When we formally move to IFRS 17 the methodology for pricing will not change: we still need to develop product and Takaful model designs, contributions and profit tests. The challenge will be in the details.
Our current methodology for profit testing is to project all the incomes and outgoes in each Takaful fund and determine the resulting profitability. For instance for a drip MRTT plan we would project the cash hows in the risk fund, the savings fund and the operators fund. One of these cash hows is the increase in reserves. This would now need to be under a regulatory basis as well as an IFRS 17 basis as we need to ensure the product is not hurting the solvency of the company and also is giving shareholders the level of profits it desires.
For some products profitability will go down significantly under IFRS 17. For instance, currently for an MRTT product the operator receives a wakala fee at policy inception which is considered an income in the operators fund at time zero. Over the policy term expenses are assumed and other outgo, with a corresponding regulatory reserve calculated. This reserve has a ‘cost of capital’. The cost is the difference between the investment return you can earn on the reserve and the required rate of return on capital by the shareholders. For instance in Malaysia perhaps a 4% investment return is reasonable, meaning you can earn 4% p.a. on the reserves held. The required rate of return on capital tends to be 10% or more, meaning the higher reserves are the more return on capital a product must earn. With CSM being held this holds back profit which also incurs this cost of capital.
Another issue is with the investment income assumptions for products which have a savings fund (PA). For instance a drip MRTT plan has a PA fund which earns an investment return and drips into the risk fund (PRF). In pricing we have tended to use the expected investment return whereas under IFRS 17 we will likely use the risk free rate as the investment assumption. This means that the PA will be expected to run out of money before the last drip into the PRF. In our reserving in the PRF under IFRS 17 we would thus continue to have claims outgo but no more drip income once the PA is used up. This will cause an increase in our PRF reserves which again increases the cost of capital requirements.
Different Takaful models will behave differently under IFRS 17. We will need to show management the effect of changing models on product pricing. For instance some mudharaba models result in expenses being incurred before profit sharing from the risk fund can be received. Products using this model might be profitable, which means CSM is required, but the operators fund has not received enough income to cover this CSM. Adjusting the model where possible may be the best pricing strategy here to avoid distortions to the accounts. In Malaysia the proposed new Takaful Operational Framework (TOF) gives a range of acceptable Takaful models. Each model might result in differing IFRS 17 treatment with resulting effects on the company accounts. Our role in pricing is to model this for management to understand the long term effects of differing models.
Currently we tend to price on a net basis, meaning if our benefits are 100% retakaful we will simply assume the retakaful rates in our pricing. As an example, perhaps our best estimate assumption is 60% M8388 (typical Malaysian mortality table) but our retakaful rates are 50% M8388. We could simply price using the retakaful rates and achieve a lower contribution rate than if we priced using 60% M8388. We can do this as we get reserve credit for the retakaful rates upfront, meaning our reserves are based on 50% M8388 rather than 60%. The ‘benefit’ of the retakaful is thus the present value of the difference between 50% M8388 and 60% M8388. Under IFRS 17 we will need to hold this difference as retakaful CSM and release it over time. Thus the effect of cost of capital could be large and depending on the view of the regulators the treatment of retakaful itself may change.
Under IFRS 17 operators will need to show their accounts gross of retakaful and the value of retakaful clearly shown. For operators that heavily rely on retakaful this will be very clear in the accounts, as will whether this retakaful is costing the operator or providing a benefit. This will put retakaful practices into clear view for anyone reading the accounts. The pricing actuary will thus need to justify the costs of retakaful to a much wider audience, with little or no room to hide these costs. Anyone who has presented to the Takaful AGM where public shareholders are involved can attest to the presence of shareholders who may only own a few shares but have a large voice in asking many questions on the accounts. This could prove challenging!
Due to this transparency of retakaful under IFRS 17 Takaful operators will need the help of retakaful operators more than ever. For instance in the prior example the retakaful operator could share experience and justifications for why 50% M8388 is reasonable for the Takaful operator. The Takaful operator could then use that for its gross pricing assumptions.
IFRS 17 is coming, this is a reality. There is nothing we can do about practices and pricing in the past. However, we CAN make a difference by quickly pricing products favorable under IFRS 17.