The premium allocation approach (or PAA) is a simplified measurement model in IFRS 17 to account for insurance contracts. It is intended for insurance contracts of short duration (i.e., one year or less contract boundary) or in cases where the results under the PAA would not materially differ from applying the general measurement model, which is the primary (or default) accounting model in the standard. However, don’t be so sure of the word “simplified”… as we’ve noted previously in one of our blog posts, there are still challenges to applying this model. In our IFRS Update: Insurance (2021) course, we highlight an issue that has led to a number of questions from our clients… including only “premiums received” when measuring the liability for remaining coverage (or LRC) under this model. Let’s take a look at this issue here.
Under the PAA approach to measuring insurance contracts, the LRC is simplified by allowing an entity to base the amount on unearned premiums, rather than having to determine the fulfillment as required under the general measurement model. Specifically, the amount recognized for the LRC at inception is depicted in the graphic below:
The part I would like to focus on relates to the “premiums received,” which is recognized both at inception and subsequently, and the “amount recognized as insurance revenue for the coverage period,” which is part of the subsequent measurement. This has caused some confusion in recent months, but as you will see, the accounting, while slightly different, is not that big of a deal from what you might be used to.
The IASB’s Transition Resource Group (TRG) was asked to confirm the IASB’s intention to use the term “premiums received” and not “receivable” which was typically the basis for measurement for short duration insurance contracts. Not only did they confirm the treatment but provided an illustration for how it will work in an agenda paperback in May 2018 (AP 06, Scenario 2). Let’s take a look at the example.
Assume a one-year insurance contract that charges EUR 1,200 in premium for the year and acquisition costs (e.g., commissions) incurred by the insurer at the beginning of the coverage period of EUR 180. For the purpose of the example and to illustrate the change in accounting, assume the premium is not paid until the END of the year.
Prior to IFRS 17, most insurers applied a model similar to U.S. GAAP for short duration contracts that recognized premiums receivable and unearned premiums. The accounting would look something like this:
Note that a premium receivable (asset) and UPR (liability) is recognized at inception, along with acquisition costs of 180 (asset). The net impact on the balance sheet is the 180 net asset position. There is no P&L impact as no coverage has been provided at inception (i.e., Day 1).
Subsequently, the UPR and acquisition costs are amortized into the P&L over the coverage period. The UPR amortization results in recognition of EUR 300/ quarter in revenue, whereas the acquisition costs amortization results in an expense of EUR 45/ quarter (not presented on the table).
How does this compare to the accounting under the PAA model in IFRS 17? Let’s compare:
Under IFRS 17, ALL amounts related to the insurance contract (e.g., UPR, premium due/collected, acquisition costs, etc.) are capture in one line item, insurance contract asset/ liability. Also, as no premiums have been RECEIVED upfront, the only item recognized at inception is the acquisition costs incurred (EUR 180).
Subsequently, acquisition costs are amortized out of the insurance contract account and insurance revenue is recognized based on the coverage provided. What’s important to note here is that the insurance revenue recognized is based on the EXPECTED premiums to be received over the contract boundary, not the amount recognized to date. In other words, total expected premiums are EUR 1,200 and therefore one-fourth, or EUR 300, is recognized each quarter, even though no premium has been RECEIVED.
You see that when comparing the old and new model, the end result is exactly the same in both the balance sheet and income statement, however, under previous IFRS, accounts are reported separately, whereas under IFRS 17, amounts are presented in aggregate in the balance sheet. To move to IFRS 17 (and assuming the old way aligns with your current approach), entities can simply “map” their old general ledger accounts to the new “LRC” line item, resulting in compliance with the new IFRS 17 PAA accounting model.
If you are a journal entry person who like debits and credits, below you will see how the journal entries work under the IFRS 17 model:
This example helped me see how the concept of accounting under the PAA for “premiums received” actually works! When premiums are collected upfront, there is little difference between the old way and IFRS 17, but premiums collected at the end of the period looks a little different, even though revenue from insurance coverage is measured largely the same way.
I hope this helps you too… and good luck with adopting IFRS 17… you’re running out of time so get going!
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