Investment Component
In this article, I would discuss a long debated topic since 2013 ED, the investment component. The IASB thinks that, without investment component, the standard would not faithfully represents the similarities between financial instruments within the scope of IFRS 9 and investment component embedded in insurance contracts within the scope of IFRS 17.[1]
To understand the calculation and eventually the controversial part of investment component, let's start with the definition in the standard first:
The amounts that an insurance contract requires the entity to repay to a policyholder even if an insured event does not occur[2]
To better understand the issue, we shall start with an illustrative example.
Assume a single pay insurance contract with $10,000 payable upon death and maturity. Surrender value is linearly interpolated between years. Interest expense is 3% and actual investment return is 4%. Mortality is assumed level 0.5% and lapse rate level 1%. Premium is set equal to present value of outgo, plus a 10% margin. Risk adjustment and expense are assumed 0 for simplicity. We use Present Value of Number of Policies (PVNOP) as the CSM carrier.
Key calculation steps are shown in appendix A.
We further make the following assumption: Investment component per death is equal to the surrender value (or guaranteed cash value). [3] Therefore, the total investment component is defined by:
The income statement generated from the above setup is:
So far so good. Now, let's change the surrender value that it becomes 0 throughout the contract.
One can see that, the investment component becomes 0 from year 1-4. Since there are no surrender outgo nor survival outgo, and the investment component per death is nil, naturally it follows that the investment component is 0.
Here is the question: The contract is by nature a pure investment contract. The insured gets the same amount regardless of whether he died or not (unless he chooses to lapse). But the investment component is 0, contradicts the policy setup.
The weird situation illustrated above is coming from the fact that, even if an insured event (death) does not occur, 2 situations may occur, namely: lapse or infocre (not lapse). Only considering surrender value ignores the amount that is potentially payable if the policyholder chooses not to lapse.
For example, in the above example, If the policyholder chooses "not lapse", the value that he can get is actually 10,000 (Maturity Benefit or Death Benefit) instead of 0 (the Surrender Value).
And, if we extend the logic forward, actually we need to consider all future period for the possibility. And in each period, we do not know how the policyholder will act (whether he chooses to lapse or not).
This leads to the following possible interpretations for the definition:
Interpretation 1: Investment Component is…
The current amounts that an insurance contract requires the entity to repay to a policyholder even if an insured event does not occur
This is the preferred (or default?) option of how IASB interprets investment component. However, this definition will be problematic in the example I have introduced above.
Interpretation 2: Investment Component is…
The maximum amounts until the end of contract that an insurance contract requires the entity to repay to a policyholder even if an insured event does not occur
This interpretation is able to solve the example I have mentioned. However, this definition implicitly implies the policyholder is completely rational, which will choose the option (to lapse or not) to maximize his gain / loss from the contract. In addition, say, if the contract is a unit-linked contract, the expected future surrender value is non-guaranteed and is not a "required" amount (but expected to be required) the entity need to repay to the policyholder.
The income statement generated from the above interpretation is:
Interpretation 3: Investment Component is…
The minimum amounts until the end of contract that an insurance contract requires the entity to repay to a policyholder even if an insured event does not occur
This interpretation attempts to strictly adhere to the standard's wording "required amount".[4] However, this will bring the 0 GCV issues back, like interpretation 1.
Interpretation 4: Investment Component is…
The higher of current amounts, or future expected amounts that an insurance contract requires the entity to repay to a policyholder even if an insured event does not occur
This interpretation takes the current amount required to repay, as well as the future expected amount together. It assumed the bounded rationality of the policyholder (and also the entity from a valuation perspective), such that he / she can only choose to lapse or not at the current period. Future repay amount is proxy by the expected present value of future outgoes per policy (BEL_PP).
The income statement generated from the above interpretation is:[5]
One may argue that, at the end it doesn't matter since investment component is only a line item in presentation, and the Revenue and Expense will cancel out each other so it has no impact on the Insurance Service Result (as indicated in the P&L result above).
Unfortunately, the IASB has decided in the final standard that, experience variance on investment component will unlock the CSM. [6] Hence, even it has no impact when actual equals expected, it does create P&L volatility if experience variance exists. You may take a look on the results generated by the above interpretations in appendix B if experience variance exists, and decide which approach makes up your mind.
The example that I have mentioned above demonstrated that why the choice of surrender value as the "amount required to repay" is insufficient, as it forfeits the obligation that may be required to fulfill in the future, which is also part of "the amount required to repay even if insured event does not occur".
Here is a summary for the 4 interpretations:
To conclude…what is the answer?
I don't know.
What do you think?
Appendix A: Key calculation steps
Appendix B: Experience Variance (10 times death)
Interpretation 1 or 3
Interpretation 2
Interpretation 4
[1] Basis for Conclusion: BC 34
[2] Standard: Appendix A
[3] Staff Paper 2B, April 2014
[4] In fact, I think the most correct way is to separate the guarantee cashflows and non-guarantee cashflows, use maximum amount for the guarantee part and minimum amount for the non-guarantee part to 100% address the wording "required amount" in the standard
[5] The differences between interpretation 4 and 2 is that, interpretation 4 considered the decrement transition for the policyholder in the future period, and interpretation 2 does not
[6] Standard: B96 (c)
In this article, I would discuss a long debated topic since 2013 ED, the investment component. The IASB thinks that, without investment component, the standard would not faithfully represents the similarities between financial instruments within the scope of IFRS 9 and investment component embedded in insurance contracts within the scope of IFRS 17.[1]
To understand the calculation and eventually the controversial part of investment component, let's start with the definition in the standard first:
The amounts that an insurance contract requires the entity to repay to a policyholder even if an insured event does not occur[2]
To better understand the issue, we shall start with an illustrative example.
