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

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

Why Worry?

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

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

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

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

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

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

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

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

Some Details All based on direct losses and expenses, reinsurance “later” 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% Net of salvage/subrogation but not deductibles (unless secured)

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

Some Example Contracts

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

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

$100 Price - Contract 1

$100 Price - Contract 2

$100 Price - Contract 3

$85 Price - Contract 1

$85 Price - Contract 2

$85 Price - Contract 3

$60 Price - Contract 1

$60 Price - Contract 2

$60 Price - Contract 3

Contract 1 Earned

Contract 2 Earned

Contract 3 Earned

Contract 1 Loss & Expense Ratios

Contract 2 Loss & Expense Ratios

Contract 3 Loss & Expense Ratios

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

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

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

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

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

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