A Liability Adequacy Test (LAT) is a financial evaluation that is largely employed in insurance accounting to actively ascertain the financial effectiveness of an insurer’s liabilities, for over the expectation of what it could be due in the future. The liability adequacy test is conducted simply to determine if the balance sheet ‘current’ value amount of the liability exceeds or is less than the expected changes to cash flows in regards to claims, benefits paid, expenses, etc. This concept was especially significant under IFRS 4 (the standard that came before it) where insurers were barred from being able to opt not to do the test at each reporting date. It could not have been ignored that there was a deficiency in the recognized liability.
It is more than insurance accounting that can be associated with the term “liability adequacy test” because it simply means that the fundament is that the company is not allowed to show any liability that is less than what it is reasonably expected to have to settle its obligations. This is a new model measuring IFRS 17’s fulfilment cash flows and related components, as opposed to the previous IFRS 4 liability adequacy measurement approach. The IFRS 17 will be effective for annual reporting periods starting on or after January 1, 2023.
A Liability Adequacy Test?
A Liability Adequacy Test looks at how much insurance contract liabilities are recorded in society’s books compared to what they will likely have to pay in the future. This primary question is:
Are the amounts of liabilities at this moment on the books sufficient to pay for the future premiums that can be expected from the insurance contracts?
An insurer tackles this question by taking into account a range of projected future cash flows and factors. These may be for example: benefits, claims, expenses, premiums or cash flows related to the existing contact, discounting or adjustment for uncertainty, to name but a few, depending on the accounting framework applied.
The test in the previous IFRS 4 standard was to ensure that the insurance liability was “likely to be adequate to fund current estimates of related cash flows”. If the identified deficiency was significant, another tackling cost was identified, and an additional liability was recognised. The significance of the Liability Adequacy test is: The basic aim of a liability adequacy test is to minimise the risk of underrating liabilities.
Insurers make promises that may be years or decades out that have to be paid. For instance, a life insurance company might take in premiums now, and only start paying out benefits in a few years’ time. Insurers may show financial strength than they really have if they record too low of liabilities.
Creating an effective liability adequacy test can help to detect potential deficiency issues before they become larger financial issues.
It can support:
- Improved and better accounting reporting.
- Better reserve management.
- Stronger risk management.
- Better capital planning and management.
- Improved actuarial analysis.
- Improved knowledge of responsibilities for the future.
Baby boomers have shown that they have a greater confidence in the stakeholders. The International Accounting Standards Board highlighted the importance of insurance liabilities being based on commitments of future insurance services and claims.
How Does A Liability Adequacy Test Work?
There are many steps to an analytical liability adequacy test. Determine which insurance policies are affected by the accident.List these insurance liabilities relevant to the accident.
The first step involves identifying the accounting requirements in the insurer’s accounting.The insurer’s accounting determines which insurance contracts and liabilities will be subject to the applicable accounting requirements.
Insurance contracts are defined as “some insurance risk” taken by the insurance company from the policyholder and an agreement to render a payment to the policyholder in the event a specified uncertain future event has a negative impact on the policyholder.
Estimate Future Cash streams:
This is followed by the estimation of cash flows of the contracts.
The following may apply to this:
- Future claim payments.
- Policy benefits.
- Claims administration expenses.
- Policy administration expenses.
- Other fulfillment costs.
- Appropriate cost of capital inflows.
- Other contract-related amounts.
The timing and risk of web payment and receipt under the insurance contracts is included in the estimates of amounts to be collected and paid under those contracts in IFRS 17.
3. Establish Appropriate Assumptions
Assumptions are key to actuarial and financial teams for predicting future results.
Examples include:
- Claims frequency.
- Claims severity.
- Mortality.
- Morbidity.
- Longevity.
- Policy lapses.
- Policyholder behavior.
- Expense inflation.
- Medical inflation.
- General inflation.
- Interest rates.
- Discount rates.
The validity of the liability adequacy test will largely rely on the quality and good governance of these assumptions.
Compute the RPV.
In the future, cash flows may need to be discounted to find their present value.
The effects of the discount rate on the calculated liability can be quite large. As a rule, the lower the discount rate or the longer the period, the greater the PV.If other things are equal, a lower discount rate will mean a higher present value for future obligations, and the longer the period, the bigger the PV.
This is especially significant for contracts with extended durations of coverage as it can severely impact liabilities reported under the policy, depending on the level of the changes to the discount rates.
