Actuarial Notes

Premium Allocation Approach

Study guide: Exam 6C

The Premium Allocation Approach (PAA) is IFRS 17's simplified measurement of the Liability for Remaining Coverage for short-duration contracts: the LRC is premium received less acquisition cash flows, released to revenue over the coverage period — essentially the familiar unearned premium mechanics. It is the model almost all Canadian P&C business uses.

\text{LRC}_{\text{PAA}} = \text{Premium received} - \text{Acquisition cash flows} - \text{Revenue recognised}

  • Eligibility. A group qualifies if the coverage period is one year or less, or if the insurer can demonstrate that PAA measurement would not differ materially from the GMM. The demonstration is required at initial recognition, per group, and must be documented.
  • What the PAA does not simplify: the LIC. Once a claim occurs it is measured identically under both models — present value of fulfilment cash flows plus risk adjustment. The PAA is an LRC simplification only, and this is the most frequently misstated point about it.
  • No Contractual Service Margin. Profit is not identified separately at inception; it emerges as revenue exceeds incurred claims. But the onerous test still applies, and an onerous group carries a Loss Component recognised immediately.
  • Practical expedients available under the PAA: acquisition cash flows may be expensed as incurred if the coverage period is a year or less; and the LRC need not be discounted if the coverage period is a year or less or there is no significant financing component. Both are policy choices to be applied consistently.
  • Why it exists. For a twelve-month policy, the GMM's full cash flow projection, CSM and coverage-unit tracking produce a number indistinguishable from unearned premium, at large cost. The PAA keeps the answer and drops the machinery.
  • Where the PAA is not available, and candidates should recognise the cases: multi-year commercial contracts, extended warranty and surety, some reinsurance held arrangements covering multiple underwriting years, and any group where experience is expected to vary enough over a longer term that the models would diverge.

Is This Group PAA-Eligible? Assess eligibility for each group.

  1. Annual personal automobile policies.

  2. A five-year construction wrap-up liability policy.

  3. A three-year commercial property policy with level annual premiums and stable expected claims.

  4. An excess-of-loss reinsurance treaty covering a single underwriting year, with claims paid over eight years.

Answer

  1. Eligible. Coverage period is one year — automatic eligibility, no demonstration needed. This is the overwhelming majority of Canadian P&C business.
  2. Not eligible without demonstration, and the demonstration will almost certainly fail. Over five years, discount rates and claim expectations will be revised repeatedly; the CSM absorption of those revisions under the GMM produces a materially different pattern from a straight-line PAA release. Construction wrap-ups are the standard example of a contract that must use the GMM.
  3. Possibly eligible, and this is where judgement is required. Level premiums and stable claims mean the GMM's CSM would release roughly evenly, close to the PAA's time-based release. The insurer must demonstrate and document that at initial recognition; the sensitivity is to how much the discount rate and claim assumptions are expected to move over three years.
  4. Eligible on coverage period — the treaty covers one underwriting year, so the coverage period is one year even though claims are paid over eight. The long payout affects the LIC, which is measured at present value plus risk adjustment regardless of model. This is the case that most cleanly separates the two ideas: coverage duration determines the model; claim duration determines the discounting.