Insurance company profit and the illiquidity premium

The profit of insurance companies that report under IFRS is affected by three rates of return – the liability pricing rate, the return from investments, and the IFRS 17 discount rate. The first two largely determine the magnitude of aggregate profit; the last mainly affects the timing of profit recognition and its classification as a service result or net financial result.

We use an interactive model to explain how interest rates determine the reported results of insurance companies. The illiquidity component of the IFRS 17 discount rate is subjective, likely to vary by company, and plays a key role in how insurance companies are valued.

One of the key benefits of the recent change to insurance accounting following the implementation of IFRS 17¹For an introduction to IFRS 17, and our explanation of the benefits for investors, see our two previous articles – ’IFRS 17 Insurance – More comparability and new insights’ and ‘Prudent versus unbiased: IFRS 17 insurance liabilities’. is the new ‘source of earnings’ analysis. In profit and loss, operating profit is disaggregated between the profit from providing an insurance service and the profit from the spread between the return on investments and the insurance liability interest expense. Each has different risk and persistency²The term ‘persistency’ is often used in the insurance industry to describe the renewal quality of insurance, including how long a customer stays on the insurer’s books. We use the term to describe the stability and predictability of profit, although both are related. characteristics, and they are likely to be valued differently by investors. Under pre-IFRS 17 accounting (and under current US GAAP) there was no such analysis.

• Insurance service result: This is the difference between insurance contract revenue and the claims and expenses arising from those contracts. It also includes onerous contract losses³An onerous contract is one where the present value of expected expense outflow is greater than the present value of revenue inflows.. The service result each period is mainly the release of unearned profit, which on day 1 is the difference between the present value of expected premiums, and present value of forecast claims and expenses. This unearned profit comprises a risk adjustment, with the balance called the contractual service margin (CSM).

• Insurance net financial result: This is the investment income earned on assets acquired by investing the insurance premiums received less the insurance finance expense due to the unwinding of the discounting applied in measuring the insurance liability. In addition to this ‘spread’ income arising from assets backing insurance liabilities, the net financial result also includes investment income on surplus investments that provide the insurance company with a capital buffer.

The discount rate applied to insurance contract cash flows when initially determining the CSM, is a key assumption in IFRS 17 accounting. Its main influence is in the source of earnings analysis.

Notice from the above descriptions of the two sources of earnings that the discount rate affects both components, but in the opposite direction. For the service result a higher discount rate reduces the present value of future claims and expenses, which (because these are paid after the premiums are received) increases CSM. A higher IFRS 17 discount rate means a higher service result. However, a higher rate also results in a larger interest accretion on the insurance liability, which reduces the spread between the investment return and that interest cost. A higher discount rate therefore gives a lower net financial result.

The IFRS 17 discount rate does not directly⁴It does have an indirect effect due to how it impacts the timing of profit recognition and therefore distributions and capital raising by insurance companies. affect the total profit (the aggregate profit over the full life of insurance contracts) arising from an insurance business – this is simply the cash received (premiums and investment income) less cash paid (claims and expenses). The total aggregate profit of an insurer (prior to other expenses and income) is determined by the so-called insurance contract pricing rate, the internal rate of return of the insurance contract cash flows, and the return on investments. However, the IFRS 17 discount rate is crucial in determining the split of that aggregate profit; additionally, it affects when profit is recognised, especially if contracts are onerous.

The following model illustrates what we describe above. The model shows financial statement effects of a portfolio of level annuity contracts written at the start of year 1, so a single annual cohort. Annuity payments commence in year 1 at 100 and decline based on an assumed mortality schedule over 30 years.

The main model inputs are the following three interest rates:

• Pricing rate: The rate implicit in the premium charged by the insurer. The initial premium received in the model is derived by discounting the schedule of annuity payments (which are fixed in the model) at this input rate. A lower rate means a higher initial premium.

• Investment return: The income derived from the investment assets. This rate does not impact the service result or interest accretion for the insurance liability.

• IFRS 17 discount rate: The rate used to measure the financial statement effects of the insurance contracts. It mainly affects the present value of future expected cash flows and the contractual service margin components of the insurance liability.

Each input rate is expressed as a premium (or possibly discount in the case of the pricing rate) to an input liquid risk free rate.

We also include a risk adjustment in the model. This is the amount charged by the insurer for non-financial risk. It is like CSM in that it forms a component of the service result, except that it is released to profit and loss based on the release from insurance risk, rather than based on the provision of insurance services.

