The Group of North American Insurance Enterprises (GNAIE) executive director Douglas Barnet took to the podium at the 12th Global Conference of Actuaries to rally for the use of earned rate for discounting life insurance contracts.
He told attendees that using an earned discount rate, as opposed to a risk-free rate, is consistent with how market participants value and price such contracts and is consistent with the principle of a market rate.
Proposals to measure life insurance liabilities using a risk-free discount rate when assets held to support these liabilities in the "fair value through profit and loss" category are measured at fair value, will lead to material uneconomic income recognition as well as inappropriate uneconomic earnings volatility, Barnet says. "Such volatility will largely be driven by an incorrect measurement emphasis on liquidity that will not typically be realized by a life insurer due to the long-term nature of its obligations. An accounting framework that results in such an accounting measurement mismatch will not provide relevant information to users of financial statements," he said, also pointing out that risk-free discount rate ignores the interdependence of assets and liabilities which are invariably bundled in life insurance transactions.
Barnert explained that a core attribute of a life insurance business is the linkage of assets and liabilities with an emphasis on long-term cash flow adequacy rather than short-term sensitivity to market movements and liquidity preferences. To ensure a consistent measurement basis for both assets and liabilities, the current market discount rate used to measure a life insurance liability should, in part, reflect the expected coupon, yield and principal payment schedule based on asset portfolios typically held to support insurance liabilities.
In addition, the current discount rate should reflect the expected investment spreads over government bonds (or sovereign debt) earned on such a portfolio based on historic data and an appropriate margin for risk.
While GNAIE does not advocate the current exit value framework, Barnet said the use of discount rates that are consistent with expected returns on both assets held and expected reinvestment strategies matches how insurance liabilities are priced, including block sale transactions, and is consistent with a current exit value framework.
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