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Unearned Premium Reserves Change is in the Wind by Roger M. Hayne Milliman & Robertson, Inc. 1999 CLRS.

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Presentation on theme: "Unearned Premium Reserves Change is in the Wind by Roger M. Hayne Milliman & Robertson, Inc. 1999 CLRS."— Presentation transcript:

1 Unearned Premium Reserves Change is in the Wind by Roger M. Hayne Milliman & Robertson, Inc CLRS

2 How Easy We Had It “Unearned premium reserves are substantial liabilities on the financial statements of property-liability insurance companies. However, they represent one liability that should be easily determined in amount, without subjectivity and based on the system and method the company elects to use.” Property-Casualty Insurance Accounting, 1994

3 Why Worry?

4 Why the Difference? n Selected companies not representative of industry (to quote the kids … “Duh!”) n Companies have relatively large proportion of multiple year business n Much warranty with short payment tails but long emergence tails n Result: Increased NAIC attention in recent past

5 NAIC Reaction n First separate UEPR treatment for “warranty” coverage (1994) n Next more complex, 3-part calculation for longer-term covers (1995) n Finally inclusion in statement of opinion (in “practices” 1997 & “instructions” 1998)

6 Warranty Rules n UEPR based on written premium n UEPR is percentage of written premium that losses and expenses arising after the valuation date bear to the total n No longer “equity” in the UEPR for prepaid acquisition expenses n Applies to all “warranty” coverages

7 Long-Term Contracts n Special rules for “long-term” contracts n Excludes: –financial guaranty contracts –mortgage guaranty policies –surety contracts n Includes: –terms of 13 months or longer –if insurer cannot cancel or change premium

8 The Rules n Three tests: –Amount refundable on cancellation –Percent losses & expenses to happen in future –Present value of future obligations (net of future premium) n Individually largest for latest 3 policy years n Aggregate largest for all prior policy years n Based on most recent data

9 Test 1 n Amount refundable (at valuation date) on cancellation n Often pro-rata n Parallels earning pattern for other coverages n May end up dominating calculation at unexpected times

10 Test 2 n Written premiums times “a” divided by “b” n Terms defined by: –a is losses and expenses expected to emerge after the valuation date –b is estimated ultimate losses and expenses n Note, expenses included n Designed to match premium inflow (earning) with loss and expense outflow

11 Test 3 n Present value of: –Expected losses and expenses after valuation date minus –Guaranteed future premiums n Discounted from date of emergence not date of payment n Some specification of interest rate used n No reference to premiums written

12 Some Details n All based on direct losses and expenses, reinsurance “later” n Interest rate in Test 3, smaller of: –YTM (yield to maturity) of 5-year treasury bills –Company’s YTM on statutory invested assets less 1.5% n Net of salvage/subrogation but not deductibles (unless secured)

13 Some Basic Observations n Premium earning not completely known when you write a contract n Tests 2 and 3 consider losses and expenses unlike UEPR calculations for other lines n If earned premiums are written minus unearned then it is possible to have negative earned premium in a year n Actual effects depend on nature of contract

14 Some Example Contracts

15 The Contracts n Contract 1 - Similar to a five-year, limited mileage extended service contract on a new car n Contract 2 - Similar to a two-year, limited mileage extended service contract on a used car n Contract 3 - Similar to an appliance warranty or unlimited mileage new-car contract

16 Three Scenarios n Note all have $80 in expected losses and expenses after policy issue n Scenarios: –$100 price, 5.0% underwriting profit –$85 price, 9.1% underwriting loss –$60 price, 48.3% underwriting loss n All actually well within reason for “real world” warranty experience

17 $100 Price - Contract 1

18 $100 Price - Contract 2

19 $100 Price - Contract 3

20 $85 Price - Contract 1

21 $85 Price - Contract 2

22 $85 Price - Contract 3

23 $60 Price - Contract 1

24 $60 Price - Contract 2

25 $60 Price - Contract 3

26 Contract 1 Earned

27 Contract 2 Earned

28 Contract 3 Earned

29 Contract 1 Loss & Expense Ratios

30 Contract 2 Loss & Expense Ratios

31 Contract 3 Loss & Expense Ratios

32 Implications n Tests appear to apply to long-term contracts in the aggregate, so effects of contracts 1, 2, and 3 may offset n For better or worse (better in speaker’s opinion) requires periodic analysis of warranty book n Detailed analysis may help get a better handle on the business

33 Analysis n Tests make distinction between: –Emergence lag (covered by UEPR) –Payment lag (covered by Loss & LAE reserves) n Analysis of experience should then also consider the two separately n Group data by policy period n Standard development still blends the two

34 Analysis (Continued) n “Extended Service Contracts,” 1994 PCAS has an approach n Group current valuation data by policy period and accident period n Most recent “diagonal” is most recent accident period and most immature, etc. n Use accident period analysis to develop diagonals

35 Some Considerations n Policy period emergence depends on contract characteristics (term, mileage, level of coverage, etc.) n Accident period lag probably more uniform across at least portions of book n Accident period lag usually short, but beware exceptions exist (processing lags because of TPA batching, etc.)

36 Some Considerations (Continued) n Know your book n Characteristics can affect analysis and comparison with other sources n In early-to-mid 1980’s changes in manufacturer warranty plagued analysis of auto warranty books n “Extended Eligibility” is latest “wrinkle”

37 Conclusions n More work for opining actuaries n Hopefully a better tool in managing long- term exposures n Although the UEPR may be “conservative” could lead to misleading year-to-year experience n Potential accounting issues when UEPR exceeds written

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