The Premium Allocation Approach (PAA) – The Shortcut

Envision taking a multi-stage rocket to the grocery store to buy a loaf of bread. That is too much. Likewise, it is pointless and expensive to force an insurance company to make use of the massive General Measurement Model for a simple, short-term contract. Let's have a look at Premium Allocation Approach (PAA).

Why do we need a shortcut?

Chapter 3 taught you the four fundamental components of the GMM or General Measurement Model. You have to project cash flows for multiple decades, apply complicated discounting rates, determine risk adjustments, and amortize the Contractual Service Margin (CSM).

What if you sell basic travel insurance for a year? You receive $120 today from the customer and, the contract expires exactly within 12 months. There's no need to calculate decades of discounted cash flows for these. The Premium Allocation Approach (PAA) is a simplified alternative developed by the accounting board.

The Eligibility Test

The PAA selection can't be based on your laziness. A group of insurance contracts can qualify for the PAA shortcut if it meets either of two stringent conditions:

• The 1-Year Rule: Each contract in the group has a coverage period of no more than one year. This includes comprehensive auto, home, and travel insurance plan.
• The Similarity Rule: The coverage is for more than one year, but the company can mathematically establish that the end number produced by the use of the PAA shortcut is not materially different from that obtained by the GMM in the full specification.

How the PAA Shortcut Works (LRC vs. LIC)

To comprehend the mathematics, it is important to understand how insurance liabilities are separated into two phases:

• Liability for Remaining Coverage (LRC): The obligation to cover the customer for the rest of the year.
• Liability for Incurred Claims (LIC): The obligation to pay the customer after an accident actually happens.

To calculate the LRC under the full GMM, all four building blocks must be used.

With the PAA shortcut, your blocks are skipped! The LRC can easily be calculated by looking at unearned premiums.

The PAA Formula

When a customer pays a $2,400 annual premium on Day 1, you have not earned that money yet. Under PAA, your Liability for Remaining Coverage is simply that $2,400. You do not need to calculate a separate Risk Adjustment or CSM.

As each month passes, you simply "allocate" or recognize a portion of that premium as revenue.

\[ \text{Monthly Revenue} = \frac{\text{Total Premium}}{\text{Coverage Months}} \] \[ 200 = \frac{2400}{12} \]

Every month, you move $100 from your LRC Liability to your Income Statement as Revenue. It is incredibly simple, straight-line accounting.

Important Note: The shortcut is applicable only to LRC. Once the client actually wrecks their car, the claim goes into the Liability for Incurred Claims (LIC). Because claims can take years to settle via the courts, the LIC must be assessed on a traditional GMM blocks (discounted cash flows and risk adjustment) basis.

The PAA offers a huge relief to general insurance companies. It lets them treat short-term premiums as a prepaid phone plan and smoothly recognize that revenue over time without much actuarial math. But what if your contract is the complete opposite of simple?