Is the PAA the secret to IFRS 17?
The Premium Allocation Approach (PAA) is a measurement model available under IFRS 17. But wait, what about the general measurement model (GMM) that’s available? Well, it seems companies have had its share of challenges in implementing the GMM, including estimating expected cash flows, estimating an explicit risk adjustment for nonfinancial risk, and adjusting the discount rate. Don’t get me started on the GMM’s subsequent measurement and financial statement presentation requirements!
So here’s where I come back to the PAA. The PAA is intended to be a simplified approach to applying the GMM under IFRS 17. It is an accounting policy election for certain insurance contracts, but not a required approach.
So is this the secret escape hatch we’ve been hoping for?
Overview of the PAA under IFRS 17
The theory behind the PAA is that the unearned premium on a group of insurance contracts is representative of the liability for remaining coverage under the policies. Of course, in addition to this liability for remaining coverage, a second component, the liability for incurred claims, will need to be recognized as claims on these policies are incurred to comprise the entire insurance contract obligation.
Under the GMM, both components are captured as part of the insurance contracts’ fulfillment cash flows.
Many may be thinking that this PAA sounds familiar. In fact, there are many similarities between the PAA and the model under U.S. GAAP’s ASC 944 for short-duration insurance contracts, commonly applied by insurers under IFRS around the world. For many, this U.S. GAAP model is a straight-forward, simple approach that would be favorable as compared to IFRS 17’s GMM. However, there are some key considerations and distinctions regarding the PAA that I would like to highlight.
Eligibility
The PAA is only allowed under IFRS 17 if:
- The coverage period for the group of insurance contracts is one year or less; or
- The PAA would result in a “reasonable approximation” to the GMM
While many contracts will be eligible due to the one year or less contract period, there are likely to be many insurers that have longer-term contracts that will try to qualify for the PAA under the second requirement. However, this criterion may be difficult to prove, especially for longer duration contracts. And at some point, proof may only be achieved through comparison to a calculation under the GMM, in which case simplification is lost! As a result, it is expected that the primary beneficiaries of the PAA will be underwriters of short-duration contracts (e.g., typical P&C contracts of one year or less).
Onerous contracts
Under the PAA, if at any time after the initial recognition the group of insurance contracts become onerous (i.e., loss making), measurement under the PAA is essentially discontinued and replaced with measurement principles consistent with the GMM (with limited exceptions). This means that even an entity that solely issues short-duration insurance contracts must still have the ability to apply the GMM if situations arise where a group of their contracts become onerous.
Liabilities for incurred claims
The PAA is really only a simplification for “half” of the insurance contract obligation line item under the GMM. While the liability for remaining coverage is simplified, the liability for incurred claims largely follows the principles of the fulfillment cash flows under the GMM. This means that in addition to estimating expected cash outflows from incurred claims, an explicit risk adjustment for non-financial risk must be included in this amount (and disclosed). Discounting of the liability for incurred claims may also be required as discussed below. Once again, this aspect of the PAA will prevent insurers from completely freeing themselves from the GMM.
Discounting
As a general IFRS principle, discounting is typically required only when there is a “significant financing component”. Consistent with this principle, the PAA allows entities to ignore the impact of discounting in certain instances. For the liability for remaining coverage component (i.e., unearned premiums), discounting is only required when the period between receipt of premiums and related coverage is more than one year. For more on premiums received under the PAA, refer to this blog post.
As it relates to the liability for incurred claims, discounting is required when the timing between the incurred claim and its ultimate payment is more than one year. If discounting is not required under the PAA, then an entity may elect as an accounting policy choice to ignore the effects of the time value of money. Otherwise, consistent with the GMM, discounting would be required. As many P&C contracts have longer tails (i.e. period between incurred claim and ultimate settlement), some amount of discounting will often be required under the PAA. For many insurers, this may represent a significant change from current practice.
Acquisition costs
Under the PAA, acquisition costs on insurance contracts with coverage periods of one year or less may be expensed as incurred rather than capitalized as part of the liability for remaining coverage. This is an accounting policy choice that can be made. Insurance contracts with coverage beyond one year must capitalize eligible acquisition costs, similar to the GMM requirements.
Will the use of the PAA spare us from IFRS 17 requirements?
The answer to this question will vary from insurer to insurer! Clearly, IFRS 17 aimed to provide relief for certain types of insurance contracts, but as discussed throughout this post, nobody will be completely “free and clear” from IFRS 17 and the GMM, whether it be due to the possibility of onerous contracts or as a result of having to calculate a liability for incurred claims.
While the PAA will provide many insurers with much desired simplifications, every insurer must understand the GMM and have the ability to apply should the need arise.
Check out our IFRS 17 fundamentals course if you’re looking for more information on the requirements of IFRS 17!
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Disclaimer
This post is for informational purposes only and should not be relied upon as official accounting guidance. While we’ve ensured accuracy as of the publishing date, standards evolve. Please consult a professional for specific advice.
