1. Valuation and Reporting of Future Warranty Claims K Sriram Consulting Actuary

2. AGENDA Warranty Claims: Concept and Characteristics Alternative Approaches for Estimating Technical Provisions Estimating Technical Provisions: GI Actuary’s Standpoint Estimating Technical Provisions: Accounting Profession’s Standpoint Current Actuarial Involvement in Estimating Technical Provisions Concluding Thoughts: Where Actuaries Can Add Value References

3. Warranty Claims: Concept and Characteristics Warranty Claims – An Example A company manufactures and sells washing machines. Under the terms of the sale contract, the company undertakes to make good, by repair or replacement,the manufacturing defects that become apparent within two years from the date of sale. Based on past experience it is probable that there will be some claims under the warranties. Issue: What is the amount of provision to be recognised for the warranty claims as on a given reporting date? It is common for an entity to provide (in accordance with the contract, the law or the entity‘s customary business practices) a warranty in connection with the sale of a product Some warranties provide a customer with assurance that the related product will function as per the agreed upon specifications. Such warranties are referred to as “manufacturers’ warranties”. Other warranties provide the customer with a service in addition to the assurance that the product complies with the agreed upon specifications. Typically the customer has the option to purchase this warranty separately. Such warranties are called as “Extended Warranties” or “Extended Service Contracts”. Manufacturer Warranties and Extended Warranties are widely used as marketing tools in the automotive sector and in the “white goods” industries. Warranties can be either short term [e.g.., one year] or long term [e.g.., two to five years]

4. Alternative Approaches for Estimating Technical Provisions Methods for reserving for warranty claims can range from the simplest to the more complex Typically the simpler methods are used for estimating short term warranty claim provisions. These methods include  Prior year payments: Under this approach, a company reviews payments from the prior year and assumes equal warranty expenses to current year products. This method may be satisfactory for short term warranties, but is inadequate if the product mix changes over time or if a company experiences extensive product growth/decline.  Payments per unit sold: This method is an improvement on the “prior year payments” that recognizes not only volume changes but also cost differences between products. For longer term warranties, such as those that cover automobiles and other durable goods, the above methods generally are inadequate because they reflect only recent payment activity and ignore the fact that most warranty claims take place near the end of the warranty period. Therefore reserving approaches similar to what general insurance actuaries use will be more appropriate.

5. Estimating Technical Provisions: GI Actuary’s Standpoint From a GI Actuary’s standpoint, the reserve or technical provision for warranty claims will be equal to the sum of the following three constituents: Technical Provision for Warranty Claims = Reserve for Claims Incurred But Not Reported Plus Reserve for Claims Reported But Not Paid Plus Reserve for Claims not yet incurred

6. Estimating Technical Provisions: GI Actuary’s Standpoint In symbols, the technical provision for warranty claims can be expressed as IBNR + RBNP +URR which in turn can be further expanded and rewritten as IBNR+RBNB+UPR+AURR(or PDR) where IBNR represents Incurred But Not Reported Claims RBNP represents Reported But Not Paid Claims URR represents the Unexpected Risk Reserve UPR represents the Unexpected Premium Reserve AURR represents the Additional Unexpired Premium Reserve (AURR is also referred to as PDR or Premium Deficiency Reserve)

7. Estimating Technical Provisions: GI Actuary’s Standpoint The RBNP reserve can be directly pulled from the reported loss data The IBNR can be estimated using conventional triangle based actuarial techniques The reporting and settlement lags are likely to be short in the case of warranty claims. Estimating URR is more difficult particularly for the long duration contracts. In the US context, the Statement of Statutory Accounting Principles 65 (SSAP65) - applicable to Warranty Insurers - provides the following guidance for calculating the URR. According to this statement URR as on an accounting date must be the maximum of 1.The amount payable if all policyholders surrendered their contracts for refund, 2.The sum over all in-force policies of the gross premium times the expected fraction of ultimate losses not yet incurred, and 3.The expected present value of future losses, from in-force policies, not yet incurred.

