Since IFRS17 Insurance Contracts came into force on January 1st, 2023, insurance companies are faced with the question of which measurement model is best suited for reporting their contracts. In this article, we look in detail at the alternatives, particularly for the P&C businesses featuring multi-year contracts within their portfolio. Special attention is given to those portfolios that are or may become onerous.
IFRS17, being a principle-based accounting standard, grants insurers a certain degree of judgement when setting-up their accounting policies. In this article, we focus on multi-year Property & Casualty (P&C) contracts, encompassing diverse categories such as construction at risk, engineering, or reinsurance risk-attaching contracts. Hence the feasible options for model selection in this context are the General Measurement Model (“GMM”) and the Premium Allocation Approach (“PAA”).
The GMM requires technical actuarial expertise to set up the best estimate assumptions and cash flows. While the model provides valuable insights into the contract’s performance by enabling the tracking of loss component, contractual service margin, and analysis of period experience adjustments, it requires intricate calculations, extensive examination of outputs, and access to reliable databases containing comprehensive and detailed data.
Compared to the complexities of the GMM, the PAA appears much simpler. Its streamlined approach, based on a premium amortization pattern akin to the existing Unearned Premium Reserve (UPR) calculation under IFRS4, renders it as comparatively easier process.
Nevertheless, the stakeholders of the P&C multi-year contracts need to carefully consider the model used – whether the advantages of the market-based GMM outweigh the operational complexities associated with its implementation. Additionally, it needs a thorough examination of whether the simplicity of reporting achieved through PAA aligns with the preferences and requirements of their respective businesses and whether their contracts meet the eligibility criteria for the PAA approach.
The application of the PAA measurement model depends on meeting specific criteria outlined in paragraph 53 of the IFRS17 standard. The simplest of these criteria is the “duration criterion” mentioned in paragraph 53b, wherein contracts with a coverage period of up to one year automatically qualify for the adoption of the simplified approach.
However, for multi-year contracts, additional considerations come into play as stipulated in paragraph 53a, followed by paragraph 54. In such instances, the standard requires to demonstrate that the PAA measurement of the remaining coverage liability does not materially differ from the GMM measurement for the same liability.
We do not delve into the definition of contract boundary and coverage period or on the materiality assessment in this article. Nonetheless, it’s worth mentioning that the coverage period used for this analysis is the IFRS17 defined contract duration (e.g. due to existence of repricing rights, cancellation clauses, renewal options or extensions to the original contract).
Regarding PAA eligibility, it is important to clarify that the requirement to demonstrate the similarity of the remaining coverage liability under both measurement models does not imply the necessity of reporting two separate sets of numbers. Instead, the assessment must be conducted for each new cohort at the inception of the contract.
In this regard, various methods have been observed among our clients to fulfill this assessment requirement, ranging from simplified Excel-based solutions to comprehensive, advanced models.
To streamline this process, cleversoft has developed a user-friendly, built-in calculation model tailored to assess PAA eligibility efficiently while facilitating comparative analysis of the two measurement approaches.
cleversoft´s integrated PAA eligibility tool allows users to input data and make decisions related to modelling choices, cohort characteristics, base accounting, and reasonable scenarios. It performs calculations in Excel, showing cash flows, PAA, and GMM roll-forwards from contract inception to maturity. Users can modify formulas to suit their needs and add explanatory narratives for judgments made. The tool can be stored with all calculations and documentation in eFrame, providing an efficient audit trail. This streamlined process ensures accurate PAA eligibility assessment and compliant reporting under IFRS17 for multi-year P&C contracts.
The key to determining the applicability of the PAA lies in understanding the behavior of the key components of the liability projection.
Under the PAA, the components that play a pivotal role in defining the value of liability for remaining coverage are: premium and acquisition cost earning pattern and payment pattern. Unlike other measurement models, the entire liability under the PAA is predicated on these patterns, independent of any changes in assumptions or interest rates.
According to Appendix B126(b) of the IFRS17 standard, the allocation of premiums to revenue in a specific period should reflect the timing of incurred insurance service expenses. Thus, in simpler terms, the key components that significantly impact the PAA measurement are:
Under the General Measurement Model (GMM), the liability projection involves a combination of several key components, which collectively build up the liability for insurance contracts. These components include present value of expected future cash flows, Risk Adjustment (RA) and Contractual Service Margin (CSM).
Thus, the key components that significantly impact the GMM measurement are:
Setting aside the measurement model, it is feasible to analyze the behaviour of the liability for remaining coverage based on the various elements and flows covered by the premium. The drivers for release of the liability can be illustrated with proximity as follows:
Based on the above analysis, the key drivers of differences between the PAA and GMM modelling can be attributed to alignment between coverage units and premium earning pattern (for the profit-element of premium) and discounting effect impacting GMM and not present in the PAA.
While the Risk Adjustment and acquisition cost also contribute to differences between PAA and GMM, their impact on liability recognition is less substantial as they are typically aligned with claims and revenue recognition, respectively. The following conclusions can be reached:
Does the existence of onerous contracts prevent the use of a simplified model? No. According to paragraph 18, the entity shall assume no contracts in the portfolio are onerous at initial recognition unless facts and circumstances indicate otherwise. By using the simplified methods, the entity does not get a straightforward answer to whether contracts are profitable or not as there is no assessment of profitability through modelling of cash flows. For the PAA the entity needs to use quantitative and qualitative assessments based on defined metrices (facts and circumstances), for instance analyzing a combined ratio.
If the entity has onerous contracts in the portfolio, it is required to establish a Loss Component (as per paragraph 57, as a difference between the PAA liability and the fulfilment cash flows that relate to remaining coverage of the group). The presence of onerous contracts does not hinder the use of the simplified model; however, it does require an additional step to calculate fulfillment cash flows, which are not automatically provided by the PAA.
Despite this additional requirement, from an operational standpoint, it remains less burdensome compared to implementing the full GMM model. Therefore, while onerous contracts introduce an extra calculation for fulfillment cash flows, the simplified model still represents a lower operational burden.
Our solution provides a range of features that can help insurers to manage their reporting processes more effectively. One of these features is the PAA eligibility tool. Its comprehensive functionalities and user-friendly interface enable users to optimize modeling choices and provide clients with valuable insights for making informed decisions about their multi-year P&C contracts.