"Market Observable data" vs "Risk Free rate" vs "Asset yield"

[Trevor]

Hi, I am trying to understand what market observable data means.

As the name suggests, I understand "Market Observable" as an actual asset yield because that is what analysts will see.
However this kind of contradicts the passage in the CMP about IFRS17 BBA.

In the CMP chapter 17 page 13, it says the discount rates are based on market observable data, and then saying it is similar to Solvency II BEL.
This could imply market observable data = risk free rate.


The examiner report in the 2020 April question 1 vi mentions (end of page 5 - start of page 6):

• Current market rates are low
• Even with allowance of default, this part ("this" refers to the liabilities I assume?) IFRS 17 > IFRS4

(Can someone clarify what does "this part" refers to? I am finding it really difficult to understand the explanation)

if current market rates are low, shouldn't the "market observable data" and asset yield both decrease? Because the actual asset yield is what the market actually observe.

Also, does the market observable data incorporate any default risk premium already?
The way I explain this answer is saying, it depends on how the company's credit default adjustment compared to those already allowed within the market observable data.
If the company allows for lesser of it, and asset yield = market observable data,
then the risk discount rate used by the IFRS 17 will be higher
and therefore reduced liability.

 

[Lynn Birchall]

Hi

Yes, market observable data would include actual asset yields on assets, including bonds. It would also include bond yield curves.

Market observable data is not the same as the risk-free rate. Chapter 17 page 13 says that under BBA IFRS 17 the discount rate is derived from observable market data. The market data is likely to be adjusted to get to the risk-free rate. In particular, a deduction for credit risk is likely to be made.

In the April 2020 Q1 vi solution extract that you refer to, I'm interpreting 'this part' to be the impact of the discount rate change on the annuity liabilities.

Best wishes
Lynn

 

[Trevor]

Market observable data is not the same as the risk-free rate. Chapter 17 page 13 says that under BBA IFRS 17 the discount rate is derived from observable market data. The market data is likely to be adjusted to get to the risk-free rate. In particular, a deduction for credit risk is likely to be made.

Hi Lynn, thanks for the clarification. The core reading mentions the discount rate is derived from market observable data, so is it that:
IFRS 17 discount rate = market observable data (yield on actual backing asset) - credit risk premium - (and anything else) = adjusted to risk free rate ~= risk free rate = Solvency II discount rate?

Therefore, IFRS17 discount rate = Solvency II discount rate? (assuming no matching adjustment)

If this is correct, then the solution will make sense as:
Current interest rates are low, so risk free rate (based on yield curve) will be lower than actual yield of backing assets.
Risk free rates are so low that even after deducting credit risk from actual asset yield, the asset yields are still higher than risk free rates

 

[Lynn Birchall]

Yes in broad principle to your relationship between the IFRS17 discount rate and the Solvency II discount rate provided your '(and anything else') includes subtracting an illiquidity premium.

Then, in circumstances where an illiduity premium was appropriate, I think I'd tweak it to go for something more like the broad principle being:
IFRS 17 discount rate = market observable data - credit risk premium = discount rate that incorporates the risk free rate and an illiduidy premium ~= Solvency II discount rate (that is made up of risk free rate + MA)

Worth me saying that none of these are really '=' in practice! In practice, the approach taken to determining the rates and the adjustments for Solvency II and IFRS17 will depend on the detail of the particular rules and standards.

 

[Trevor]

I see, thanks for the clarification, its clear now!
The reason I am aware that the 'anything else' includes liquidity risk premium, but there may be other items such as the downgrade risk, and possibly any other items I'm not aware of.

Since we are in this question, can I ask another part of the solution that I don't understand too?
In the same question, the end of page 5 of the examiner report compares the IFRS17 BE Assumption against the current IFRS BE assumption plus small margin for prudence.
and then goes on saying "this part" (assume they meant discount rate or profit) IFRS 17< IFRS 14.

However later in the solution, it compares the IFRS 17 Risk adjustment (RA) against the small margin.
Is the small margin double counted?
ie: the BEL + small prudence for margin is compared against the 'fulfilment cashflows' & 'time value of money' of IFRS 17 (BEL equivalence)
and then this small prudence for margin is re-considered again when comparing with the RA of IFRS 17

I would have matched the current BEL against the 'fulfilment cashflows' & 'time value of money';
and the prudence margin against the RA
If I see it this way, the only factor that causes difference will be how the RA compares with the prudence margin (ignoring the CSM)

 

[Lynn Birchall]

Hi

If I've understood your post correctly, then your understanding of this comparison seems sound to me

At the end of page 5, I'm reading the solution as basically saying 'if we compare the IFRS 4 reserve (using BE assumptions + margins for prudence) with the IFRS17 reserve (BEL), then all else being equal IFRS 4 reserve > IFRS17 reserve.

And then later the solutions is making a different comparison and essentially saying if we're comparing IFRS 4 reserve with IFRS 17 (BEL + RA) then the comparison depends on how the RA compares with the prudence margins as you say.

Hope that reassures
Thanks
Lynn