Is the Premium Allocation Approach the IFRS 17 shortcut insurers have been looking for?

Hand drawing a shortcut through a chalked maze.

Complying with the IFRS 17 insurance contracts accounting standard is hard work, especially for firms writing long-term contracts. Pamela Hellig discusses the potential for the premium allocation approach to relieve the pressure.


When we talk about IFRS 17 and all its challenges, what we are actually talking about is the general measurement model (GMM). With all the attention given to building blocks, contractual service margin (CSM) and coverage units, it seems that the premium allocation approach (PAA) is either neglected or not even considered as a viable option.

But, in dismissing this simplified approach, are long-term insurers adding unnecessary cost and complexity to their new IFRS 17 worlds?

What is the Premium Allocation Approach (PAA)?

The PAA is a simplification of the GMM. It follows the principles of the GMM, in terms of grouping, delayed release of revenue, etc, but allows a more basic measurement approach. Most notably, it allows the entity to measure the amount relating to remaining service by allocating the premium over the coverage period.

Not only is it a much simpler model for liability measurement and revenue recognition, but it is also similar to the current methods used under IFRS 4 by the industry, so for companies choosing to follow the PAA, the methodology and model changes would be less significant than they would be under the GMM.

The reason many long-term insurers have not seriously considered using the PAA is because of its stringent eligibility criteria, set out in paragraph 53 of the IFRS 17 Standard:

“An entity may simplify the measurement of a group of insurance contracts using the premium allocation approach…if, and only if, at the inception of the group:

  1. the entity reasonably expects that such simplification would produce a measurement of the liability for remaining coverage for the group that would not differ materially from the one that would be produced applying the requirements [for the General Measurement Model]; or
  2. the coverage period of each contract in the group…is one year or less.”

Are these criteria as restrictive as they appear?

Coverage period one year or less

The coverage period is the period during which the entity provides coverage for insured events. This period includes the coverage that relates to all premiums within the boundary of the insurance contract.

IFRS 17 defines the contract boundary in paragraph 34 of the Standard as follows:

“Cash flows are within the boundary of an insurance contract if they arise from substantive rights and obligations that exist during the reporting period in which the entity can compel the policyholder to pay the premiums or in which the entity has a substantive obligation to provide the policyholder with services… A substantive obligation to provide services ends when:

(a) the entity has the practical ability to reassess the risks of the particular policyholder and, as a result, can set a price or level of benefits that fully reflects those risks; or

(b) both of the following criteria are satisfied:

the entity has the practical ability to reassess the risks of the portfolio of insurance contracts that contains the contract and, as a result, can set a price or level of benefits that fully reflects the risk of that portfolio; and

the pricing of the premiums for coverage up to the date when the risks are reassessed does not take into account the risks that relate to periods after the reassessment date.”

This definition seems to state that any possible future cash flow is inside the contract boundary, unless the entity can meet the high bar of the criteria to exclude. If, however, the terms of the insurance contract state that the insurer has the right to reprice or even cancel the contract with, say, 30 days’ notice, the coverage period may be well within the one-year boundary allowed by the PAA1. Thus, even long-term insurance contracts may be eligible for the PAA, without having to prove similarity to the GMM.

No material difference from the GMM

The definition of ‘material’ in this instance needs to be defined by the insurer, but if the following three conditions hold, they may be able to apply the PAA, even if the coverage period of the contracts under consideration is longer than one year:

Future premiums are sufficient to cover future claims and expenses when they occur, without timing differences, i.e. the premium paid in a given month fully covers the expected claims and expenses pertaining to that month.

The allowance for risk adjustment in the premium is sufficient to cover the difference between best estimate cash flows and risk adjusted cash flows for each reporting period. In order to be able to prove this, the methodology used to calculate risk adjustment needs to be carefully considered. For example, if the risk adjustment is allowed for by adding a margin to premiums charged, it could be relatively straightforward to ensure that the risk adjustment allowed for in the premium runs off at the same rate as risk in portfolio.

The coverage units selected under the GMM ensure that profits are recognised in line with the profit priced into each premium.

A simple spreadsheet exercise shows that if these conditions are met, the liability for remaining coverage (LRC) under the GMM and the PAA are very similar. These assumptions are not always realistic, but meeting them may be possible for some products, such as certain term assurance contracts with increasing premiums.

Other considerations

Even if the aforementioned conditions hold and the LRC seems similar under the two approaches, it is also necessary to consider the variability in fulfilment cash flows. Paragraph 54 of the IFRS 17 Standard states that:

“The criterion in paragraph 53(a) is not met if at the inception of the group an entity expects significant variability in the fulfilment cash flows that would affect the measurement of the liability for remaining coverage during the period before a claim is incurred. Variability in the fulfilment cash flows increases with, for example:

a) the extent of future cash flows relating to any derivatives embedded in the contracts; and

b) the length of the coverage period of the group of contracts.”

It would be up to the insurer to decide their appropriate interpretation of variability in fulfilment cash flows and whether it would be an impediment to using the PAA.

Furthermore, the PAA assumes that no contracts in the portfolio are onerous at initial recognition, unless facts and circumstances indicate otherwise (paragraph 18 of the Standard). Paragraphs 57 and 58 describe how to account for the case where at any time during the coverage period, facts and circumstances indicate that a group of insurance contracts is onerous. So, the PAA does not seem designed to measure onerous contracts, but the treatment thereof may still be similar to how insurers currently account for loss-making contracts under IFRS 4, and hence the PAA may still be an attractive option.

Conclusion

Although the PAA has largely been disregarded by long term insurers, there may be a case for using it based on some relatively simple investigations and close examination of the contracts’ terms and conditions – especially if it means potentially avoiding the model and system upheavals that would be required under the GMM. One should, however, also consider whether one is complying with the spirit, and not just the letter, of the IFRS 17 Standard – as one’s auditors will surely be considering the same.

Pamela Hellig is a senior actuarial manager at MBE Consulting. Email: pamelah@mbe-intl.com

Notes

(1) The insurer will still need to consider their practical ability to reassess the risks; i.e. cancellation or repricing may strictly be allowed under the terms of the contract, but would practical issues, such as reputational risk, prevent enforcement of such terms?

Pamela Hellig