $\begin{align*} &= \$370\text{M} + 0.08(\$370\text{M}) + \$4\text{M} \\ &= \$370\text{M} + \$29.6\text{M} + \$4\text{M} \\ &= \$403.6\text{M} \end{align*}$ 
with the reinsurance asset reduced by $0.02 \times \$90\text{M} = \$1.8\text{M}$ to $\$88.2$ M.

IFRS 17:

$\text{LIC} = \$370\text{M} + \$26\text{M} = \$396\text{M}$

with the reinsurance asset reduced by $\$1.5$ M for non-performance risk (and increased by its own risk adjustment, ignored here for comparability).

The gross liability falls by $\$7.6$ million. Two distinct reasons, and separating them is the point of the exercise:

$\$4$ million because the interest rate MfAD is gone — the IFRS 17 discount rate carries no prudence at all.

$\$3.6$ million because the risk adjustment ( $\$26$ M) is smaller than the claims development MfAD ( $\$29.6$ M), reflecting the actuary's choice of the $70\text{th}$ percentile.

The disclosure difference is the larger point. Under the old regime a reader saw " $8\%$ claims development MfAD" and could not tell what confidence that represented. Under IFRS 17 the reader sees " $70\text{th}$ percentile" and can compare directly with any other insurer — which is what the change was for.