5. Do Take into Account Risk and Uncertainty
The cash flow of the insurance company is unknown in the future.
So it is important for an insurer to take into account the uncertainty with regard to future outcomes. For non-financial risk, IFRS 17 would calculate risk adjustment as the amount of compensation required by an insurer for his assumption of insurance risk.
6. Translate 6 the Calculated Amount With the Recorded Liability
The amount of the obligation is then compared to the recognized amount of the liability.
If the existing liability is not large enough within the accounting framework, it must be recognised if there is a deficiency.
The purpose of a liability adequacy test is just that: test if liabilities are adequate.
What are some of the factors that can influence a Liability Adequacy test?
There are a number of assumptions that can alter the results.
Claims Frequency
Claims frequency can be described as the anticipated number of claims.
Rising claims frequency will typically result in an increase in the projected cash flows. This can lead to a higher amount needed to provide for the connected commitments.
Claims Severity
Claims severity is how big or costly the expected impacts of individual claims are.
The number of claims can remain the same for an insurer, but the claims’ value could be significantly increased when they are more costly.
Mortality and Longevity
When developing life or annuity products, it is important to make sound assumptions about mortality and longevity.
The estimation of future death rates can have an impact on future outflows from benefits and changes in longevity can have a strong impact on the products which have long payment periods.
Morbidity
Illness and disability, recovery, and other health related outcomes can have an impact on health and disability insurance products.
Policy Lapse Rates
A lapse rate is the percentage of policies which are lapsed prior to their scheduled expiration.
Any alteration of the policy holders’ actions can have an impact on further premiums, benefits, costs and profitability.
Inflation
Inflation could reduce the financial resources available to make future claims and operating costs.
Medical-insurance companies may be more affected by increases in medical costs, and property and casualty insurance companies may have to increase repair and replacement expenses.
Discount Rates
Discount rates are used to discount future cash flows.
Seeing that the changes in the discount rates can have a significant impact on the calculated liability for long-term obligations, the changes in these rates are likely to be required in the future.
Expenses
Insurance requirements may encompass future requirements in claims handling, administration, policy servicing and more.
Failure to account for future cost of materials may lead to an overly generous (or inadequate) estimate of liability adequacy.
What Happens If You Have An Inadequate Liability?
If the assessment also concludes there’s a deficiency, there’s a possibility that they’ll be substantial.
The carrying amount of the insurance liability would have been adjusted to recognize a shortfall from the relevant future cash flows if it was determined that the carrying amount was inadequate under IFRS 4.The result of the former IFRS 4 liability adequacy test would have been to adjust the carrying amount of the insurance liability to recognize a shortfall relating to the evaluation of the relevant future cash flows.
This could lead to:
- Higher reported liabilities.
- Lower profit.
- Lower equity.
- Changes to capital ratios.
- Increased management scrutiny.
- Reassessment of assumptions.
- PriceChanges.
- Additional risk-management actions.
The accounting treatment will be different today depending on the accounting framework applied as IFRS 17 has replaced IFRS 4 which was previously used to account for insurance contracts.
The IFRS 4 Liability Adequacy Test
It is important to have an understanding of the history of LAT. The IFRS 4 mandates the insurance companies to undertake a ‘liability adequacy test’ at every reporting date. The aim was to keep cash funds to cover known insurance obligations in line with the current estimated cash streams involved, from relevant contractual commitments. When the liability proved to be not sufficient, another liability was recognized and the deficiency had an impact upon income. This was a part of IFRS 4’s transitional insurance accounting framework.
Understands The Liability Adequacy Test In IFRS 17
IFRS 17 Insurance Contracts rendered the accounting environment a whole new one.
IFRS 17 provides the principles for the recognition, measurement, presentation and disclosure of insurance contracts. It calls for a measurement of current cash inflows and outflows as well as a matching of profits with insurance services rendered.
In contrast to the approach taken under IFRS 4, where assets and liabilities are measured based on whether they could have been an exception to the principle of measurement to fair value/with imputed costs, IFRS 17 now brings current estimates into the measurement of insurance contract liabilities.
The following ideas are key:
Fulfilment cash flows.
Discounting.
Non-financial risk – risk measurement adjustment.
Contractual service margin.
The sharing of liability for coverage after the match.
The insurance provides coverage for claims that had been incurred.
An insurance contract liability’s contractual service margin is, for example, the unearned profit margin component of the contractual liability, and is recognized as the insurer provides services under the contract.
