22 May 2023

IFRS 17: simplifying accounting for multi-year reinsurance contracts

There are circumstances in which the Premium Allocation Approach can be used for multi-year reinsurance contracts, as Milena Lacheta explains

After more than a decade of development, the accounting standard IFRS 17 Insurance Contracts became effective on 1 January 2023.

The standard is principles-based and therefore leaves some space for diversity in interpretation and practical applications. Its paragraphs addressing recognition, measurement and presentation of ceded reinsurance have been one of the more difficult conundrums for industry experts.

Most head-scratching accompanying 1.1.2023 renewal preparations were in respect of multi-year contracts. The pressing question has been whether a given multi-year reinsurance structure would be eligible for the Premium Allocation Approach (PAA).

Model choices for P&C insurers

Milena LachetaIFRS 17 offers a default measurement model for insurance contracts issued and for reinsurance contracts held: the General Measurement Model (GMM).

Although a product of an accounting standard, this valuation model is considerably actuarial in nature, and similarly to Solvency II, it determines the value of insurance liabilities based on a net present value of all the cash flows pertaining to a group of contracts, plus a risk adjustment.

However, unlike Solvency II, the GMM-measured insurance liabilities explicitly include a layer representing unearned future profit called the Contractual Service Margin (CSM), which is amortised into the income statement over the contract's coverage period. This is the heart of IFRS 17: the mechanics of the model enforce both timely recognition of underwriting losses and recognition of profit in line with the provision of re/insurance coverage. This overarching principle is fundamental to multi-year contracts of life insurers and many P&C insurers.

However, P&C insurers underwriting short-term business (12 months or less) can opt to apply the less onerous PAA.

In some cases, the PAA can also be applied to contracts with a duration beyond 12 months

While the PAA's requirements for the claims incurred are almost identical to those of the GMM (discounting, risk adjustment), its forward-looking premium allocation pattern closely resembles today's widely accepted practice of unearned premium reserving. The International Accounting Standard Board designed the PAA to be a good proxy of the GMM and therefore applying the PAA instead of the GMM should not result in different financial impacts. Consequently, the primary reasons for using the PAA are operational simplification and a reduction in the reporting burden.

In some cases, the PAA can also be applied to contracts with a duration beyond 12 months. The high-level principle allows this as long as the PAA results are not materially different from the would-have-been GMM measurement results. This introduces the PAA eligibility test — yet another accounting test exercise along the lines of testing for impairment and testing adequacy of premium reserves. However, the PAA eligibility test is based solely on a principle of simplification being a good proxy.

Multi-year reinsurance covers

Multi-year reinsurance covers can be accounted for under the PAA in three ways:

  1. The value of the cover is considered immaterial
  2. The cover is material, but can be considered as a sequence of one-year covers instead of a single multi-year cover
  3. The cover is considered material, multi-year (so it does not meet the two conditions above), but passes the PAA eligibility test

1. Materiality

The value of a reinsurance cover would be considered material when together with other information included in the financial statements it could influence decisions that the reader of these statements makes after reading them. Accounting auditors follow specified guidance to determine materiality thresholds.

Gallagher Re's tip is to always discuss materiality directly with your accounting advisor and/or your auditor. In our experience, the vast majority of the reinsurance covers we placed have met materiality thresholds.

2. Sequence of one-year covers

Cash flows relating to existing and future contracts are separated by contract boundaries. These boundaries help to determine which cash flows to include in the valuation of a given group of insurance contracts. According to IFRS 17, a contract boundary sets an end to a contract when a substantive obligation to pay the premiums or to provide service ends. This happens when:

  • The reinsurer has the practical ability to reassess the risk and reprice the contract; and/or
  • The pricing of the initial premium did not take into consideration risks after the reassessment date1

Taking a closer look at these two conditions:

The reinsurer has the practical ability to reassess the risk and reprice the contract

For example, direct insurance contracts sometimes contain a notice period where the policyholder can cancel on the 90th day of the coverage period, stop being insured and stop paying premiums. Accounting-wise, two separate contracts would be recognised: one for the first 90 days; and the other for the remaining duration of the contract (if the holder chooses to continue). This could shorten the coverage period of each contract and make it PAA-eligible.

In practice, we see very few contracts that would meet such criteria

In theory, a three-year reinsurance contract could be measured under the PAA as a series of three annual contracts if the cedant could enter into an agreement for a few years but have the right to cancel the contract every 12 months regardless of circumstances. This would mean that at every renewal the reinsurance premium could be reset (dependent on loss experience).

In practice, we see very few contracts that would meet such criteria: firstly, cedants use multi-year contracts to pay a lower premium and lock it in at the origination date; secondly, most reinsurance contracts (other than cancel-and-rewrite contracts) can be cancelled only in a specific set of circumstances (e.g. war, credit default, change of ownership, etc.).

