Would the application of the premium allocation approach result in business as usual?
Application of the premium allocation approach
The new Insurance Contracts Standard (ICS) is expected to be issued at the end of the year. The focus of the ICS is the Building Block Approach (BBA) which has been introduced as the new model to recognise and measure insurance contracts, impacting mostly life insurers. Many short-term insurers may have argued that the new ICS will not impact them as a simplified model, the Premium Allocation Approach (PAA), will result in business as usual. The PAA is intended to be a proxy for the more complex BBA.
For short and long-term insurers wanting to apply the PAA, the most important consideration is whether the contracts written by the insurers will meet the criteria for the PAA to be applied. Use of the PAA is permitted (but not required) if:
- the coverage period of the contract at initial recognition is one year or less; or
- use of the PAA produces measurements that are a reasonable approximation to those of the BBA – i.e. at inception, the entity expects no significant variability in the fulfilment cash flows.
Many South African short-term insurers are expected to be able to meet the criteria for applying the simplified PAA - thereby avoiding some complexities introduced by the BBA. However, not all contracts currently considered to be short-term will automatically meet the criteria to apply the PAA. Contracts with a longer tail, such as engineering and liability business, may not meet the above criteria for the application of the PAA, and therefore the BBA should be applied. Short-term insurers should consequently review the possible impacts which the new ICS may have on their contracts.
The 2016 South African Insurance Survey contains an detailed example of how PAA is a good proxy of the BBA.
How should this example be applied to insurance contracts?
Many assumptions are used in this example to simplify the illustrations, however in real life cases nuances for each contract may create additional complexities. When reviewing the example, insurers should evaluate how their contracts are different, and what impact this would have.
Specifically, insurers should consider the timing of cash flows and the level of prudency within current insurance contract liabilities.
What should insurers do?
As we move closer towards an issued Standard on Insurance Contracts, insurers should understand the differences between their current accounting basis, and the PAA or BBA.
An understanding of how the PAA and BBA differ will facilitate in the decision as to which method to apply. It is time to look forward, and brace the “unusual” as the application of the PAA may not result in business as usual as some insurers are expecting.
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