An update from the Premium Allocation Approach work stream
Here, Brendan Counsell of the Institute of Actuaries’ AASB 17 Implementation Taskforce provides an update on the ‘premium allocation approach’, or PAA to assist Australian actuaries involved in implementing the new accounting standard.
The PAA work stream is another of the technical groups of the Institute of Actuaries’ AASB 17 Implementation Taskforce which overall is focused on producing guidance for Australian actuaries involved in implementing the new accounting standard.
Previous updates have covered measurement approaches available under AASB 17 – namely the general model (‘building block approach’ or ‘BBA’) and the variable fee approach (‘VFA’). A third measurement approach available under AASB 17 is the ‘premium allocation approach’, or PAA. The PAA is a simplified model for short duration contracts and is expected to be available for many general insurance and health contracts as well as some life insurance contracts. This is the topic for this month’s update.
The PAA work stream meets monthly and includes a wide range of participants from general insurance, health insurance and life insurance backgrounds.
What is the premium allocation approach?
The premium allocation approach measures the ‘liability for remaining coverage’ associated with a group of insurance contracts at the end of a reporting period as the sum of:
- The opening liability, plus
- Premiums received during the period, less
- Insurance acquisition cash flows (if applicable), plus
- The amortisation of insurance acquisition cash flows during the period (if applicable), less
- Allowance for the time value of money if there is a significant ‘financing component’ associated with the contracts, less
- The amount recognised as revenue for coverage provided during the period, less
- Any ‘investment components’ (i.e. payments made to policyholders that are not contingent on an insured event) transferred to the liability for incurred claims during the period.
In summary, the PAA method is not dissimilar to measurement approaches applied under the current Australian accounting standard AASB 1023 for general insurance contracts and also simplifications applied for valuing certain types of life insurance contracts under AASB 1038.
The ‘liability for incurred claims’ is included within the scope of the PAA work stream due to its significance for many short duration contracts. It is important to note, however, that the liability for incurred claims is relevant for all insurance products regardless of the measurement approach used to calculate the liability for remaining coverage (i.e. PAA, BBA or VFA).
Which products qualify for PAA?
PAA can be used as the measurement approach if, at inception of the group:
- The coverage period for each contract is one year or less, or
- The entity reasonably expects that such simplification would produce a liability for remaining coverage for the group of contracts that would not differ materially from that produced using the building block approach.
Defining the coverage period based on the ‘contract boundary’ can be subjective and is the focus of another work stream to be covered as part of a future update. Suffice to say that PAA is expected to be available for many general and health insurance contracts and some life insurance contracts.
What are the key interpretations on which the PAA work stream is focused?
A key focus for the PAA work stream is how PAA eligibility is assessed for contracts with a coverage period of more than one year, i.e. contracts for which PAA does not automatically apply. The PAA eligibility criteria are subjective with some key questions being:
- How, and at what level, is materiality assessed when comparing outcomes against the building block approach? Can allowance be made for the materiality of the group of contracts to the overall financial statements even if the difference in outcomes is considered ‘material’ for the group of contracts?
- What is meant by ‘reasonably expects’ when assessing uncertain future outcomes?
- What is meant by ‘significant variability’ in the fulfilment cash flows for which the standard explicitly specifies that the PAA eligibility criteria are not met?
Many other professional and industry working groups, such as the International Actuarial Association and accounting bodies are concurrently focussed on these interpretations. The Institute of Actuaries’ AASB 17 taskforce is monitoring external developments and incorporating these into its deliberations.
Other key topics that our PAA technical workstream is expected to cover for include:
- The pattern of revenue recognition over the coverage period.
- Circumstances in which a ‘significant financing component’ exists under the contract and allowance for the time value of money should be made.
- Specific considerations for reinsurance contracts measured using PAA.
- Considerations for transition to the new standard.
- Treatment of some industry-specific items such as risk equalisation and pooling mechanisms for certain types of health insurance and general insurance.
In summary, while the PAA is viewed as a ‘simplified’ method and certainly not as technically complex as BBA or VFA, there are plenty of subjective areas that can have significant implementation implications for insurers.
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