Step 1: Identify the true meaning of current insurance measurement.Step 1 – Liability Adequacy Test – Identify the true meaning of current insurance measurement.
It is essential to not assume that all modern insurers conduct a form of LAT today, akin to that done under IFRS 4.
IFRS 4 is best associated with the term liability adequacy test. The new measurement model in IFRS 17 brought a complete change to the approach in the measurement of insurance contracts that includes future cash flows based on current estimates.
When looking for information on liability covering, make sure you spot the framework of accounting and jurisdiction that you are considering.
This is especially significant for professionals like accountants, actuaries, auditors, financial analysts and insurance accounting students.
What Is Meant By Fulfilment Cash Flows?
One of the key principles of IFRS 17 revolves around the concept of fulfilment of cash flows. According to the IFRS Foundation, they are “estimates of the amounts which an insurer expects to receive from customers and pay to the holders of the policy, for claims, benefits and costs and obligations, including the effect of any timing and risk the insurer faces in receiving or payment.
What in practice does fulfilment cash flows answer?What practically does fulfilment cash flows answer? How much does the insurance company want to be paid and paid out for carrying out its obligations under the insurance contract? This contributes to the importance of their significance in the measure of insurance contract liabilities per IFRS 17.
What’s A Risk Adjustment?
Determining insurance results isn’t certain.
An insurer may anticipate that a set of policies is going to bring about a specific rounded out of claims, but it may not really turn out that way.
The non-financial risk is adjusted for compensation needed to cover uncertainty of insurance risk.
Insight value of this concept is crucial because valuing a certain liability may be done based on one expectation of cash-flow which may not be sufficient in showing the uncertainty of the cash-flow.
The Contractual Service Margin (CSM) Is What?
Another relevant and significant phraseology in IFRS 17 is the contractual service margin (CSM). It is the profit on insurance policies which is not earned.
IFRS 17 does not immediately recognize the profit expected in the insurance agreement, but instead recognizes the margin over contractual (or promised) amounts under the insurance agreement over the period the insurance services are provided, in accordance with the requirements of IFRS 17.
This enables better matching of recognition of insurance services with the associated revenues.
Why Is Accurate Data Important For Liability Adequacy?
The bases for a liability adequacy test are the only thing in the system that makes it reliable because if information is incomplete or fraudulent, the liability position of a fund may not match that of the fund’s sponsor. Only bad data can lead to bad forecasts. Possible issues with the data are:
- Missing claims information.
- Incorrect policy records.
- Duplicate records.
- Incorrect dates.
- Incomplete historical experience.
- Inconsistent classifications.
- Incorrect expense information.
- Poor data integration.
Such high quality Data is particularly significant for insurers who have millions of Policies.
Explain why the governance of Assumption is important. Huge impacts can be made by assumptions on liability measurements. In particular, future obligations can be understated if an insurance provider assumes it will deal with claims which increase at a regular rate while the actual claims costs increase at a high rate. Assumption Governance can hence be achieved through:
- Documenting assumptions.
- Reviewing historical experience.
- Indicators of comparing the expected and actual outcomes.
- Conducting sensitivity analysis.
- Obtaining appropriate approval.
- Revising prediction with the changes in evidence.
- Records of audit trail.
Good governance helps to minimise the risk of false liability measurements arising due to assuming too much.
Actuarial Duties In Relation To Adequacy Of Liability
Since so much of insurance payments has to do with probability, statistics, financial assumption, and forecasting, actuaries take an important part in determining the insurance liability.
Insurers can use actuarial analysis to help in the estimation of:
- Future claims.
- Mortality.
- Longevity.
- Morbidity.
- Lapses.
- Expenses.
- Policyholder behavior.
- Cash-flow timing.
- Risk.
The claims are complicated in more complex products (for example, long policyholder behavior, guarantees, product selectiveness).
Pay responsibility and financial soundness
If someone requires insurance coverage, it’s essential to have the right amount. Insurers do not care whether their customer builds up future bills to cover the costs that arise after the customer pays their premiums. Insurers don’t care if their customer incurs potential future expenses after paying their premiums in the future. Understating liabilities can be a domino effect that can affect the company’s reported financial position. Precise measurements are useful to management to understand:
- Future obligations.
- Capital needs.
- Product profitability.
- Reserve requirements.
- Emerging risks.
- Potential financial stress.
Appropriate measurement is especially significant in insurance contracts due to the highly variable cash flows that they can generate over long periods, according to the IFRS Foundation.