The model is interactive – try changing each of these inputs to see how the results vary.

The model is clearly simplified. In particular, we do not consider any changes to assumptions over the course of the annuities. The financial statements presented are therefore the forecast results, assuming actual outcomes (such as mortality and investment returns) are the same as the initial assumptions. None of our simplifications affect the validity of the analysis or the message we have for investors. Furthermore, although we use annuity contracts to illustrate, the same effects apply to all insurance contracts, albeit to varying degrees.

Interactive model – Insurance company profitability and the IFRS 17 discount rate

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Understanding the model outputs

The financial statements cover only selected years – the full 30 years can be seen in the ‘data’ sheet in the downloadable version of the model.

The day 1 balance sheet shows the premium received that is invested in financial assets, and an equivalent insurance liability which is split between the present value of expected claims (annuity payments), a risk adjustment, and a residual balancing figure contractual service margin (CSM). Both the risk adjustment and CSM represent unearned profit and are recognised in profit and loss over the life of the contracts. We assume the risk adjustment is a simple percentage of the present value of outstanding claims – various techniques are applied in practice.

A negative CSM indicates the cohort of contracts is ‘onerous’, with an immediate loss included in the year 1 profit and loss statement. The ‘day 1’ balance sheet is shown prior to this loss being recognised. If the cohort of insurance contracts is onerous, we assume that additional assets are transferred from capital so that the assets shown in the balance sheet fully back the insurance liability.

The profit recognised in a period is assumed to be immediately distributed (or redesignated as backing shareholders’ equity) such that the investment assets linked to this portfolio always equal the insurance liability. This ensures that any net investment return in profit and loss is purely the spread between the investment return and insurance liability financial expense.

The remaining financial statements show the run-off of assets and liabilities, and the resulting impact on profit and loss.

• Investment assets produce the investment income recognised in profit and loss. The balance sheet amount declines as assets are sold to pay claims and as any profit is ‘distributed’.

• Present value of insurance cash flows (also called the best estimate liability) is accreted at the IFRS 17 discount rate and is reduced each period as claims are settled.

• Risk adjustment is accreted⁵The accretion of the risk adjustment is optional under IFRS 17. In our view, recognising an interest expense for all components of the insurance liability provides a more meaningful source of earnings analysis. each year, and the reduction recognised in profit and loss.

• Contractual service margin is also accreted each year and allocated to profit and loss based on the amount of insurance coverage provided each year (the ‘coverage units’). Notice that the aggregate profit recognised in profit and loss is higher than the initial CSM and risk adjustment on day 1 due to the time value of money accretion.

The cumulative cash flow arising from the insurance contracts (and the backing financial assets) must always be the same as the aggregate profit recognised. Essentially, the IFRS 17 accounting specifies when this aggregate amount is recognised, and how it is presented, in profit and loss.

Clearly, the IFRS 17 discount rate is an important driver of the accounting we describe, but what exactly does IFRS 17 say it is, and how much flexibility do companies have when selecting it?

The IFRS 17 discount rate and its implications

IFRS 17 says that the discount rate applied in measuring the present value of insurance cash flows should:

IFRS 17 para. 36

For insurance cash flows that are not linked to underlying assets⁶For insurance contracts where cash flows to policyholders are linked to underlying assets, such as participating contracts, the liability discount rate must reflect that linkage. For example, the discount rate for liability cash flows that represent a distribution of the return on a portfolio of equity assets should be equal to the expected return on those assets. (such as payments to annuity contract policyholders) the discount rate must be a risk-free rate of the appropriate duration and currency, adjusted to reflect the liquidity characteristics of the liability.

The liquidity of a liability is an interesting concept and, it seems, the subject of some disagreement. It could refer to the ability of the holder of that liability (the insurer) to transfer or settle the liability or, alternatively, to the potential for liability cash flows to take place earlier (or later) than expected.

If earlier than expected payments are possible, the insurer would need to hold more liquid assets. However, if the schedule of cash payments is largely pre-determined (albeit still subject to insurance risk, such as longevity) the insurer can safely hold more illiquid assets and capture the illiquidity premium in its asset returns. If liability cash flows can be hedged by purchasing illiquid risk-free assets of the appropriate currency and duration, it follows that the discount rate should be the return on those assets.

