IFRS 17 Series Implementing IFRS 17 Discount Curves:

Author Theoretical and Practical Challenges

Steven Morrison
Senior Director-Research Introduction
IFRS 17 requires liability cash flows to be discounted at rates that reflect the characteristics of
Contact Us the cash flows including their liquidity. As a principles-based standard, IFRS 17 does not specify
Americas liability discount rates and entities must develop their own assumptions. Such assumptions
+1.212.553.1658 are important as they could have significant implications for the IFRS 17 balance sheet, future
[email protected]
profits, and volatility.1 This has reignited the classical actuarial debate of how to estimate the
Europe illiquidity premium, a topic which has occupied actuaries since the introduction of market-
+44.20.7772.5454
[email protected] consistent reporting in the early 2000s. Recently, significant thought and effort have gone into
the specification of IFRS 17 discount rates allowing for liquidity.2
Asia (Excluding Japan)
+852.2916.1121
[email protected] The challenge of incorporating the illiquidity premium extends beyond estimating its size. For
Japan
example, the insurer might apply the illiquidity premium to products where stochastic models
+81.3.5408.4100 are used for valuation. This presents its own set of challenges, both theoretical and practical,
[email protected] to which insurers are now turning their attention. In this paper, we compare two potential
approaches.

Valuation of contracts with participation features under IFRS 17

IFRS 17 does not prescribe the methodology for valuation of contracts with participation
features, in particular contracts with embedded guarantees. However, a standard approach
adopted in other contexts (such as calculation of Best Estimate Liabilities under Solvency II) is
to use stochastic modeling techniques with scenarios generated using a risk-neutral Economic
Scenario Generator (ESG).

Discount rates are used in two separate parts of this calculation:

»» To discount liability cash flows.
»» To calculate returns on underlying items. In a risk-neutral ESG, the expected returns on all
assets are equal to the assumed “risk-free” interest-rate.

Now, it seems consistent with the principles of the standard that (stochastic) liability cash
flows are discounted using a rate that reflects the liquidity characteristics of those cash flows.
What is less clear is whether expected returns on the underlying items should be equal (on
average) to the liability discount rate, or some other rate?
1 Profit Emergence Under IFRS 9 and IFRS 17: The impact of choice of liability discount rate, Gavin Conn & Steven Morrison
https://www.moodysanalytics.com/-/media/article/2019/profit-emergence-under-ifrs9-ifrs17-the-impact-of-choice-of-
liabillity-discount-rate.pdf
2 A cost of capital approach to estimating credit risk premia, Alasdair Thompson & Nick Jessop
https://www.moodysanalytics.com/-/media/article/2018/a-cost-of-capital-approach-to-estimating-credit-risk-premium.pdf

MOODY’S ANALYTICS IMPLEMENTING IFRS 17 DISCOUNT CURVES: THEORETICAL AND PRACTICAL CHALLENGES 01
The Single Yield Curve approach
There is a precedent for this question. The Solvency II Volatility Adjustment (VA) is an adjustment to risk-free interest rates that can be
interpreted as allowing for the illiquidity of liabilities in the calculation of the Best Estimate Liabilities (BEL). In our experience, insurers
using stochastic modeling techniques to calculate the Solvency II BEL have typically incorporated the VA both in the rate used to
discount liability cash flows and in the rate used to calculate average returns on assets.3 We call this approach the Single Yield Curve
approach since a single yield curve is used both for calculating returns on assets and for discounting.

To illustrate, suppose that we have a contract where the policyholder receives the value of an underlying fund in 10 years’ time,
subject to a minimum guarantee equal to the initial market value of the assets in the fund. We assume no charges for simplicity.

Figure 1 shows how the value of this liability, as a proportion of the initial market value of the underlying fund, varies depending on
the assumed illiquidity premium on the liabilities.4 The value is broken down into two components: (1) the value of the policyholders’
claim on the underlying fund; (2) the value of any guarantee shortfalls (the Cost of Guarantees).

Figure 1: Example liability valuations under the Single Yield Curve approach

We note that the Cost of Guarantees decreases with increasing illiquidity premium, partly because the cash flows are being
discounted at a higher rate, but also because the average return on the fund is assumed to increase with the illiquidity premium and
so the guarantee is less likely to bite. We also see that the main component of the liability, the value of the policyholders’ claim to the
underlying fund, is always equal to 100% of the initial market value of the assets in the fund and does not depend on the illiquidity
premium. The rate used to discount is exactly equal to the average return on the underlying fund and so cancels out in the valuation.

3 Such an approach is proposed in Practical application of Liquidity Premium to the valuation of insurance liabilities and determination of capital requirements, CRO Forum
(2011), which suggests “a proportion of the liquidity premium should be added to the swap curve for both the accumulation and discount rate.”
4 Valuations assume a Black-Scholes model with a “risk-free” rate of 2% (+ illiquidity premium) and fund implied volatility of 10%.

MOODY’S ANALYTICS IMPLEMENTING IFRS 17 DISCOUNT CURVES: THEORETICAL AND PRACTICAL CHALLENGES 02
From an implementation point of view, the single yield curve approach simply involves replacing the risk-free yield curve in the
ESG with the liability discount curve. We note, however, two potential issues with the approach, the first practical and the second
theoretical:
»» When you change the risk-free yield curve in an ESG, it typically has a knock-on effect on asset prices that are calculated in the ESG.
Risk-free bond prices obviously change, as do corporate bond prices, and option prices.
Some insurers have tried to adjust for such impacts by recalibrating other parameters in the ESG to compensate for these changes.
In particular, if the liability discount curve incorporates an illiquidity premium (and so risk-free rates are higher than those implied
from risk-free assets in the market), the insurer can recalibrate the ESG credit spread model to ensure that the model still recovers
market corporate bond yields. This is achieved by assuming that model credit spreads are lower than market spreads to offset the
assumed illiquidity premium. However, this approach has its limits: where corporate bond prices are trading at a spread that is
lower than the assumed illiquidity premium,5 these prices cannot be matched by the model unless it permits negative spreads.

