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April 2015

Alternative Approaches to Discounting Under the Spotlight

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Jason Malone, left, and Les Rehbeli

By Jason Malone, FCIA, and Les Rehbeli, FCIA

Those involved in the valuation and financial reporting of insurance contract or pension liabilities are probably aware of the current direction of the International Accounting Standards Board (IASB) with respect to the discounting of these liabilities to reflect the time value of money.

What may not be as commonly understood is that the respective IASB standards for insurance contracts—International Financial Reporting Standard 4 (IFRS 4)—and for pensions—International Accounting Standard 19 (IAS 19)—present different approaches to discounting the future liability cash flows. Considering the current research project undertaken by the IASB, one wonders whether the IASB will eventually seek convergence of the different approaches for discounting insurance versus pension liability cash flows. This article explores some of the similarities and differences in approaches between these two standards.

In principle, both standards are attempting to achieve a similar goal: to discount the liability cash flows at a rate that reflects the characteristics of the liability. The differences lie in the level of judgment left to the practitioners to derive the discount rate. Where the insurance standard outlines a principle-based approach to derive the appropriate discount rate, the pension standard offers a more prescriptive approach.

The IFRS 4 exposure draft (ED) released in 2013 requires insurers to discount the future cash flows using discount rates that are consistent with observable market prices for instruments whose characteristics reflect those of the insurance contract liability in terms of timing, currency, and liquidity. It also directs insurers to ignore any factors that influence the market rates that are not relevant to the insurance contract liability. What this means is that the discount rates reflect any illiquidity premiums observed in market pricing, but ignore credit risk premiums, as these are unrelated to the liability. Practically, the ED offers two approaches for deriving these discount rates but, in theory at least, these should result in the same answer. Under the first approach, "top-down", an insurer would base the calculation on the observed yields of a portfolio of assets that supports the liability, and remove any credit risk premiums inherent in the market prices. By contrast, the "bottom-up" approach begins with the observed risk-free rates and adds an illiquidity premium, where the illiquidity premium reflects the liquidity of the liability. In certain cases (for example, where the policyholders’ return is linked to the performance of underlying assets as would occur with participating insurance or universal life insurance), the discount rate is set in relation to those underlying returns, reflecting a principle called "mirroring".

In the current version of IAS 19, the standard requires plan sponsors to discount future cash flows with the applicable high-quality corporate bonds. In countries where there is no deep market for such bonds, government bonds shall be used. In Canada, our market has been defined as "liquid"; thus high-quality corporate bonds are used to determine the discount rate for post-employment benefit programs. They have been interpreted to be a corporate bond with the two highest ratings given by credit rating agencies, such as Aa. This application stems from a letter sent to the Financial Accounting Standards Board by the Securities Exchange Commission more than 20 years ago. Most standard-setters globally have looked at this approach to determine the rate and in most cases have not strayed away from the Aa approach. In particular, the IASB’s IFRS Interpretations Committee has discussed the discount rate methodology numerous times in the past decade and although there is no unanimity on the current approach, there is no other approach that does have unanimity.

Both the insurance and pension approaches have many practical challenges for application in Canada. The key challenge faced by both is a lack of depth of publicly traded long-duration assets that match the duration of the liabilities, which generally extend much longer than the available assets. This requires insurers and post-employment benefit plans to develop approaches for extrapolating observed market prices beyond the duration at which the last market price is observable. At this point, can we still say that the discount rate is based on the market? IFRS 4 addresses this by clarifying that the discount rates cannot be inconsistent with observed market rates, implying that any reasonable extrapolation approach could be used. IAS 19 states that the discount rate for longer maturities can be extrapolated using market rates along the yield curve.

Another key challenge that is seemingly unique to insurance contract liabilities is the selection of an appropriate illiquidity premium in a bottom-up approach. One first needs to classify the liability in terms of how liquid one perceives it to be. One then needs to be able to derive illiquidity premiums from the observed asset market prices. The former is difficult to achieve, as insurance contract liabilities are not generally traded and are not really considered "liquid" in the market sense of the word. And splitting the discount rate into its component parts (for example, risk-free yield, credit spread, and illiquidity premium) can also be an abstract challenge, especially in a market where there is limited depth of corporate bond issues. How much of the observed risk premium is truly attributed to credit versus liquidity?

Some practitioners are therefore considering the top-down approach as being easier to implement, although one still has to address the decomposition of asset market risk premiums into credit versus liquidity. The liquidity question is also a key item within the benefits area. As noted earlier, under IAS 19, corporate bonds can only be used if there is a deep enough market. The measure as to whether or not the market is deemed deep is not well defined and is left to the practitioners’ judgment. The impact can be quite significant as discount rates would revert to government, which can be significantly lower. One can question whether or not the Canadian market is deep enough with a handful of Aa corporate bond issues beyond 10 years but the Canadian community has accepted that it is in fact deep and as such uses the corporate bond environment to define discount rates.

A final topic relates to disclosure of changes in discount rates from period to period. This is a complex topic in the insurance valuation world, and varies based on whether the contracts are participating or non-participating. For non-participating policies, practitioners also will be required to value certain components of the liability at discount rates originally determined at contract issue, and present the resulting changes in liabilities as part of regular income, while presenting changes due to current market consistent discount rates as part of Other Comprehensive Income, or OCI. For participating insurance, the rules and considerations are still being discussed for the application of this principle. The volatility of the corporate market from year to year is also a big issue in the post-employment environment. IAS 19 (Revised) has moved some of the volatility off the profit and loss statement and onto the OCI, but plan sponsors are still struggling to adjust to the rapid movement of interest rates of the past several years.

As can be seen, there are many similarities in approaches between the two standards. Time will tell whether the IAS will ultimately move to converge the approaches.

Jason Malone, FCIA, is a member of the International Relations Council. Les Rehbeli, FCIA, is Vice-chair of the International Insurance Accounting Committee.

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