Discount rate to be used for insurance contracts
Discounting is a significant issue for long-term insurance contracts. Some argue that insurers often price the policies using as a discount rate a rate of return on their investments, and to use a different rate, such as a risk free rate, would lead to day one losses.
Taking account of past decisions to use 'building blocks' measurement model, not to fair value liability and specifically not to include own credit risk, the staff developed an objective for the discount rate. It is to adjust the estimated (probability-weighted) cash flows for the time value of money in a way that reflects the characteristics of the liability, and not those of the assets used to fund insurance liabilities, unless the cash flows to the policyholders are linked to the performance of such assets, as in the case of participating contracts. In particular, the discount rate should take into account the liquidity risk, as this is a risk present in the liability and is not reflected in the other 'building blocks'. Both the IASB and FASB members were unanimous in supporting this objective and liquidity risk was thought to address some of the 'day one loss' concerns.
There was some discussion about how best to estimate the discount rate. The staff suggestions were:
- not to prescribe a detailed guidance beyond that of the measurement objective, or
- to suggest using a high quality corporate bond as an easy to use and comparable discount rate, that is consistent with the IAS 19 pension accounting.
The first method would result in the discount rate being a risk free rate plus a liquidity premium. Using the high quality corporate bond was not supported because, while more practical, it seems to be a proxy for own-credit risk, some countries do not have such bonds, and it is less theoretically sound. The debate then focused on own-credit risk, since it is not specifically addressed in the proposed objective. A number of FASB and IASB members wanted to include it.
Including own-credit risk would improve matching of the performance of insurance contracts and the insurance investments where investments are carried at fair value. However, referring to the recent IFRS 9 project decisions on own-credit risk, the FASB suggested that the discount rate should be based on the characteristics of the liability, being the risk-free rate plus liquidity risk, that the ED should include separate questions about an adjustment incorporating own-credit risk. Both Boards agreed unanimously. The Boards then voted unanimously to include specific guidance from the relevant IASB/FASB literature on the principles of how to estimate the discount rate to avoid double-counting of risk.
On participating contracts, the staff recommend considering the return on the linked assets where this influences, even if partially, the insurance contract cash flows. If the linked assets represent a 'replicating portfolio' that fully matches actual cash flows of insurance liability in all cases and can be measured directly, then no need to use a building blocks approach. If not, the return on linked assets should be considered in arriving at a discount rate that reflects characteristics of the liability, as per the agreed objective. The FASB members clarified that for assets the discount rate discounts contractual rather than expected cash flows. There is a need to avoid double-counting of the risk of uncertainty of cash flows in both expected cash flows and discount rate. Using a replicating portfolio, if it exists, avoids this double-counting. IASB - all but one member/FASB - unanimously supported the staff's suggestion, subject to seeing it clarified as above.