Unlike in our simplified model above, in practice, discount rates will be a yield curve not a single rate. Determining the illiquid risk-free yield curve is not easy. Even the liquid risk-free rate can be challenging. Most investors are familiar with government bonds providing the basis for liquid risk-free rates, but different approaches can be used in deriving a government bond yield curve. An alternative is to use the OIS (Overnight Index Swap) curve as a proxy for risk-free rates. The curve is easier to construct, although we would argue that there is an element of credit risk inherent in the OIS rates.

However, the most challenging part of the IFRS 17 discount rate is the illiquidity premium. This cannot be easily observed in the market since there are few, if any, truly risk free but illiquid investments. IFRS 17 permits two approaches – top-down and bottom-up.

• A bottom-up illiquid risk-free rate is simply the liquid yield curve with an addition of an assumed premium for illiquidity. One approach we have seen is to base this premium on the yield of covered bonds,⁷Covered bonds are in effect secured bonds issued by corporates, usually banks. The two methods of obtaining repayment reduce investment risk, but do not eliminate it entirely. although these are also not truly free of investment risk. The difference in yield of listed and private debt (assuming equivalent investment risk) may also be used.

• A top down illiquid risk-free rate is where the company starts with the expected return on the actual or ‘reference’ portfolio of assets backing the insurance liability, and adjusts this to remove the premium inherent in that return due to investment risk. In the case of bond investments, this means removing the premium that covers expected defaults and, additionally, the premium that compensates investors for the risk (variability) of those defaults (sometimes called unexpected defaults).

The IFRS 17 discount rate disclosure requirements are quite extensive and should help investors compare the approaches of different companies and investigate the reasonableness of the rates chosen. The extract below is from the financial statements of UK insurer Phoenix Group. Writing bulk annuity contracts is a major part of their business, and they separately identify the discount rates used (other companies may include annuities as part of aggregated disclosure for a wider business unit).

Phoenix Group IFRS 17 discount rate disclosures

Phoenix Group 2023 financial statements

The company gives a useful and detailed explanation of the approaches used, but what really matters for investors is the end result and whether it is reasonable and comparable.

The liquid risk-free spot rates shown above almost exactly match the OIS rates given by the Bank of England. These are increased by an illiquidity premium of 1.73% for UK annuities. Interestingly, this is significantly higher than the 0.49% applied to annuities denominated in Euros. We do not know why there is such a large difference; it could be a function of the market for Euro denominated bonds (investors, for some reason, demand a lower premium for illiquidity) or perhaps because the liquidity characteristics of the European annuity contracts differ from their UK equivalent.

We are no experts in actuarial science, but the 1.73% illiquidity premium does seem high to us. If someone can tell us how to achieve a guaranteed return on an investment this much above OIS rates by simply forgoing liquidity, we would like to buy it for our own pension portfolio! Nevertheless, the illiquidity premium used by Phoenix is consistent with that used by its UK peers and is approved by the auditors.

The implications of the illiquidity premium in terms of the profitability of Phoenix can be seen in their disclosures about new contracts written in the year. The extracts below show the impact of new contracts on CSM and the components of the related present value calculation.

The first table below shows part of the roll-forward disclosure for ‘Retirement Solutions’ insurance contracts (which we think is predominantly annuities). The figure of £435m is the CSM recognised for new contracts written in 2023, with a further £167m of profit in the form of the risk adjustment . These will be recognised in profit and loss over the life of the contracts. The service result for the current period is mainly the allocation of CSM and risk adjustment arising from contracts written and purchased in prior periods – the £260m and £39m below.

Phoenix Group Retirement Solutions CSM disclosure

Phoenix Group 2023 financial statements

(This is just the first part of the roll-forward table – see page 229 of the Phoenix Group 2023 annual report for the full disclosure.)

The second table shows separately the present value of premium inflows (£7,794m) and expected present value of claim and expense outflows (£7,192m). The difference between these is the sum of the CSM and risk adjustment (£602m) – the total unearned expected profit arising from new contracts written in the period .

Phoenix Group Retirement Solutions analysis of new insurance contracts

Phoenix Group 2023 financial statements

The ratio of CSM to the present value of premium inflows for new contracts is an important measure of profitability and a key driver of the future service result, and the service result relative to the net financial result. In the case of Phoenix, the margin is 5.6% (435 / 7,794), or 7.7% if we include the risk adjustment.

