Acknowledgment of insurance contracts

1. There are cases where back-dated applied. The data occur in 2023, Company
received the Premium in 2023 but the insurance start date is backdated to 2021.
Is it allowed to recognize the insurance contract from the initial date the
premium is received (2023)? Or this should be from insurance start date (2021)?
What is the +/- (impact) for those options?
If recognition at the initial date the premium is received is allowed, how far the
time gap is allowed between insurance start date and premium received date?
Fyi, Perta is planning to use following approach:
• Non-Saving Product: Insurance start date (2021)
• Saving Product: Initial date the premium is received by the Company (2023)

Under IFRS 17, an insurance company should recognise a group of insurance

contracts at the earliest of the following dates:

- The Beginning of the Coverage Period of the Group of Contracts: This is the
date when the insurance coverage begins.
- The Date When the First Payment from a Policyholder in the Group Becomes
Due: This is the date when the company becomes entitled to a payment from
the policyholder.
- The Date on Which the Group Becomes Onerous: This is the date when it is
determined that the group of contracts will result in a net outflow of
resources, i.e., the group is expected to be loss-making.

Reference: IFRS 17, Paragraph 25

For the non savings contract: In this scenario, the earliest date is the beginning of
the coverage period in 2021. The recognition of the insurance contracts is not
dependent solely on the receipt of the first premium but rather on the initiation of
the coverage period.

For savings products: If it is a savings product, the recognition principles under

IFRS 17 still apply. For a savings product classified under IFRS 17, the recognition
criteria are the same (as above). So, if the savings product's coverage period
starts in 2021, the group of contracts should be recognised in 2021, even if the
first premium payment is not made until 2023.

Discount rate

2. Perta is planning to use a top-down approach for Severance Product and

bottom-up approach for the remaining products. Could you please explain more
details on how do determine it especially for the illiquidity premium?
Top-down approach
• Please provide the step by step on how to determine the illiquidity premium.
Are there any differences in methodology to determine illiquidity premium in
top-down and bottom-up approach?

Top down approach

The top-down approach is a method used to derive discount rates for insurance
liabilities under IFRS 17. This approach begins with the yields on a reference
portfolio of assets, such as high-quality corporate or government bonds, and
adjusts these yields to reflect the characteristics of the insurance contract cash
flows, including the removal of the credit risk premium and adjustments for
liquidity.

Steps Involved in the Top-Down Approach

Start with Market Yields:

- Identify the yields on a reference portfolio consisting of high-quality, liquid
bonds. These bonds should have similar maturities to the insurance contract
cash flows.

Adjust for Credit Risk Premium:

- Determine the portion of the yield that compensates for the credit risk. This
involves comparing the yields on corporate bonds with the yields on risk-free
government bonds of similar maturities.
- Subtract the credit risk premium from the observed yields of the corporate
bonds to arrive at a yield that represents a risk-free rate adjusted for
liquidity.

Adjust for Illiquidity Premium:

- Identify the illiquidity premium by comparing yields between liquid corporate

bonds and less liquid corporate bonds of similar credit quality and maturity.
- Adjust the resulting yield from the previous step to reflect the liquidity
characteristics of the insurance contract cash flows. This may involve
adding or subtracting an illiquidity premium depending on the specific
circumstances of the liabilities being valued.

Example

1. Observed Yields:
o Government bond yield (risk-free rate): 2%
o Liquid corporate bond yield: 3.5%
o Illiquid corporate bond yield: 4.5%
2. Calculate Credit Risk Premium:

Credit Risk Premium = Liquid Corporate Bond Yield −

Government Bond Yield = 3.5% − 2%= 1.5%

3. Adjust for Credit Risk:

Adjusted Yield after CRP = Liquid Corporate Bond Yield −

Credit Risk Premium = 3.5% − 1.5% = 2%

4. Calculate Illiquidity Premium:

Illiquidity Premium = Illiquid Corporate Bond Yield −

Liquid Corporate Bond Yield = 4.5% − 3.5% = 1

5. Final Adjusted Yield (Discount Rate):

Final Discount Rate = Adjusted Yield after CRP + Illiquidity Premium= 2% +

1% = 3

There are differences when calculating the illiquidity premium for the bottom
up approach.

