IAN 7 – Premium Allocation Approach

IAN 7 – Premium Allocation Approach

This International Actuarial Note (IAN) provides background and suggested practice on the criteria and measurement of contracts accounted for under the Premium Allocation Approach (PAA) under IFRS X.

What is the Premium Allocation Approach?

The Premium Allocation Approach (PAA) is a simplification of the Building Block Approach (BBA) to measuring insurance contract assets and liabilities. It is an optional measurement approach for contracts of short duration under IFRS X, prior to and during the exposure period of the contracts. The IASB has noted they have developed only one model for measuring insurance contracts, the BBA, with the PAA as an approximation during the coverage period for a short duration contract.

This International Actuarial Note (IAN) focuses on the “liability for remaining coverage”, or for the liability before the occurrence of an insured event. For measurement of the liability from the point of occurrence of an insured event, the “liability for incurred claims”, the reader should refer to IAN’s 2 through 5. These IANs cover the relevant building blocks under the BBA which are applicable in the post exposure period. There is no contractual service margin under the liability for incurred claims as by definition the contractual service margin is amortized over the coverage period of the contract.

When should the PAA be applied?

There is a practical expedient that permits the use of the PAA if a contract’s coverage period is 12 months or less. In cases where the contract is greater than 12 months in duration the standard indicates that the PAA can be used if it would produce estimates that would be a “reasonable approximation to those that would be produced when applying the requirements” of the BBA.

If I wish to use the PAA on contracts greater than 12 months in length, do I have to test whether the PAA is an approximation of the BBA?

The standard doesn’t explicitly require a test to demonstrate the PAA is an approximation of the BBA. It does however indicate that contracts would not meet the requirements to use the PAA if “at contract inception, the entity expects significant variability, during the period before a claim is incurred, in the fulfilment cash flows that are required to fulfil the contract”. The standard further indicates that this would exclude any contracts with embedded derivatives and variability is expected to increase the longer the duration of the contract.

One thing to note is that significant variability is around the fulfillment cash flows and not just the expected nominal cash flows. This would include the amount of discount and risk adjustment, which is also sensitive to the time value of money. Taking into account the time value of money is requiring management to include in the assessment of significant variability the level and variability of interest rates.

As practice emerges we are likely to see increasing documentation to justify the use of the PAA based on the duration of the contracts. Those contract just over 12 months in duration in a stable, low interest rate environment will likely be justified with limited qualitative documentation outlining the nature of the business and why that business is not expected to result in significant variability in the fulfillment cash flows. For contracts greater in length, three to five years in duration, or those shorter than three years but in higher or unstable interest rate environments are likely to require periodic testing to demonstrate the variability in the cash flows are not significant relative to the revenue recognition under the PAA.

What is the initial measurement approach to the liability for remaining coverage?

The initial amount recorded for a contract under the PAA is the:

  I.  Premium received at the time of contract recognition;

  II.  Less any acquisition costs paid at time of recognition*;

  III.  Plus or minus any other pre-coverage cash flows; and

  IV.  Plus any onerous contract liabilities.

*If the contract is 12 months or less the directly attributable incurred acquisition costs may also be subtracted from the liability.

While initially thought of as an unearned premium model, the PAA’s initial measurement criteria will not provide users of the financial statements with as much information as a grossed up unearned premium model. The PAA, through approximating the building block approach of netting cash inflows and outflows, will clearly understate the future exposure by the amount of premium owed under the inforce contracts. It will also make comparisons between companies more difficult using a Written Premium to Capital ratio due to the lack of information of the level of premium that remains unpaid for in-force contracts.

This measurement approach doesn’t capture any expectation of policy cancellations, which if significant on premiums paid could result in overstatement the liability.

When is the contract recognized?

The recognition criteria for contracts under the PAA are the same as the BBA. A contract is recognized at the “earliest of the following:

(a) the beginning of the coverage period;

(b) the date on which the first payment from the policyholder becomes due; and

(c) if applicable, the date on which the portfolio of insurance contracts to which the contract will belong is onerous.”

The first criterion is how most writers of short duration contracts recognize contract under local GAAPs. The second criterion would be triggered if any premium deposit, installment or the full amount is due prior to the start of the coverage period. We will discuss onerous contracts later.

What is the subsequent measurement approach to the liability for remaining coverage?

At subsequent measurement periods the liability for remaining coverage is measured as the previous recorded amount:

  I.  “plus any premium received in the period;

  II.  minus the amount recognised as insurance contract revenue for coverage that was provided in that period….;

  III.  plus any onerous contract liability recognised in the period ……;

  IV.  plus (or minus) the effect of any changes in estimates that relate to any onerous contract liability recognised in previous periods…..;

  V.  plus any adjustment to reflect the time value of money”.

The last item applies only where there is a significant financing element to the contract and it is an election as long as the time between providing the relevant portion of insurance coverage and the due date for the corresponding premium is less than 12 months.

How is revenue recognized for the subsequent measurement period?

The IASB has said that the revenue should be recognized based on the passage of time, i. e. pro rata, unless “the pattern of release from risk differs significantly from the passage of time”. In these cases the revenue should be recognized using the “expected timing of incurred claims and benefits”.

Care should be taken as to what should be considered significant. Clearly the premium associated with a homeowners policy in Florida, where hurricane season falls between June and December of each year, would differ significantly from the passage of time. But other types of policies may have more subtle seasonal effects that would, due to the large number of policies sold, have a significant impact on revenue. For example take most auto policies in the northern states of the US incurred 72-74% of incurred losses over the first 9 months of a calendar year with the remaining 26-28% being incurred over the last quarter with the inclement winter months. This difference is subtle in terms of ultimate loss but could have a significant impact on the revenue recognition and bottom line profit of the company if the premium was recognized in line with the expected timing of incurred claims.

If I am electing to use Other Comprehensive Income (OCI) for changes in interest rates in subsequent measurement periods for the liability for incurred claims, what is my locked-in discount?

If electing the OCI option to minimize the volatility from changes in interest rates in profit and loss, under the BBA the discount rate is locked-in at the start of the coverage period of the contract. The IASB has allowed for a practical difference with the PAA whereby the discount rate is locked in based on the date incurred losses are recognized. Effectively, for practical purposes, for each portfolio of contract this would imply the locked-in discount rate would be based on the average accident date of a period (quarterly or annual).

Remaining topics covered by this IAN are:

Treatment of onerous contracts – refer to the BBA guidance in other IANs. Separating onerous from non-onerous contracts. Portfolio/unit of account

Reinsurance – recognition based on underlying contracts

Bifurcation of non-insurance features

Presentation

Transition

Possible questions to be answered include:

What is an onerous contract? How do I measure it? How often do I have to test for it?

How is outwards reinsurance dealt with under the PAA?

How is inwards reinsurance dealt with under the PAA?

When and how to I bifurcate non-insurance features under the PAA?

How are results presented under the PAA?

What do I need to do on transition to the new standard if I am going to measure my liabilities using the PAA?