There are three measurement approaches under IFRS 17 for different types of insurance contract:
General model should be applied to all insurance contracts, unless they have direct participation features or the contract is eligible for, and the entity elects to apply, the premium allocation approach.
Premium allocation approach is an optional simplification for measurement of liability for remaining coverage for insurance contracts with short-term coverage.
Variable fee approach should be applied to insurance contracts with direct participation features. This approach deals with participating business where payments to policyholders are contractually linked and substantially vary with the underlying items. This approach cannot be used for the measurement of reinsurance contracts.
The general model of measurement of insurance contracts is based on the following estimation parameters:
- fulfillment cash flows, comprising of:
- a current estimate of unbiased and probability-weighted future cash flows expected to arise during the life of the contract;
- a discount adjustment to reflect the time value of money and financial risks, such as liquidity and currency risks (layers of discounting);
- an explicit risk adjustment for non-financial risks; and
- a contractual service margin representing the unearned profit from the contract.
An entity may simplify the measurement of the liability for remaining coverage of a group of insurance contracts using the Premium Allocation Approach (PAA) on the condition that, at the inception of the group:
a) the entity reasonably expects that this will be a reasonable approximation of the General Model, or
b) the coverage period of each contract in the group is one year or less
Thus, the variable fee approach (VFA) is applied to insurance contracts with direct participation features that contain the following conditions (‘eligibility criteria’) at initial recognition:
- the contractual terms specify that the policyholder participates in a share of a clearly identified pool of underlying items;
- the entity expects to pay to the policyholder an amount equal to a substantial share of the returns from the underlying items; and
- a substantial proportion of the cash flows the entity expects to pay to the policyholder should be expected to vary with cash flows from the underlying items.
In order to be in scope of the VFA, an insurance contract would need to meet all the three eligibility criteria stated above, and this eligibility test is only performed at inception. In addition, it is noted that the definition refers only to the terms of the insurance contract, and therefore it is not necessary that the entity holds the identified pool of underlying items.