The bottom-up approach involves starting with a risk-free rate and then adding
adjustments for the liquidity characteristics of the insurance contract cash
flows. This approach is directly opposite to the top-down approach, where you
start with observed yields and subtract risk premiums. Here’s a step-by-step
guide on how to implement the bottom-up approach:

Step-by-Step Process

1. Identify the Risk-Free Rate:

o Select the yield on high-quality government bonds as the risk-free rate.
Government bonds are typically considered to have minimal credit risk.
o Ensure the risk-free rate matches the currency and maturity of the
insurance contract cash flows.
2. Determine the Liquidity Characteristics of the Insurance Contracts:
o Assess the liquidity characteristics of the insurance contracts' cash
flows. Insurance liabilities often have different liquidity profiles
compared to typical market instruments.
o Identify the illiquidity premium that should be added to the risk-free rate
to reflect these characteristics.
3. Calculate the Illiquidity Premium:
o The illiquidity premium can be estimated by comparing yields on liquid
and illiquid bonds of similar credit quality and maturity. The difference
between these yields provides an estimate of the illiquidity premium.

Illiquidity Premium = Yield on Illiquid Bond − Yield on Liquid Bond

4. Add the Illiquidity Premium to the Risk-Free Rate:
o Combine the risk-free rate with the estimated illiquidity premium to
derive the discount rate.

Discount Rate = Risk-Free Rate + Illiquidity Premium

• “Starting Point: Begin with the yield curve for high-quality corporate or
government bonds”
Please provide the step by step on how to determine the yield curve for high-
quality corporate or government bonds.
Is there any difference between government bonds in this step and
government bond (risk free rate) in bottom-up approach?

Step-by-Step Guide to Determining the Yield Curve for High-Quality

Corporate or Government Bonds

Step 1: Data Collection

Identify High-Quality Bonds: Select a sample of high-quality corporate or

government bonds. High-quality bonds typically have a high credit rating
(e.g., AA or AAA).
Government Bonds: Treasury bonds, notes, and bills are considered high-
quality government bonds.
Corporate Bonds: Select bonds from corporations with high credit ratings.
Gather Market Data: Obtain the latest market data for these bonds. This
includes:
1. Bond Prices
2. Coupon Rates
3. Maturities
4. Yield to Maturity (YTM)

Sources: Financial news websites, Bloomberg, Reuters or central bank

websites.

Step 2: Clean and Organize Data

Ensure Data Accuracy: Verify that the data collected is accurate and up-to-
date.
Organize Data: Create a spreadsheet or database to organize the bond data
by maturity, coupon rate, and current market price.

Step 3: Calculate Yields

Determine Yield to Maturity (YTM): Calculate the YTM for each bond if it is
not already provided.
 Step 4: Plotting the Yield Curve

Arrange Yields by Maturity: List the calculated yields alongside their

corresponding maturities.

Step 5: Smooth the Yield Curve

Interpolation: Apply interpolation methods to fill in gaps between observed

yields. Common methods include linear interpolation or more sophisticated
spline interpolation.

Step 6: Validate the Yield Curve

Comparison: Compare the generated yield curve with existing benchmarks

or published yield curves from reliable sources (e.g., central banks or
financial institutions).
Adjustments: Make any necessary adjustments to ensure the yield curve
accurately reflects current market conditions.
References

This information was sourced from Investopedia: Yield Curve

• Can you please explain on how remove the credit risk premium inherent in
the bond yields?
See top-down approach answer above

3. We understand that locked-in rate is determined at the initial recognition of the

insurance contract and remains unchanged while discount rate will be updated
regularly at each reporting date to reflect current market conditions.

Are there any differences in the methodology used to determine the discount
rate and locked-in rate? or they use the same methodology and the difference
only as stated in the first paragraph?

Under IFRS 17, insurance companies use discount rates to measure the present
value of future cash flows related to insurance contracts. The standard
distinguishes between the "locked-in rate" and regularly updated discount
rates, and their application depends on the nature of the measurement model
being used.

Locked-in Rate

Definition: It is the discount rate determined at the initial recognition of the

contract.
 Purpose: This rate is used to determine the interest accretion on the contractual
service margin (CSM) and the liability for remaining coverage (LRC).

Regularly Updated Discount Rates

Definition: These rates are updated to reflect current market conditions and are
used for the fulfilment cash flows, which include the present value of future
cash flows and the risk adjustment.

Purpose: The regularly updated discount rates ensure that the measurement of
the fulfilment cash flows reflects the current economic environment.

