Impact of Covid-19 on margins over and above best estimate assumptions in financial reporting

Meeting

A group of Life actuaries, working as part of the IFoA Covid-19 Action Taskforce (ICAT) have been considering various ways that the pandemic has affected Life insurers.

This blog is discussing considerations when setting margins over and above best estimates assumptions in financial reporting.

Introduction

Assumptions, whether operating or economic, play an important part in placing a value on an insurers’ liabilities or determining the premium paid for a life insurance policy. Assumption setting has been a subjective area of actuarial work. Firstly, data is required to set assumptions whether internal or external to the company.  Secondly, the data needs to possess certain attributes to make it a reliable input to the actuarial process to reflect the likely future experience. However, despite all the efforts, the assumption setting process can still be perceived as more art than science.

Key considerations

With this in mind, and in order to improve consistency and transparency, financial reporting metrics have set out high-level principles around setting assumptions over the years. A common theme that has emerged is the requirement to set the assumptions on a ‘best estimate’ basis with no prudential margins. The best estimate bases have been synonymous with ‘probability-weighted’ scenarios or cash flows. This may not be straightforward to observe by external parties given the disclosures.

In any case, best estimate assumptions are an ‘estimate’. For this reason, a margin for uncertainty is required. Allowance for this uncertainty evolved over the years under various supplementary reporting metrics, eventually leading to the risk margin in Solvency II. However, the purpose of risk margin was distorted primarily due to the low-interest rate environment in recent years.

In summary, best estimate assumptions should be considered including an appropriate risk allowance for any uncertainty. The allowance of such margins may be perceived as a departure from the best estimate basis.

Covid-19 has increased a whole range of uncertainties to an unprecedented level. This uncertainty can be seen as a challenge to the robustness of assumptions to be used for year-end valuation. But it is an opportunity for actuaries to advise management in decision support by highlighting scenarios as a result of the assumption setting process.

Although most valuation bases will take the long-term view, the impact of potential volatility in the next few years should not be discounted. The smoothing of past experience should not lead to a sudden jump in the best estimate assumptions. As always, the year-end valuation process will require the interaction of different assumptions coming together to form a holistic view of a company’s financial results where the ultimate sign-off will have to be given by the company management.

The allowance for margins depends on the financial reporting framework and the methodology in place in a particular company. It can be argued that reporting culture and even geographical location may play a part around whether assumptions are genuinely ‘best estimate’ or ‘best estimate with prudence’. Ideally, the margins should not be in lieu of ‘prudence’ but merely an extension to justify a best estimate basis. Depending on the company practice, it will not be uncommon to see Covid-19 provisions to be set in place to reflect the uncertainty associated with demographic, persistency and expense assumptions. The margins to address uncertainty arising from Covid-19 will be those which are clearly explained and monitored separately to give comfort to the users of financial accounts. These should also be supported with ‘Covid-19 sensitivities’ to give context around the future scenarios. It may be difficult to imagine the next ‘new normal’ on the eve of year-end reporting 2020. But that’s why margins can be used as a path to converge to the long-term assumptions of the next new normal, possibly unwinding depending on how the pandemic evolves.

Conclusion

This year-end will be no different, perhaps with the exception of financial reporting actuaries working from home and the additional uncertainty that need to be addressed in the assumption setting process. There will then be the usual competing priorities in year-end financial results where we believe that the allowance of margins, either way, is plausible and can be accepted as long as the assumption setting process is equally science as it is art.

 

*The members are Anjali Mittal, Burcin Arkut, Isha Aggarwal, Isha Kulkarni, Jagrit Bagga, James Gillespie, Justine Morrissey, Mcebisi Dhlamini, Nainjeet Juneja, Natalia Mirin (Workstream Lead), Roy Perlson, Sanjoli Choudhary and Thomas Treacy.