IFRS 17 comes into force on 1 January 2023 and introduces the Premium Allocation Approach (PAA) for simpler liability calculations. We take a look at the PAA and key challenges for insurers.
The PAA offers a simpler alternative to the General Measurement Model (GMM) for calculating liabilities and applies to short-dated contracts and those that would produce a similar measurement under GMM. A huge benefit of the PAA is that general insurers will not be required to estimate future claims or do any form of contractual service margin (CSM) measurement or tracking. This can remove the need for a CSM tracking tool, lowering ongoing costs and resourcing.
Despite the simpler approach, the PAA is by no means straightforward, and implementation has been more challenging than originally thought. We look at the three key challenges below.
While short term contracts lasting less than a year are automatically eligible for the PAA under IFRS 17, it can also be used for longer-term contracts although it’s trickier to prove eligibility. Long-dated contracts are eligible for the PAA if the liability for remaining coverage (LRC) calculation is comparable to that under the GMM. That means many insurance firms will need to run the GMM anyway to demonstrate eligibility. The result will also need to be reviewed and signed off by auditors, with agreement over how key inputs affect LRC sensitivity.
The earnings mechanism present in both models is the main reason the LRC calculations could vary. The IFRS 17 PAA typically uses a ‘passage of time’ methodology, while the GMM uses coverage units that include complex factors such as the size and timing of expected cash flows.
Similarly, different approaches to discounting could also cause the LRC to deviate between the two models. This is particularly relevant for contracts with cashflows extending further into the future, making it more challenging to demonstrate PAA eligibility.
Demonstrating eligibility and ongoing measurement may require new systems and processes. This is because IFRS 17 requires more data than IFRS 4, at a more granular level - particularly LRC calculations, which have previously been aggregated at a higher level and are not currently collected in the right level of detail. In addition, current systems are based on receivable premiums, but under PAA, the LRC is based on received premiums only, so firms will need to update their systems.
It’s also important to consider the long-term implications for eligibility as it’s not necessarily a one-off process due to changing circumstances over time. If firms use the PAA by default for short term contracts, such as motor or medical policies, they may need to apply the GMM further down the line due to the introduction of longer-dated products. Firms may want to consider the value of using the IFRS 17 PAA if ultimately they need to apply the GMM in the long term.
Onerous contracts under PAA
IFRS 17 makes a distinction between profitable, onerous or potentially onerous contracts and how they are treated. Under the PAA, losses for onerous contracts must be recognised immediately, but it’s not always easy to determine if a contract is onerous. This is in contrast to the GMM, which has clear criteria for determining onerous contracts – so PAA may add unnecessary complications.
The International Accounting Standards Board (IASB) encourages firms to assume a contract is not onerous unless "facts and circumstances" indicate otherwise. That said, it doesn’t define the relevant "facts and circumstances", and it’s ultimately a decision for the individual firm and their auditor. Some firms are updating existing indicators, such as modifying the combined ratio to include the risk adjustment or discounting to produce an "IFRS compliant metric". Others are using pricing data, business plans or profitability expectations to determine if a contract is onerous. It’s worth noting that the latter approach brings pricing data into scope for the audit.
PAA and discounting
As PAA predominantly applies to short term contracts, discounting isn’t usually material. But discounting is still required in the following circumstances:
If cash flows are not expected to be paid within one year, which would be the case for the majority of general insurers
For onerous contracts, when comparing the LRC under the GMM and the PAA
When a significant financing component is present, requiring discounting of the LRC at locked-in rates
For the last instance, a significant financing component occurs when cash flows are expected to be settled beyond a one-year time frame. This may be due to insuring as part of a pool or profit commissions on reinsurance outward arrangements.
Recognising the need for discounting is one thing, but the next step is determining what the IFRS 17 discount rate should be. Firms can use a top-down or bottom-up approach, both bringing their own challenges: If following a top-down approach, there’s the question of whether to use a pre-existing or reference portfolio. If using a bottom-up approach, firms need to decide how to define the illiquidity premium of an insurance contract, which in turn relies on how illiquid the LRC and liabilities for incurred claims (LIC) are. Defining illiquidity is particularly problematic, and IFRS 17 offers little clarity on the subject. As such, the sector has been left to develop a market consensus, and there is a considerable variation to date
So, is the PAA worth it?
While the IFRS 17 PAA may seem more straightforward and appear lighter on resources, in reality, it can be as challenging as the GMM. Demonstrating eligibility, establishing discounting requirements, and the use of loss components do not simplify the process – they just present a different set of challenges. Depending on individual business portfolios, the PAA may be more trouble than it’s worth, offering limited benefits while demanding more evidence for an audit trail. The decision ultimately lies with each firm and largely depends on its portfolio, business plan and expected future business; for example, any reinsurance outward arrangements and the need for discounting. Considering the full implications of the PAA will help you plan ahead and make sure there are no surprises further down the line if you chose to implement it.
Contact Simon Sheaf for further information on the PAA and IFRS 17 implementation.