Both the locked-in rate and the regularly updated discount rates can be derived
using similar methodologies

If during the valuation process there is differences between lock-in rate and
discount rate, What is the impact? Does the impact go to OCI or P&L?

1. Locked-in Rate: Used primarily for calculating interest accretion on the

Contractual Service Margin (CSM) and the liability for remaining coverage (LRC).
2. Updated Discount Rates: Used to measure the present value of future cash
flows and the risk adjustment, reflecting current market conditions.

Impact on Financial Statements

The impact of differences between the locked-in rate and updated discount rates
depends on Perta’s accounting policy choice for presenting the effects of changes in
discount rates. According to IFRS 17, entities can choose to present the effects of
changes in discount rates either in profit or loss (P&L) or in other comprehensive
income (OCI). This will need to be documented in your TPP for both accountants and
actuaries.

Accounting Policy Choices

1. Profit or Loss (P&L)

• Changes Recognized in P&L: If Perta chooses to recognise changes in

discount rates in profit or loss, all differences between the locked-in rate and
the updated discount rates will directly impact the P&L. This includes both the
interest accretion on the CSM and the effect of changes in the discount rates
on the fulfilment cash flows.
• Reference: IFRS 17, Paragraph 87 states that entities may present the effects
of changes in the finance income in profit or loss.
2. Other Comprehensive Income (OCI)

• Changes Recognized in OCI: If Perta opts to recognise changes in discount

rates in OCI, the effects of discount rate changes on the fulfilment cash flows
are reported in OCI, reducing the volatility in P&L.
• Impact on P&L and OCI:
o Interest on CSM: Interest accretion on the CSM using the locked-in rate
is recognised in P&L.
o Changes in Fulfilment Cash Flows: The impact of changes in updated
discount rates on the fulfilment cash flows is recognized in OCI.

4. Who will be responsible for determination of discount rate, lock in rate and
illiquidity premium? Actuarial or investment department? What is the common
practice in insurance industries?

It will be a collaborative effort to produce the discount rates. From what I have
seen in other industries, the following are some of the responsibilities for each
of the departments:

Actuarial Department:

- Determining the methodology for discount rate calculation.

- Setting the initial locked-in rate at the time of contract recognition.
- Periodically updating discount rates based on the methodology.
- Ensuring the rates align with regulatory requirements.

Investment Department:

- Providing current market data and yield curves.

- Analysing the liquidity characteristics of the investment portfolio.
- Advising on the appropriate illiquidity premium based on market conditions.

Risk Adjustment

5. Perta will use margin approach, but this margin (x%) will be embedded to the
best estimate projection cashflow instead of the best estimate assumptions.
Have you found the same approach in the market? Is it allowed? Any
recommendation on how to determine the margin (x%)? Or you will still
recommend adding the margin to the best estimate assumption instead of
projection cashflow?

Embedding a margin (x%) into the best estimate projection cash flows instead of
the best estimate assumptions is not an approach I have seen in the market,
though it may exist. The more typical approach is to add the margin to the best
estimate assumptions. However, IFRS 17 does not explicitly prohibit embedding
margins directly into the cash flows, provided that the overall measurement
objective of the standard is met.
IFRS 17 Guidance on Margins

Risk Adjustment for Non-Financial Risk:

• Paragraph 37: The risk adjustment for non-financial risk is the compensation an
entity requires for bearing the uncertainty about the amount and timing of the
cash flows that arise from non-financial risk as the entity fulfills insurance
contracts.

If you are increasing the BEL by a % it is difficult to show to the auditors/regulators

which of the risks you are considering thus resulting in more questions. The margin
should reflect the uncertainty in cash flows and the risk aversion of Perta. However if
you do go for this method, possible ways Perta could calculate the % could be the
following:

- Historical Data Analysis: Using historical experience to quantify the margin

required. Even though this would be hard as you cant specify which risks you are
considering.
- Scenario Analysis: Assessing different scenarios to understand the potential
variability in cash flows. Perta will still need to substantiate the confidence level
associated with the increase in the BEL.