Assume a single pay insurance contract with $10,000 payable upon death and maturity. Surrender value is linearly interpolated between years. Interest expense is 3% and actual investment return is 4%. Mortality is assumed level 0.5% and lapse rate level 1%. Premium is set equal to present value of outgo, plus a 10% margin. Risk adjustment and expense are assumed 0 for simplicity. We use Present Value of Number of Policies (PVNOP) as the CSM carrier.
Key calculation steps are shown in appendix A.
We further make the following assumption: Investment component per death is equal to the surrender value (or guaranteed cash value). [3] Therefore, the total investment component is defined by:
The income statement generated from the above setup is:
So far so good. Now, let's change the surrender value that it becomes 0 throughout the contract.
One can see that, the investment component becomes 0 from year 1-4. Since there are no surrender outgo nor survival outgo, and the investment component per death is nil, naturally it follows that the investment component is 0.
Here is the question: The contract is by nature a pure investment contract. The insured gets the same amount regardless of whether he died or not (unless he chooses to lapse). But the investment component is 0, contradicts the policy setup.
The weird situation illustrated above is coming from the fact that, even if an insured event (death) does not occur, 2 situations may occur, namely: lapse or infocre (not lapse). Only considering surrender value ignores the amount that is potentially payable if the policyholder chooses not to lapse.
For example, in the above example, If the policyholder chooses "not lapse", the value that he can get is actually 10,000 (Maturity Benefit or Death Benefit) instead of 0 (the Surrender Value).
And, if we extend the logic forward, actually we need to consider all future period for the possibility. And in each period, we do not know how the policyholder will act (whether he chooses to lapse or not).
This leads to the following possible interpretations for the definition:
Interpretation 1: Investment Component is…
The current amounts that an insurance contract requires the entity to repay to a policyholder even if an insured event does not occur
This is the preferred (or default?) option of how IASB interprets investment component. However, this definition will be problematic in the example I have introduced above.
Interpretation 2: Investment Component is…
The maximum amounts until the end of contract that an insurance contract requires the entity to repay to a policyholder even if an insured event does not occur
This interpretation is able to solve the example I have mentioned. However, this definition implicitly implies the policyholder is completely rational, which will choose the option (to lapse or not) to maximize his gain / loss from the contract. In addition, say, if the contract is a unit-linked contract, the expected future surrender value is non-guaranteed and is not a "required" amount (but expected to be required) the entity need to repay to the policyholder.
The income statement generated from the above interpretation is:
Interpretation 3: Investment Component is…
The minimum amounts until the end of contract that an insurance contract requires the entity to repay to a policyholder even if an insured event does not occur
This interpretation attempts to strictly adhere to the standard's wording "required amount".[4] However, this will bring the 0 GCV issues back, like interpretation 1.
Interpretation 4: Investment Component is…
The higher of current amounts, or future expected amounts that an insurance contract requires the entity to repay to a policyholder even if an insured event does not occur
This interpretation takes the current amount required to repay, as well as the future expected amount together. It assumed the bounded rationality of the policyholder (and also the entity from a valuation perspective), such that he / she can only choose to lapse or not at the current period. Future repay amount is proxy by the expected present value of future outgoes per policy (BEL_PP).
The income statement generated from the above interpretation is:[5]
One may argue that, at the end it doesn't matter since investment component is only a line item in presentation, and the Revenue and Expense will cancel out each other so it has no impact on the Insurance Service Result (as indicated in the P&L result above).
Unfortunately, the IASB has decided in the final standard that, experience variance on investment component will unlock the CSM. [6] Hence, even it has no impact when actual equals expected, it does create P&L volatility if experience variance exists. You may take a look on the results generated by the above interpretations in appendix B if experience variance exists, and decide which approach makes up your mind.
The example that I have mentioned above demonstrated that why the choice of surrender value as the "amount required to repay" is insufficient, as it forfeits the obligation that may be required to fulfill in the future, which is also part of "the amount required to repay even if insured event does not occur".
Here is a summary for the 4 interpretations:
|
#
|
Reason
for support
|
Reason
for decline
|
|
1
|
Simple
and practical, support by the IASB's examples
|
Ignored
future obligations
|
|
2
|
Most
prudent
|
Unrealistic
as assuming 100% rationality
Depends
on product feature, "required" amount can be guaranteed or
unguaranteed.
|
|
3
|
Strictly
adhere to the standard's wording "required amount"
|
Can
result in similar situation as indicated by interpretation (1).
Depends
on product feature, "required" amount can be guaranteed or
unguaranteed.
|
|
4
|
Balance
between the above approaches
|
Not
intuitive, does not imply from the wording in the standard
|
To conclude…what is the answer?
I don't know.
What do you think?
Appendix A: Key calculation steps
Appendix B: Experience Variance (10 times death)
Interpretation 1 or 3
Interpretation 2
Interpretation 4
[1] Basis for Conclusion: BC 34
[2] Standard: Appendix A
[3] Staff Paper 2B, April 2014
[4] In fact, I think the most correct way is to separate the guarantee cashflows and non-guarantee cashflows, use maximum amount for the guarantee part and minimum amount for the non-guarantee part to 100% address the wording "required amount" in the standard
[5] The differences between interpretation 4 and 2 is that, interpretation 4 considered the decrement transition for the policyholder in the future period, and interpretation 2 does not
[6] Standard: B96 (c)
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