The relatively small margin illustrates how important the IFRS 17 discount rate is – if the PV of insurance outflows were to be increased by only £435m, due to the selection of a lower discount rate, the CSM would be reduced to zero. We don’t know exactly the duration of the insurance cash outflows but, based on our assumptions and using our model above, we think that if the illiquidity premium were to be reduced from 1.73% to 1.03%, the CSM for these contracts would have been zero and a reduction to 0.77% would result in a zero aggregate profit – the combination of CSM and risk adjustment.

The risk adjustment may be combined with the CSM when thinking about insurance contract profitability. However, the risk adjustment may have a significant impact on reported results if a contract is onerous, in which case losses must be recognised immediately. An onerous contract is defined as one with negative CSM, not a negative overall profit (CSM + risk adjustment). Try different risk adjustment and IFRS 17 inputs in our model to see the effect.

The interactive model above (when first loaded) has inputs that we think are similar to those of the Phoenix Group annuities. Notice we show a margin of 7.7% to match the margin disclosed by Phoenix. Our assumption about the investment return is purely a guess since we don’t have any data about the assets specifically backing the annuity contracts. Nevertheless, we think the model and data shown is a reasonable depiction of the economics of an annuity business, despite the simplifications we have applied, including the assumption of a flat yield curve.

The second chart in the model shows the split of operating profit between the service result and net financial result for a different assumed illiquidity premium. This shows how sensitive the split is to the illiquidity premium assumption.

Illiquidity premium effect on cumulative service and net investment result

The Footnotes Analyst insurance contract model

Profit classification and insurance company valuation

Insurers essentially have two sources of profit: (1) writing contracts that have a positive net present value (the CSM plus risk adjustment); and (2) investing premiums to generate a spread between the investment income and the interest cost of the insurance liability. Each source of profit has different characteristics in terms of risk and persistency and, therefore, may be valued differently.

The service result is similar to the operating profit of any other sector and is driven by the efficiency and pricing power of the company. In our model select a lower ‘pricing rate’ (lower because this is the cost of the liability) and see how this increases the premium charged and the resulting CSM. A high service result may well be persistent and, with a strong franchise, may be of relatively low risk.

The net financial result is very different. It depends on the return on investments relative to the cost of the liability (the interest accretion). A higher return can be achieved in two ways: (1) superior investment management skill to outperform the market; and/or (2) risk taking. Neither of these would seem to be as persistent or as valuable as the service result.

Achieving persistently superior returns by better investment management is difficult (as many of you will know only too well). Risk taking is perhaps an easier way to generate higher (expected) investment returns. However, what is gained in terms of return is lost (arguably all of it) through the value impact of the additional risk. Borrowing to invest in higher risk but higher return assets does not, in itself, create value – just look at how the market prices equity swaps to see this in practice.

Higher risk taking shows up as higher volatility of profit in financial investments. However, companies may seek to minimise the apparent volatility of their results by either selecting the OCI option in IFRS 17 or by non-GAAP measures – this is a topic that deserves a separate Footnotes Analyst article.

In our view, investors should apply a higher multiple to the insurance service result than the net financial result. Indeed, we would be reluctant to apply any sort of multiple to the net financial result derived from insurance liabilities and the related ‘backing’ assets. There is certainly value in the surplus assets held (assets backing capital) but arguably little or no additional value from the remaining net financial result.

It is because of this difference in the value effects of different sources of profit that the IFRS 17 accounting is so useful to investors, but also why investors should scrutinise the IFRS 17 discount rate, and particularly the more subjective illiquidity premium component. In our view, insurers have an incentive to maximise the discount rate. This may have little impact on overall profitability, but it does increase the more valuable service result component.

Insights for investors

• The insurance contract pricing rate and the return on investments largely determine the aggregate profitability of an insurance business. The IFRS 17 discount rate mainly impacts the timing of profit recognition and how that profit is classified.

• A higher IFRS 17 discount rate results in a higher contractual service margin and higher insurance service result, but a lower net financial result.

• If the IFRS 17 discount rate is below the insurance contract pricing rate (after allowing for the risk adjustment) the insurance contracts will have a negative CSM, be classified as onerous, and the loss immediately recognised.

• Positive CSM is accreted and released to profit and loss over the life of the insurance contracts based on the amount of coverage provided in each period.

• The service result may be perceived by the market to be significantly more valuable than the spread component of the net financial result. Scrutinise the IFRS 17 discount rate and particularly the assumed illiquidity premium – are they a reasonable reflection of illiquidity and are they comparable between companies?

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