Adding Margin to Best Estimate Assumptions:

The more conventional approach, which aligns closely with the IFRS 17 requirements,
involves adding the margin to the best estimate assumptions rather than embedding it
directly in the cash flows. Here’s why:

1. Transparency and Clarity:

o Adding the margin to assumptions ensures greater transparency and
clarity in the calculation process.
o It allows stakeholders to see the impact of the margin for each risk
separately from the underlying cash flow projections.
2. Alignment with IFRS 17 Principles:
o This method aligns well with the IFRS 17 principles outlined in Paragraph
37 and Paragraph 38, ensuring the risk adjustment for non-financial risk
is appropriately reflected.
3. Consistency with Industry Practice:
o This approach is more consistent with common industry practices.

Recommendations

I recommend that Perta conducts a thorough investigation to identify the most suitable
RA method for their needs. Observations in the Indonesian market indicate that the
Value at Risk (VaR) approach at a 75% confidence level is commonly employed.
Adopting a method not widely used in the market could attract scrutiny from regulators.
Therefore, aligning with prevalent practices is advisable to ensure regulatory
compliance and minimise potential challenges.
UAT Process for IFRS17 Modelling in the Prophet

6. Perta will be doing UAT for IFRS17 Modelling in the Prophet. Could you please
advise what scenarios that are usually tested under UAT?
Is it possible for you to share all scenarios that need to be tested and the output
expectation so Perta can have a sense of it?

Common UAT Scenarios for IFRS 17 Modelling in Prophet

1. Basic Functionality Testing

o Scenario: Load a sample set of contracts and ensure the system
processes them without errors. These will be your test packs which will
make it easier to test.
2. Contractual Service Margin (CSM) Calculation
o Scenario: Test the calculation of CSM for different types of insurance
contracts (e.g., life, non-life, reinsurance).
o Expected Output: Accurate calculation of CSM, with values matching
manual calculations or alternative validated models. We would advise
you to build replicators which will help in training staff into how the CSM
calculation is done.
3. Risk Adjustment Calculation
o Scenario: Validate the risk adjustment calculations for non-financial
risks.
4. Discount Rate Application
o Scenario: Test the application of discount rates to future cash flows.
5. Cash Flow Projections
o Scenario: Validate the projection of future cash flows under various
scenarios (e.g. best estimate, stressed scenarios).
6. Changes in Assumptions
o Scenario: Test the impact of changes in key assumptions (e.g., mortality
rates, lapse rates, expense assumptions) on model outputs. Dows it
change the profitability grouping
7. Aggregation and Grouping
o Scenario: Verify that contracts are correctly aggregated and grouped
according to IFRS 17 requirements.
8. Loss Component and Onerous Contracts
o Scenario: Test the identification and accounting for onerous contracts.
9. Presentation and Disclosure Requirements
o Scenario: Validate that the system can generate reports and disclosures
required by IFRS 17.
10. Reinsurance Contracts
o Scenario: Test the modeling of reinsurance contracts and their impact on
primary insurance contracts.
11. Integration with Financial Systems
o Scenario: Ensure that the Prophet model integrates seamlessly with
other financial and reporting systems.
 FIS guided you through a process diagram. For each element in that diagram,
it is essential to ensure that the model runs efficiently, the DCS scripts
execute correctly, and there is a seamless connection to the IDR.

Modification and Termination of Contract Recognition

7. Majority of the portfolio is group products, and even though the premium is
overdue for over 1 year, this contract is still considered as active. Do you have
any comments on this? What is the impact if the Company keep assuming those
contracts as active or inactive?

This question is difficult to answer without looking at the policy documentation

but I would recommend the following;

1. Review Contract Terms: Carefully review the terms and conditions of the
group contracts to determine the appropriate treatment of overdue
premiums.
2. Assess Payment History: Evaluate the payment history and likelihood of
recovering overdue premiums to make informed decisions about the active
status of the contracts.
3. Update Assumptions: Regularly update assumptions and models to reflect
the true status of contracts based on the latest available information.
4. Regulatory Alignment: Ensure alignment with IFRS 17 and local regulatory
requirements in the treatment of overdue premiums and the active status of
contracts.

Insurance Acquisition Cashflow

8. Determination of expense assumption.

For instance, salary expenses for several employees who are focussing on
marketing 2-3 products. The allocation of the expense per product should be
based on the actual experience of the company (expense study).
If the study is not ready yet, any recommendations on how to allocate it?

Expenses are discussed in the separate mail with Maeline and accounting team.

Other Topics

9. Can you please explain more about swing premium for accrual? What is it? What
is the use of it and how the Company apply it? Should the Company consider it
in the assumption? How to determine the assumption? What is the impact?

TBC