Choose the appropriate liability coverage and pricing.
Analysis of insurance liabilities can also make a significant contribution to pricing information.
An insurance company might determine that some products are not being charged an adequate premium for the risk that they are taking on if losses and costs keep surpassing predictions.
The management can then consider:
- Revising premiums.
- Changing underwriting criteria.
- Modifying product features.
- Adjusting coverage limits.
- Improving claims management.
- Purchasing additional reinsurance.
- Changing distribution strategies.
However, liability analysis is not about a mere accounting exercise. Can offer data applicable to greater business strategies.
Liability Adequacy and Reinsurance
Reinsurance is a means by which insurance companies pass some of the risks to another insurance company.
If a significant exposure is found as a result of the liability analysis, an insurer may consider the possibility of reinsuring to make exposure risk less volatile and/or to preserve capital.
Reinsurance does not remove any underwriting or actuarial duty nor any accounting obligation, but it may play a vital role in any insurer’s risk-management program.
Some frequently encountered problems regarding liability adequacy testing:
There may be some complexity with conducting a proper LAT.
Data Complexity
Large insurance companies have vast quantities of insurance policy and claim data. It can be difficult to compile a comprehensive, accurate picture.
Long-Term Uncertainty
Predicting insurance liabilities are by their nature rather uncertain, as they could span many years in the future.
Economic Changes
Inflation, interest rates, economic growth and financial-market conditions can make a huge difference to the assumptions.
Changing Customer Behavior
Economic conditions, product design, competition or other factors may lead to a change among the policyholder’s behaviors.
Complex Insurance Products
Always expect multiple models for products with guarantees, options, participating features or multiple benefit structures.
Regulatory Changes
There may be changes to accounting and regulatory obligations, which could necessitate updating systems and processes, as well as documentation.
A Strong Liability Adequacy Process Has A Number Of Benefits
A well-structured liability assessment process can be beneficial not only for accounting compliance but also for other aspects.
Better Financial Reporting
Correct liabilities are used to give a truer reflection of insurers’ obligations on their financial statements.
Improved Risk Management
Identifying potential deficiencies through proven opportunities can be a catalyst to identify emerging risks.
Better Capital Planning
Management can utilise the liability data as part of its decision-making process in relation to future capital needs.
Stronger Governance
Formals establish accountability of assumptions, models, data and financial reporting.
Improved Strategic Decisions
Knowing who is liable can have an impact on pricing, product development, underwriting and reinsurance.
Greater Stakeholder Confidence
Clear and accurate reporting improves the transparency of information for investors, regulators, policyholders and other stakeholders on an insurer’s financial situation.
Some Tips On How Companies Can Make Liability Testing Better
There are some practices organisations can use to enhance their liability measurement processes.
Maintain High-Quality Data
Set up controls to collect, validate, transform and reconcile data.
Review Assumptions Regularly
Historical assumptions need to be examined and revised as necessary, in light of past experience.
Perform Sensitivity Analysis
This sensitivity analysis can demonstrate the impact of altering assumptions such as claims, inflation, interest rates and more on liabilities.
Strengthen Model Governance
Models must be examined and documented independently and tested and then approved as appropriate.
Maintain Clear Documentation
All assumptions and methodology decisions that are significant must be well documented.
Produce financial, actuarial and actuarial/scientific reports.
There are many elements to interdependent information and processes that need to be maintained by the accounting, finance, actuarial, risk and technology teams.
Here is a very simple example of non-Liability Adequacy.Here is a really simple example of non-Liability Adequacy.
Suppose an insurance company has booked an insurance liability of $10 million.
The effect of applying the applicable measurement requirements to the analysis thereof is that the expected future obligations are $11.2 million.
The disparity suggests the recorded liability might not be enough according to the alternative plan.
A $1.2 million deficiency, under the historic IFRS 4 LAT, would have called for more liability to be recognized.
The most basic idea is illustrated in this simplified example:
Be aware that recorded liability is less than required liability = potential deficiency.
In real life, however, actual insurance accounting can be far more complicated as it is influenced by the chosen standard, contracting relationships, cash-flow assumptions, discounting, risk adjustments and more.
An Insurance Company Only Should Have Liability Adequacy?
The test which is classified as formal Liability Adequacy Test is most closely related to insurance accounting, specifically IFRS 4.
That general principle – whether recorded obligations are adequate to cover obligations in the future, can, however, apply to other businesses.
