IFRS 17 is here and it’s a pretty big deal if you are in the insurance industry! Back in June, we highlighted its arrival in one of our blog posts. Now that we’ve had a few months to digest the standard, we see that for many, the implementation of IFRS 17’s general measurement model (GMM) will pose significant challenges. This might include the estimation of expected cash flows, an explicit risk adjustment for non-financial risk, all adjusted by a discount rate to take into account the time value of money. As if that wasn’t hard enough, the subsequent measurement and financial statement presentation requirements only add to these challenges. But what about IFRS 17’s “simplification” to the GMM, called the premium allocation approach (or “PAA)? Is that the escape hatch we’ve all been looking for?
The PAA is intended to be a simplified approach to applying IFRS 17’s GMM. It is an accounting policy election for certain insurance contracts, but not a required approach. The theory behind this approach 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 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 at this point that this PAA sounds familiar. In fact, there are many similarities between the PAA and the model under US GAAP’s ASC 944 for short-duration insurance contracts, commonly applied by insurers under IFRS around the world. For many, this US 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 must be taken into account before you are “free and clear.” Here are a few of these considerations:
This simplified approach is only allowed under IFRS 17 if:
1.The coverage period for the group of insurance contracts is one year or less; or
2.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. An 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).
Under the PAA, if at any time after the initial recognition the group of insurance contracts under the simplified model 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.
As a general principle under IFRS, 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 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.
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.
Is the PAA Going to Spare Us from IFRS 17?
The answer to this question will vary from insurer to insurer. Clearly, the IASB aimed to provide relief for certain types of insurance contracts, but as we’ve discussed here, nobody will be completely “free and clear” from IFRS 17 and its 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.
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