IFRS 17 Premium Allocation Approach (PAA) – Simplified but not Simple

 

In this video Legerity’s IFRS Global Lead Mark Miller looks at challenges in measurement, data and incurred claims; and how the Premium Allocation Approach (PAA) may reduce the challenge of IFRS 17 for many insurance firms.

Video Transcript

There are quite a lot of complications that we need to be thinking about before fully launching into PAA and just assuming it’s a relatively simple change from what we’re doing now.

Measurement Challenges

I think the first thing is around measurement. Not every insurer will be eligible for PAA, so there are strict rules about eligibility.

The simplest one is if you’ve got contracts for less than one year, then you automatically apply for longer contracts. You need to fundamentally demonstrate that by applying PAA, the answer that you’re going to get is not materially different from the general model; and there’s a sort of restriction on that as well.

If you expect your cash flows to be significantly variable, then again you won’t be able to use the PAA. We have to think about how we’re going to qualify for PAA and if you do have contracts that are longer than one year; making sure your auditors are involved at an early stage and that your justification is valid.

IFRS 17 is all based around the unit of account, and so that means grouping contracts together for measurement purposes and PAA is no different. We do have to think about how we’re going to group our contracts together when we’re doing the PAA approach.

Then there’s a quiet contract. Often insurers are buying books of business or transferring books of business around the group. Unfortunately, under the PAA it’s often the case that you can run into difficulty if the contracts have moved into runoff, effectively where the general model principles then apply.

It’s going to be important to consider making sure you have the right kind of solution that can handle acquired books of business, because inevitably that may well happen in the future.

I think the biggest area that is probably a complexity for is onerous contracts. If the contract is deemed to be onerous, and the standard uses the words facts and circumstances, so you don’t necessarily have to measure fully the contracts under the general model every reporting. But if indeed it is clear that the contracts are onerous, then you need to, unfortunately, apply the full GMM functionality.

Data Challenges

Although you’re getting a simplification, you need to be very aware that you may require the GMM functionality in your solution around data. With groupings with different kinds of categories, it’s often going to be the case that data isn’t at the right level of granularity. That could be in this aggregation of data and you’re going to need some processes to manage that.

That allocation engine, as part of the solution, is going to be very important and those allocations could be quite complex. They may require to be based on balances or indeed they may be based on non-financial aspects, so you need quite a sophisticated allocation engine to handle that the fundamental measurement of the liability for remaining coverage in PAA is based on what’s premium received.

In the early days people just thought ok premium but then you know it’s become clear that this really is premium received i.e the cash premium received by the company. I think a lot of businesses may not have that kind of data easily accessible. So, that’s something to look into early in the project is really how can you measure premium received and in a timely manner book that for your accounting.

In terms of the LRC we have the LRC release mechanism, so you know currently a lot of insurance using a premium earned basis under PAA you’re allowed to release it based on a simple straight-line time basis. But there are other mechanisms if appropriate where you might need to release it based on a risk profile; so it’s important to look at the kind of calculations that you might need for your LRC release and have you really got the correct data and can it be assigned to the relevant PAA contracts.

I think another thing to think about is when they’ve got open cohorts and you’re building up premiums for policies over time, we need to be able to track those premiums as they’ve been booked and therefore the releases may need to be attached to those so there could be some complications in that mechanic. And another area is pre-acquisition costs so this could mean simply that you just paid the broker before the policy incepted and you need to keep track of that asset before amortizing it against the revenue line.

But there’s recently in the- you see in the exposure Draft is you’re actually allowed now to allocate some of the acquisition costs to renewals and that means A) you’re going to have to run that kind of allocation calculation but then secondly, you’re going to have this acquisition cost asset on the balance sheet waiting to see if the policy reviews or not. You need to test it for impairment and indeed have an aspect of your solution that can measure and keep track of that

Incurred Claims Challenges

One of the biggest areas, that unfortunately isn’t necessarily simplified in PAA, is the incurred claim. Incurred claims are effectively measured under the general model principles.

Insurers may not have as part of their current actuarial process, the ability to produce cash patterns, because you need to measure your incurred claims based on the future projected cash flow, so the outputs of your actuarial model need to produce cash and cash-flow-type outputs.

If your claims are expected to settle within one year then you don’t need to do any discounting, but if you do have longer liability claims then discounting under the general model principles apply. In which case you’ll need to think about the correct rate and of course make sure the finance expenses are correctly accounted for in the books.

I think another area is particularly around claims is the modelling of claims. So, you know the date that you need to look at for incurred claims projection is the reporting date so, that may not be you know how your modelling currently works where you might be looking at accident year or another basis.

Also, the way that you’re actually projecting your claims may not group neatly into the IFRS 17 group. So, there could be a number of areas around the modelling of your incurred claims that need changing to map into the processes required for IFRS 17.

And similarly, the incurred claims have to have a risk adjustment attached to them so you may be currently producing some sort of risk margin or a Solvency II basis.

Whether that applies in IFRS 17 needs to be reviewed and you’ll need a process to produce a risk adjustment at the level of granularity from either of the IFRS 17 groups. So, it’s not necessarily the case that your current claims modelling and forecasting process will be suitable for IFRS 17, and it needs to be looked at early in the project.

Reinsurance Challenges

A lot of reinsurers are looking to see whether they can apply the PAA, and indeed, general insurance may well have reinsurance on the book.

Reinsurance is an aspect that needs to be factored into the project. It’s not obvious that your reinsurance contracts can be measured under the PAA, so that needs to be tested. Just because the underlying contract is measured under PAA, it doesn’t necessarily follow that your reinsurance can.

Reinsurance contracts can be quite complex, and there can be issues in terms of assessing what is the initial recognition point, and what is the overall contract boundary. And indeed, there can be mismatches with the underlying contracts which may create further complications if you have been accounting for your reinsurance based on the underlying contract data.

The reinsurance aspects of IFRS 17 require you to look at cash flows for relating to credit risk for counter-party. This may well not be something you’re doing now, so you’ll need access to credit risk models.

One of the most complex areas now in IFRS 17 is to address mismatches between profitability on underlying contracts and reinsurance. That has been addressed to some extent in the standard now, but you do need to maintain these links between the underlying contracts and the reinsurance contract.

Where you have proportionate reinsurance, you’re allowed to take into account the loss on the underlying business, and potentially recognize gains on your proportionate reinsurance. A lot of insurers would find this useful and therefore, you need that that mapping and that ability to look at balances and that’s an area where sub-ledger solutions are particularly strong.