Organizations can have ongoing agreements where they agree to provide and receive services such as:
- Warranties.
- Employee benefits.
- Service obligations.
- Long-term contracts.
- Environmental commitments.
- Pension-related obligations.
- Guarantees.
As IFRS 4 LAT is not a universal standard for accounting these obligations, they are subject to other applicable standards that govern their accounting treatment and such accounting treatment should not automatically be referred to as accounting IFRS 4 LAT.
In this module, students will review the basics of the Liability Adequacy Test and the Auditor Report.
Auditors could check the procedures followed to value insurance liabilities that could be substantial.
Some areas for focus might be:
- Data quality.
- Actuarial models.
- Assumptions.
- Discount rates.
- Claims projections.
- Risk adjustments.
- Model controls.
- Management judgments.
- Documentation.
Where the insurance activity is that of a complex business there may need to be a degree of interdependence between the financial auditors and the actuarial experts in estimating the liability.
Data, Assets, and Liability Adequacy Test and Financial Reporting. Data Assets and Liability Adequacy Test and Financial Reporting.
Financial reporting would be contingent on the measurement of liabilities using the applicable framework for accounting.
IFRS 17 determines the measurement of insurance contract liabilities by using a current-value approach that considers expectations of future cash flows, risk factors, and other factors outlined in the IFRS insurance contract standard.
Finally, the movement of the aggregate insurance liability is a complex issue that requires the insurer to have solid systems for collecting data, making assumptions, determining cash flows and providing a narrative.
The Liability Adequacy Test: It Is Crucial For Investors
When investors are studying an insurance company, they should be aware that an insurance company’s reported profit is affected in part by the estimates of future insurance obligations. Reported financial results also can change when there is a change in the liability assumptions. Investors might consider analysing:
- Reserve development.
- Claims trends.
- Assumption changes.
- Discount-rate effects.
- Capital adequacy.
- Insurance service results.
- Profitability by product.
Rising or falling insurance contract liabilities.Sudden increase or decrease in insurance contract obligations.
Confidence in the quality of financial information may be enhanced through the use of a well-designed liability measurement framework.
FAQs
What do you mean by Liability Adequacy Test?
An analysis of whether identified insurance liabilities are at least the correct level to meet future obligations is called a Liability Adequacy Test. It has been implemented for IFRS 4 to provide a means for identifying insurance contract liabilities that were understated.
What’s the significance of the Liability Adequacy Test?
This ‘liability adequacy test’ aims to identify a potential understatement of insurance liabilities. Well measured liability is a good foundation for the accurate reporting, managing risks, planning capital expenditure and making informed business decisions.
Does IFRS 17 still include the ‘Liability Adequacy Test)?
IFRS 17 replaced the old insurance accounting model in IFRS 4 and has installed a new comprehensive current measurement model. An IFRS 4-type LAT should not, therefore, be taken to be an IFRS 17-type LAT.
On what points do the following factors play a role in the Liability Adequacy Test?
Some of these are expected claims, the level of claims severity, mortality and morbidity, gaps in policies, cost, inflation, rates of discount, policyholder behavior, and the uncertainty of cash flows into or out of the policies.
What is the consequence if the insurance liabilities are not sufficient?
The accounting consequence depends on the accounting framework that is applicable. The prior IFRS 4 approach called for triggered both the recognition of additional liability and the recognition of an expense. Instead of relying on the measurement and recognition parts of IFRS 16, IFRS 17 has its own.
Conclusion
The Liability Adequacy Test is essentially the means that insurers achieve the objective of being appropriately funded to cover their future obligations, as expressed by reported insurance liabilities. In the past, IFRS 4 gave insurance financial undertakings the freedom to undertake a liability adequacy test at any reporting date and to recognize a shortfall of the recorded liability. Now, under IFRS 17, the future cash flows and risk adjustments of an insurance contract are explicitly included in the measurement as are other components of insurance contracts, and IFRS 17 is a complete framework.
Even though DEA has been replaced, accountants, actuaries, auditors, investors, insurance professionals and financial analysts can still benefit from knowing more about the theory of the liability adequacy test, as it provides them with some helpful insights into the importance of reasonable assumptions, accurate information and the right valuation practices and finance governance. From the perspective of some of the past application of IFRS 4 or the current IFRS 17 financial measurement, the underlying principle that governs financial statements issued by an insurer is always to present a “true and fair view” of the liabilities that the insurer expects to discharge.
