IFRS 17 identifies two types of variable that can affect cash flow estimates [IFRS 17 B42]:
- Market variables (i.e., those that can be observed in, or derived directly from, markets (for example, prices of publicly-traded securities and interest rates))
- Non-market variables (i.e., all other variables, such as the frequency and severity of insurance claims and mortality)
Market variables affect estimates of cash flows in participating contracts (contracts with participation features), and non-participating contracts, e.g., if cash flows vary with changes in an index for price inflation.
Estimated cash flows reflect the perspective of the entity, provided that estimates of any relevant market variables are consistent with observable market prices for those variables. IFRS 17 has similar requirements to IFRS 13 Fair Value Measurement for maximising the use of observable inputs when estimating market variables [IFRS 13 3]. Consistent with IFRS 13, if variables need to be derived (for example, because no observable market variables exist) they need to be as consistent as possible with observable market variables [IFRS 17 B44].
The standard refers to the notion of a replicating asset or replicating portfolio of assets as a means of measuring the liability based on market information. A replicating asset is one whose cash flows exactly match, in all scenarios, the contractual cash flows of a group of insurance contracts in amount, timing and uncertainty. In some cases, a replicating asset may exist for some of the cash flows that arise from a group of insurance contracts. The fair value of that asset reflects both the expected present value of the cash flows from the asset and the risk associated with those cash flows. If a replicating portfolio of assets exists for some of the cash flows that arise from a group of insurance contracts, the entity can use the fair value of those assets to measure the relevant fulfilment cash flows instead of explicitly estimating the cash flows and discount rate [IFRS 17 B46].
IFRS 17 does not require an entity to use a replicating portfolio technique. Judgement is required to determine the technique that best meets the objective of consistency with observable market variables in specific circumstances. In particular, the technique used must result in the measurement of any options and guarantees included in the insurance contracts being consistent with observable market prices (if any) for such options and guarantees [IFRS 17 B48].
The application guidance is clear that although market variables will generally provide a measurement basis for financial risks (e.g., observable interest rates) this will not always be the case. The same is true for non-financial risks and non-market variables. For example, some non-financial risks could be observable in markets, whereas not all financial risks will be observable.
In practice, we believe that the use of a replicating portfolio is likely to be rare as IFRS 17 refers to an asset whose cash flows exactly match those of the liability.
Estimates of non-market variables should reflect all reasonable and supportable evidence available without undue internal or external cost or effort [IFRS 17 B49]. Entities need to assess the persuasiveness of information from different sources, as shown below: Market and non-market variables cash flow estimation
Persuasiveness of internal and national mortality statistics [IFRS 17 B50]
An entity that issues life insurance contracts should not rely solely on national mortality statistics. It should consider all other reasonable and supportable internal and external information available without undue cost or effort when developing unbiased estimates of probabilities for mortality scenarios for its insurance contracts. For example: Market and non-market variables cash flow estimation
- Internal mortality statistics may be more persuasive than national mortality data if national data is derived from a large population that is not representative of the insured population.
- Conversely, if the internal statistics are derived from a small population with characteristics that are believed to be close to those of the national population, and the national statistics are current, an entity should place more weight on the national statistics. Market and non-market variables cash flow estimation
Estimated probabilities for non-market variables should not contradict observable market variables. For example, estimated probabilities for future inflation rate scenarios should be as consistent as possible with probabilities implied by market interest rates [IFRS 17 B51]. Market and non-market variables cash flow estimation
In some cases, market variables and non-market variables may be correlated. For example, there may be evidence that lapse rates (a non-market variable) are correlated with interest rates (a market variable) [IFRS 17 B52]. Similarly, there may be evidence that claim levels for house or car insurance are correlated with economic cycles and therefore with interest rate inflation. The entity should ensure that the probabilities for scenarios and risk adjustments for non-financial risk that relate to market variables are consistent with the observed market prices that depend on those variables [IFRS 17 B53]. Market and non-market variables cash flow estimation