CSM assumption adjustments

[Viridian]

There is an Acted paragraph in the notes that says:
"If changes are made to non-investment assumptions, the CSM is adjusted to offset any resultant change in the BEL and RA. The total liability remains unaffected by the assumption change"

What is the rationale behind adjusting the CSM directly for changes in assumptions? How is this adjustment made? Also unclear on what exactly it means by saying the total liability is unaffected by the assumption change?

Any help appreciated!

 

[Lindsay Smitherman]

Hi

As an example, let's say that the company has decided that future mortality is going to be lighter than it previously thought, so reduces its mortality assumptions on term assurance business and that results in the BEL+RA reducing by 100. At the same time, the CSM would be adjusted by increasing it by 100 to offset that reduction.

Thus the total liability (BEL+RA+CSM) is unaffected by the assumption change.

The aim is to avoid having a 'lumpy' emergence of profits and to avoid capitalising profits that relate to future events ('future services' in IFRS parlance). There is no one-off profit arising when the assumptions are changed (in this example, without the CSM adjustment there would have been an extra 100 of profit). Instead, the higher CSM (ie the extra 100) would be released gradually over the run-off of the cohort. Hence the profit impact of the assumption change is smoothed over time.

Hope that helps?

 

[Viridian]

Thanks Lindsay - that's a lot clearer now. And why is it not the same approach for changes in investment assumptions?

 

[Lindsay Smitherman]

Ah - great follow-up question! The SA2 course doesn't go into this detail, but FWIW my hunch is as follows:

For the BBA method, we are talking about conventional without-profits products - so the only investment assumption used for the liability valuation would be the discount rate, which is risk-free.

Such business would typically be backed by fixed-interest bonds, and may be pretty well matched. So if risk-free rates fall (or are expected to fall), the value of liabilities would increase but the value of the backing assets would increase correspondingly, as the yield curve is pushed down (and vice versa if risk-free rates increase).

Hence overall there would be no one-off profit emerging from the investment assumption change (other than to the extent that the assets and liabilities are mismatched), so no need to make an offsetting CSM adjustment.

Hopefully that sounds plausible!

 

[Viridian]

It does sound plausible, but hypothetically in the event that matching isn't perfect, I'm unclear on how CSM would be impacted by a change in the discount rate. There's another section under the VFA part, that states:

"If the discount rate increases, the BEL and RA will fall. Under the BBA approach, similar to Solvency II, this will create a release of profits (which will be shown in the profit and loss statement (P&L) or income statement). In contrast, under the VFA approach, this profit release will get absorbed by the CSM"

This seems to suggest that an emergence of profit from the discount rate change is possible under BBA - but it's released straightaway.

 

[Lindsay Smitherman]

Yes, there can be some release of profit (or a loss) under the BBA approach if risk-free rates change: the overall amount of such profit/loss will reflect the extent of any mismatch between assets and liabilities (as I indicated above). This is as there would be under Solvency II for such products.

You asked why the CSM isn't adjusted under the BBA for a discount rate change. The rationale is as I explained: that there should be an offsetting movement in assets, so the overall impact of an investment assumption (ie discount rate) change isn't anywhere near as significant as would be the impact of a non-investment assumption change. Particularly since, for the type of products covered by the BBA, the assets and liabilities are likely to be fairly well matched.

If the CSM was adjusted to offset the change in {BEL+RA} from a discount rate change (in the same way that it is for a non-investment assumption change), there would be a significant one-off profit at that time (since the asset value would move but the liability value wouldn't) - which would go against the idea of smoothing profit emergence. Hence the CSM is not adjusted under the BBA for a discount rate change.

On the other hand, as explained in the course notes, the CSM is adjusted under the VFA method for an investment assumption change.

So in answer to your point 'I'm unclear on how CSM would be impacted by a discount rate change' the answer is:
- Not impacted at all under the BBA
- Adjusted under the VFA

 

[Michal Piatra]

It does sound plausible, but hypothetically in the event that matching isn't perfect, I'm unclear on how CSM would be impacted by a change in the discount rate. There's another section under the VFA part, that states:

"If the discount rate increases, the BEL and RA will fall. Under the BBA approach, similar to Solvency II, this will create a release of profits (which will be shown in the profit and loss statement (P&L) or income statement). In contrast, under the VFA approach, this profit release will get absorbed by the CSM"

This seems to suggest that an emergence of profit from the discount rate change is possible under BBA - but it's released straightaway.

Under the BBA, the BEL (or PVFCF in IFRS17 terms) is valued at locked-in discount rates. These are locked assumptions for yield curves at the initial recognition of the contract. The changes on the PVFCF which which are offset by the CSM are valued using these locked-in rates. Hence, there is no impact from the change of discount rates as these are fixed from the beginning of the contract.
E.g. there is assumption update of mortality, so we take the impact on future cashflows discounted at the locked-in rates, this impact is then offset by the movement in the CSM.

However, on the balance sheet the PVFCF is valued at the current discount rates. This is not reflected in the CSM, therefore the difference between locked-in value of PVFCF and current value of PVFCF has to flow through somewhere. This is what the paragraph is saying about. It can be either through P&L or OCI based on the individual company's decision I think. This should be then offset by the movements in Assets as Lindsay described.