More importantly, such changes to risk-free rates and credit spreads could (depending on the choice of ESG models) result in
changes to volatility of asset returns, which in turn result in changes to prices of options on those assets. Though such changes
could be allowed for in recalibration of other model parameters, this creates an additional calibration effort which could be
significant.

The calibration issues can be avoided by applying the illiquidity premium as an adjustment to ESG outputs, such as asset returns
and discount factors, rather than adjusting the ESG’s input risk-free yield curve (and other calibration parameters). However,
application of such adjustments is likely to require implementation effort within the ESG and/or cash flow model.

»» If you assume an illiquidity premium on liability discount rates, it seems natural to expect a corresponding illiquidity discount in
liability valuations. Using the Single Yield Curve approach, we observe this behavior in the valuation of the Cost of Guarantees.
However, we do not see it in the valuation of the policyholders’ claim to the underlying fund, which is always equal to the market
value of the underlying fund regardless of the assumed illiquidity premium. If we expect to see that the illiquidity premium is
reflected in the valuation of the policyholders’ claim to the underlying fund, we need a different approach.

The Dual Yield Curve approach

An alternative approach is to use two different rates:
1. Rate used to discount liability cash flows = risk-free rate + liability illiquidity premium.
2. Expected return on underlying items = risk-free rate + asset illiquidity premium.6

We call this approach the Dual Yield Curve approach.

Figure 2 shows how the value of the example contract varies with the liability illiquidity premium under the Dual Yield Curve
approach. Here we assume an asset illiquidity premium of 20 bps, and the liability illiquidity premium is expressed in terms of its
difference relative to the assumed asset illiquidity premium.

5 For example, this could be the case for bonds with a higher credit quality than the average rating of the bonds in the reference portfolio used to derive the illiquidity
premium.
6 Strictly speaking, expected returns on each individual asset class are adjusted for their specific illiquidity premia.

MOODY’S ANALYTICS IMPLEMENTING IFRS 17 DISCOUNT CURVES: THEORETICAL AND PRACTICAL CHALLENGES 03
Figure 2: Example liability valuations under the Dual Yield Curve approach

As with the Single Yield Curve approach, the Cost of Guarantees decreases with increasing illiquidity premium because the cash flows
are being discounted at a higher rate. However, the effect is less than in the Single Yield Curve approach (as under the Single Yield
Curve approach there is an additional effect due to the liability illiquidity premium impacting on the expected return on assets).

More significantly, the value of the policyholders’ claim to the underlying fund is only equal to the market value of the underlying
fund in the case where liability and asset illiquidity premia are the same. If the liability illiquidity premium is greater than that on the
underlying assets, the policyholders’ claim to the underlying fund is valued at a discount to the market value of the fund, reflecting
that the policyholder has given up some liquidity by accessing the fund through an insurance “wrapper” (rather than buying the fund
assets directly). On the other hand, if the liability illiquidity premium is less than that on the underlying assets, the policyholders’
claim to the underlying fund is valued at a premium to the market value of the underlying assets, reflecting that the insurance
wrapper provides additional liquidity in this case (relative to buying the fund assets directly).7

In terms of practical implementation within an ESG, both the Single Yield Curve and Dual Yield Curve approaches assume that the
expected return on assets includes an illiquidity premium relative to the risk-free rate, with the liability illiquidity premium being
used in the former case and the asset illiquidity premium being used in the latter. As noted in the discussion of the Single Yield Curve
approach in the previous section, the implementation of an illiquidity premium as an adjustment to the risk-free curve can create
issues related to calibration of other ESG assumptions, in the event that the liability illiquidity premium exceeds the market spread on
assets. The Dual Curve approach should avoid this problem, as the assumed asset illiquidity premium should never exceed the asset’s
market spread. Alternatively, the asset illiquidity premium can be implemented as an adjustment to ESG output asset returns, rather
than adjusting the ESG’s input risk-free yield curve. Either way, the liability illiquidity premium would be applied as an adjustment to
output discount factors.

7 Similar differences are observed in closed-end funds, which often trade at a discount or premium to the underlying Net Asset Value. This “puzzle” is sometimes (at least
partly) attributed to relative liquidity differences between the underlying assets and the closed-end fund.

MOODY’S ANALYTICS IMPLEMENTING IFRS 17 DISCOUNT CURVES: THEORETICAL AND PRACTICAL CHALLENGES 04
What is the ‘right’ approach?
As far as we are aware, there is no standard accepted theory of valuation incorporating illiquidity. In particular, the classic option
pricing literature is based on a dynamic replication argument that makes no allowance for the illiquidity characteristics of the cash
flows being replicated, nor those of the replicating portfolio. So what is the “right” approach?

Unfortunately, the standard itself does not provide a definitive answer. As IFRS 17 does not prescribe the methodology and
assumptions to be used in valuing liabilities, insurers need to use judgment as to the appropriate approach given their views on
illiquidity, and be able to justify such assumptions to auditors. In particular, the incorporation of illiquidity premia into existing
stochastic modeling approaches could result in changes to the interpretation of standard accepted tests of appropriateness (in
particular “martingale” or “1=1” tests), requiring careful communication with auditors.

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