MILLIMAN
“IFRS reserves are likely to be higher than GAAP reserves once the risk adjustment is taken into account, particularly in a low interest rate environment.”
amount, and therefore increase reserves, regardless of which risk adjustment method is used. Most relevant for captives are:
• The risk of low-frequency/high-severity events such as natural disasters;
• Long-tail lines of business such as workers’ compensation and excess liability insurance; and
• High layers of coverage.
IFRS reserves are likely to be higher than GAAP reserves once the risk adjustment is taken into account, particularly in a low interest rate environment. Higher reserves at the outset result in delayed recognition of income. The same dollar amount would be paid out as before IFRS, but the additional amount recorded as reserves cannot be counted as income until the insurance risk abates.
New models and new decisions to be made The risk adjustment will present perhaps the most daunting aspect of reserving for captives under the new accounting standards. Under IFRS it is defined as “the compensation the insurer requires to bear the risk that the ultimate cash flows could differ from those expected”, and it is an explicit entry on the balance sheet. The insurer should consider both favourable and unfavourable outcomes in a way that reflects its degree of risk aversion. Thus a captive that is more risk-averse would place more weight on the possibility that actual losses could exceed expected losses.
The July 2010 exposure draft from the IASB identifies three approaches to calculating the risk margin:
• Confidence level; • Conditional tail expectation; and • Cost of capital.
Each of these approaches involves complex actuarial analysis, but the choice of approach is as much a business decision as an actuarial one. Managers should be involved in the decision rather than simply delegating it to the actuary. Regulators and auditors are unlikely to view methodology-hopping favourably—making the initial decision all the more important.
Overall, the requirement to calculate the risk adjustment adds significant complexity to the reserving and reporting process, brings additional work for auditors, actuaries and accountants, and—for businesses that understand the importance of these matters to their balance sheets—means increased participation of business decision- makers, from board members to management.
Variability in financial results The chart in Figure 2 summarises the calendar-year incurred losses (defined as paid losses plus the change in the discounted loss reserve) for a sample captive with expected annual (undiscounted) losses of $100. Using a constant interest rate of 3.2 percent to discount the reserves (the average of the five-year US Treasury rates from 2002 to 2011) and a risk margin of 15 percent, the first-year incurred losses would be $105.85. Incurred losses for the second calendar year would be slightly lower, as the incurred losses of $105.85 for the second policy year would be offset by the decrease in the risk margin required of the first policy year.
When we introduce annual fluctuations in the interest rate for discounting (here using the actual changes in the five-year US Treasury rate from 2002 to 2011), we add fluctuations in the calendar-year incurred losses. Such fluctuations result in corresponding changes in annual underwriting income, and highlight the need to identify separately the impact of changes in the interest rate, changes in the risk margin, and actual loss experience.
76 CICA | Forty years of captive leadership
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