Cancel-and-rewrite contracts attracted the most questions at 1.1.23 renewals. In such contracts, the reinsurer does not have a cancellation option, but the cedant does (at the end of each year), provided the profit commission has not been eroded by losses. If there have been losses, there is no profit commission to be paid in future years until the losses have been paid back via an experience account. The general expectation is this multi-year reinsurance contract will be cancelled at the end of year one and rewritten, but if there is a loss, the contract will have to continue for the remaining two years. Such a cancellation clause is conditional and therefore year one cannot be treated as a one-year contract eligible for the PAA modelling.

Our understanding is that such contracts would be considered as a multi-year contract with a path dependency (probability-weighted for each loss scenario for years 1-3) because the contract boundaries are conditional (we refer to them as soft contract boundaries). As such, it would not qualify automatically for the PAA but would need to pass the PAA eligibility test. Only contracts where cedants can cancel the contract after 12 months in all circumstances would be automatically eligible for the PAA.

The pricing of the initial premium did not take into consideration risks after the reassessment date

If the reinsurance premium paid upfront in year one takes into consideration the economics of the cash flows occurring after 12 months, then the contract is considered a multi-year contract. For example, if a reinsurance contract is priced such that pricing of the initial premium in year one takes into account a profit commission to be paid out in year three, then there is an economic link between cash flows from year one and year three and the contract is considered multi-year and will need to be tested in the PAA eligibility test.

3. The PAA eligibility test

As we have described, there are two types of multi-year contracts that will need to be tested for PAA eligibility:

  • Loss-occurring multi-year covers that are material and have soft boundaries
  • Risk-attaching covers that are material2

The key conceptual step is to understand the drivers of differences between the two models

To pass the test, the value of a reinsurance contract measured under the PAA must not differ materially from the would-have-been the GMM value.

Many clients have asked us if the comparative nature of the PAA test means they would need to build the GMM to compare its results to the PAA: the answer is no. Comparing the results of the two approaches can be done using a simplistic valuation or can be a robust conceptual exercise.

The key conceptual step is to understand the drivers of differences between the two models. The PAA is an accounting model where the premium is amortised from the balance sheet to the P&L over time. The GMM is an actuarial model sensitive to forward-looking assumptions that will affect expected values of cash flows, levels of discount rates and levels of risk adjustment. We can analyse each of these three building blocks of the GMM to understand its impacts on material differences between the GMM and the PAA.

Future cash flows. At the risk of oversimplifying, the PAA uses expected premium receipts that will be amortised over time and the GMM uses expected values of cash flows. The shorter the time horizon, the greater certainty we can assign to the payments. The more predictable the cash flows of a multi-year cover, the smaller the difference between the GMM and the PAA.

Discounting. The GMM requires all cash flows to be discounted while the PAA does not. Discount impacts depend on the level of interest rates. The higher the interest rates, the greater the impact of discounting. From the 2007 financial crisis until recently, the risk-free rates in developed economies were extremely low and not a point of concern for many of our clients. However, in a rising rates environment the impact of discounting increases. This means our clients must pay closer attention not to the level of interest rates itself, but to the amount and timing of cash flows in the contract. The biggest impact of discounting stems from very large amounts occurring far into the future. Accordingly, cedants may consider negotiating the timing and amounts of specific payments from reinsurers (e.g. ceding or profit commissions). The earlier the cash flow occurs, the smaller the impact from discounting, and therefore the smaller the difference between a model that includes a discounting requirement (GMM) and one that does not the (PAA).

Risk adjustment. Conceptually similar to the Solvency II risk margin, IFRS 17 represents the cedant's view of compensation for variance in cash flows that they cede to the reinsurer. The greater the cash flow variance, the greater the risk adjustment. Any payments that are contingent and dependent on a number of scenarios (including extreme scenarios), such as profit commissions or reinstatement premiums, would normally increase variance in cash flows from the contract.

This is not to say that reinsurance covers containing all these features are unlikely to pass the eligibility test. They simply warrant an educated conversation with the broker, reinsurer, auditor and accounting advisor.


As a reinsurance broker, we highlight to our clients key actions to consider:

  • Always discuss materiality directly with your accounting advisor and/or your auditor. In our experience, the vast majority of the reinsurance covers we placed have met materiality thresholds
  • Pay attention to cancel-and-rewrite clauses in reinsurance contracts as they do not turn multi-year contracts into one-year contracts that are automatically PAA eligible. Such contracts are likely to require the PAA eligibility test
  • Carefully consider timing and probabilities of payments of the reinsurance contract's cash flows: The more predictable the reinsurance contract's cash flows, and the earlier they occur, the greater the chance the multi-year contract will be PAA eligible

Milena Lacheta is Head of Strategic and Financial Advisory UK at Gallagher Re. Email: [email protected]


1 IFRS 17 Insurance Contracts para. 34(b)
2 A risk-attaching reinsurance contract is considered to have a coverage period of 24 months, which in IFRS 17 constitutes a multi-year contract subject to the PAA eligibility test.