Contract Boundary
This chapter will cover two key issues: one regarding Coverage Period and Coverage Term, and the other concerning the recognition date for coverage or calculation.
The Coverage Period and Coverage Term
Coverage Term refers to the duration specified in the insurance contract, which can also be called the Legal Term. In contrast, Coverage Period refers to the duration defined under IFRS 17 standards, and it can also be referred to as the Accounting Term. The main emphasis is on interpreting the Coverage Period itself.
“In the insurance industry, it is possible to encounter a Coverage Period that exceeds the Coverage Term.”
For example, in the Engineering sector, suppose the contract term is 3 years (indicating a Coverage Term of 3 years), but the Coverage Period could be 5 years. This is because there is an additional 2-year responsibility for extended warranty at the end, making the Coverage Period longer than the Coverage Term. Generally, most insurance contracts have a coverage period that is equal to the coverage term.
This Coverage Period determines the model used for calculation as follows:
If Coverage Period <= 1 year, a simple calculation model can be applied (This is referred to as the PAA Method, which stands for Premium Allocation Approach).
If Coverage Period > 1 year, a PAA Eligibility Test must be conducted. If the test is passed, a simplified calculation model can be used. If the PAA Eligibility Test is not passed, then a general calculation model (GMM Approach, which stands for General Measurement Model) must be used, incorporating fulfillment cash flows (covered in subsequent sections), which aligns with the Coverage Period.
Another typical example is Single Premium insurance covering a 3-year period, where both the Coverage Term and Coverage Period are 3 years. In this scenario, the Coverage Period is greater than 1 year, but it may pass the PAA Eligibility Test and hence can use a simple calculation model (PAA Approach).
Another interesting point for insurance companies is the Coverage Period of risk attaching reinsurance (or facultative reinsurance). Typically, this Coverage Period is longer than that of the insurance policies received from the insurer, as these reinsurance contracts are structured as treaties rather than individual policies like those of non-life insurers.An example is provided in the image below,
Treaty A is renewed annually, and the coverage period of the policy is 3 years. If we consider the length of the coverage period from the first day of coverage under the treaty until the end of the coverage period of the last policy issued before the treaty's renewal date, the coverage period of the treaty would be 4 years.
Treaty B is renewed every 2 years, and the coverage period of the policy is 2 years. Thus, the coverage period of the treaty would also be 4 years, as shown in the image above.
In summary, reinsurance treaties do not operate on a policy-by-policy basis. They require allowance for run-off time, meaning if renewals occur annually, an additional year of run-off must be considered. Similarly, if renewals occur every 2 years, then 2 years of run-off time must be factored in. Therefore, reinsurers tend to lean towards using a general calculation model (GMM Approach) due to Coverage Periods exceeding 1 year.
The recognition date for coverage or calculation.
In this section, there are three key characters to understand. The first character is “Enter Into Contract.” The second character is “Risk of Contract Incepts”, and the final character is “Valuation Date”.
Enter into Contract: The date premiums or funds are received.
Risk of Contract Incepts: The date when coverage begins (if an incident occurs before this date, coverage does not apply).
Valuation Date: The date used for assessment or evaluation.
Therefore, money received before the Risk of Contract Incepts (Enter Into Contract occurring before Risk of Contract Incepts) is referred to as Advance Premium. This concept was traditionally recognized as other liabilities before the adoption of IFRS 17, where it is now classified as insurance liabilities (differing from previous accounting items like Prepaid Premiums).
Additional examples and interpretations commonly observed are:
If Enter into Contract coincides with Risk of Contract Incepts, it means coverage starts immediately upon premium payment.
Valuation Date occurs after Risk of Contract Incepts, from which Unearned Premium Reserve (UPR) calculation begins.
Policies paid after coverage begins (where Risk of Contract Incepts precedes Enter Into Contract) are akin to traditional principles, often referred to as Due Premiums.
In summary, this chapter discusses time periods and counting days as fundamental concepts. The critical aspect that will impact subsequent chapters is the interpretation of Coverage Period, influencing the choice of calculation models and financial reporting. This will be elaborated upon in relevant chapters specifically addressing these topics later on.
Written by Master Tommy (Pichet)
FSA, FIA, FRM, FSAT, MBA, MScFE (Hons), B.Eng (Hons)
All rights reserved for the content of this article. Do not use it for any commercial gain. In addition to receiving permission from ABS company only.
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