Risk Adjustment for Non-Financial Risk

Study guide: Exam 6C

The Risk Adjustment for Non-Financial Risk (RA) is the compensation an insurer requires for bearing the uncertainty in the amount and timing of cash flows arising from non-financial risk — insurance risk, lapse risk and expense risk. It is an entity-specific measure under IFRS 17, and its confidence level must be disclosed, whatever technique was used to set it.

$\text{RA} = \text{Value placed on bearing uncertainty in non-financial cash flows}$

What it is not. It is not a prudential margin set by a regulator, not a provision for adverse deviations at a prescribed level, and not compensation for financial risk — interest rate and market risk are captured in the discount rate, not here.
It is entity-specific. Two insurers with identical liabilities may hold different risk adjustments because they have different degrees of risk aversion, different diversification, and different views of the uncertainty. This is a deliberate departure from a market-consistent measure and it is why the confidence-level disclosure exists — it makes the difference comparable.
Common techniques: the confidence level (VaR) approach, translating a chosen percentile of the liability distribution into an amount; the cost of capital approach, charging a rate on the capital required to run off the liabilities; and the conditional tail expectation (CTE/TVaR) approach. Whichever is used, the equivalent confidence level must be disclosed.
The five characteristics IFRS 17 says a risk adjustment should exhibit: low-frequency/high-severity risks attract higher adjustments than high-frequency/low-severity ones; longer-duration contracts attract higher adjustments than shorter ones; wider probability distributions attract higher adjustments than narrower ones; the less that is known about the estimate and its trend, the higher the adjustment; and emerging experience that reduces uncertainty reduces the adjustment.
Diversification. The RA reflects diversification only to the extent the entity benefits from it, and the level at which diversification is recognised (entity or group) must be disclosed — a significant judgement, because entity-level diversification can substantially lower the number.
Release pattern. The RA is released to profit as risk expires, so a long-tail line releases it slowly. Under the reinsurance held measurement the sign flips: the RA on reinsurance held represents risk transferred away, and it increases the reinsurance asset.

Setting the Risk Adjustment Two Ways An insurer's discounted fulfilment cash flows for incurred claims are $\$250$ million. The liability distribution is approximately lognormal with a coefficient of variation of $12\%$ . The insurer targets the $75\text{th}$ percentile.

Alternatively, the capital required to run off the liabilities is $\$95$ million in year 1, declining $30\%$ per year, and the cost of capital rate is $6\%$ .

Compute the RA under each and compare.
Answer Confidence level approach. For a lognormal with mean $\mu_X = 250$ and $CV = 0.12$ :
 $\begin{align*} \sigma^2 &= \ln(1 + 0.12^2) = 0.014286 \\ \sigma &= 0.11952 \\ \mu &= \ln(250) - \tfrac{1}{2}(0.014286) = 5.51930 \end{align*}$ 
The $75\text{th}$ percentile uses $z_{0.75} = 0.6745$ :
 $\begin{align*} x_{0.75} &= e^{5.51930 + 0.6745(0.11952)} \\ &= e^{5.59991} \\ &= \$270.4\text{M} \end{align*}$ 
$\text{RA} = \$270.4\text{M} - \$250\text{M} = \$20.4\text{M}$

Cost of capital approach. Capital of $95, 66.5, 46.55, 32.59, \ldots$ million, charged at $6\%$ and discounted (at $4\%$ , say) is approximately:
 $\begin{align*} \text{RA} &\approx 0.06 \times \frac{\$95\text{M}}{1 - 0.70/1.04} \\ &= 0.06 \times \$290.6\text{M} \\ &= \$17.4\text{M} \end{align*}$ 
Comparison. The two techniques give $\$20.4$ million and $\$17.4$ million — an $\$3$ million difference on the same liability, driven entirely by methodology and parameter choice.

This is exactly why IFRS 17 requires the confidence level disclosure rather than the technique: an insurer using the cost of capital approach must still translate $\$17.4$ million into an equivalent percentile (here, roughly the $71\text{st}$ ) so a reader can compare it with the first insurer's $75\text{th}$ . Without that translation, "we hold a risk adjustment" would convey nothing.