Building Block 2
The ED requires discounting of the cash flows using discount rates that are based on the characteristics of the insurance liabilities – i.e. their currency, duration and liquidity. The discount rate should not reflect the characteristics of the assets backing the liabilities, unless the amount, timing or uncertainty of the contracts’ cash flows depends on the performance of specific assets (e.g. participating contracts). The discount rate should be determined using a risk free rate, adjusted with an illiquidity premium calibrated on the illiquidity of the contractual cash flows. For example, a payout annuity displays highly illiquid cash flows because the policyholder cannot withdraw cash from the contract or redeem the contract at will.
There is not currently a widely accepted technique for determining illiquidity premiums. The ED includes disclosure requirements relating to the process used to select material assumptions, including the method for selecting discount rates and the associated illiquidity premiums when applicable. The approach to the selection of discount rates is similar to the basis used in the IFRS for non-insurance provisions (IAS 37) and to the approach used under the fair value measurement of financial instruments (IAS 39).
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