8. Estimating Technical Provisions: Accounting Profession’s Standpoint The Ind AS applicable to warranty claims provisions is Ind AS 37: Provisions, Contingent Liabilities and Contingent Assets. What is a “Provision” under Ind AS 37? The Standard defines a provision as a liability of uncertain timing and amount A provision shall be recognised when  an entity has a present obligation (legal or constructive) that is a result of a past event  It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation and  A reliable estimate can be made of the amount of the obligation

9. Estimating Technical Provisions: Accounting Profession’s Standpoint Is a provision for “Warranty Claims” required under Ind AS 37 (Recognition Aspect)? Appendix F which accompanies Ind AS37 clearly states that a provision is required for warranty claims. The rationale is as follows:  Present obligation as a result of a past obligating event – The obligating event is the sale of the product with a warranty, which gives rise to a legal obligation.  An outflow of resources embodying economic benefits in settlement – Probable for the warranties as a whole.  A reliable estimate of the obligation can be made on past experience

10. Estimating Technical Provisions: Accounting Profession’s Standpoint How is the amount of provisions determined (Measurement Aspects)? Paragraph 36 to 83 of Ind AS 37 deal with the measurement aspect The amount recognised as a provision shall be the best estimate of the expenditure required to settle the present obligation at the end of the accounting period. An entity can use the following techniques to determine the best estimate of the amount of provision  Weighted Average of all possible outcomes by their associated probabilities or  The single most likely outcome.

11. Estimating Technical Provisions- An Example from Ind AS37 An entity sells goods with a warranty under which customers are covered for the cost of repairs of any manufacturing defects that become apparent within the first six months after purchase. If minor defects were detected in all products sold, repair costs of Rs.1 million would result. if major defects were detected in all products sold, repair costs of Rs. 4 million would result. The entity’s past experience and future expectations indicate that for the coming year, 75% of the goods sold will have no defects, 20% of the goods sold will have minor defects and 5% of the goods sold will have major defects. Therefore the expected value of the cost of repairs is: (75% of nil) + (20% of 1m) +(5% of 4m) = Rs 400,000

12. Estimating Technical Provisions: Accounting Profession’s Standpoint How is the amount of provisions determined (Measurement Aspects)?(continued) The risks and uncertainties that inevitably surround many events and circumstances shall be taken into account in determining the best estimate of the provision Where the effect of the time value of money is material, the amount of a provision shall be the present value of the expenditures expected to be required to settle the obligation. The discount rate (or rates) shall be a pre tax rate (or rates) that reflect(s) current market assessments of the time value of money and the risks specific to the liability. The discount rate(s) shall not reflect risks for which future cash flow estimates have been adjusted Future events that may affect the amount required to settle an obligation shall be reflected in the amount of a provision where there is sufficient objective evidence that they will occur.

13. Estimating Technical Provisions: Accounting Profession’s Standpoint What are the disclosures required under Ind AS37? Paragraph 84 and 85 of the Standard deals with the relevant disclosures For each class of provision, an entity shall disclose:  The carrying amount at the beginning and end of the period;  Additional provisions made in the period, including increases to existing provisions;  Amounts used (i.e. incurred and charged against the provision) during the period;  Unused amounts reversed during the period; and  The increase during the period in the discounted amount arising from the passage of time and the effect of any change in the discount rate.

14. Estimating Technical Provisions: Accounting Profession’s Standpoint What are the disclosures required under Ind AS37? (Continued) An entity shall disclose the following for each class of provision:  A brief description of the nature of the obligation and the expected timing of any resulting outflows of economic benefits;  An indication of the uncertainties about the amount or timing of those outflows. Where necessary, an entity shall disclose the major assumptions made concerning future events ; and  The amount of any expected reimbursement, stating the amount of any asset that has been recognised for that expected reimbursement.

15. Example Under IND AS 37 for Qualitative Disclosures A manufacturer gives warranties at the time of sale to purchasers of its three product lines. Under the terms of the warranty, the manufacturer undertakes to repair or replace items that fail to perform satisfactorily fro two years from the date of sale. At the end of the reporting period, a provision of Rs. 60, 000 has been recognised. The provision has not been discounted as the effect of discounting is not material. The following information is disclosed: A provision of Rs. 60,000 has been recognised for expected warranty claims on products sold during the last three financial years. It is expected that the majority of this expenditure will be incurred in the next financial year, and the balance amount will be incurred within two years after the reporting period.

16. Current Actuarial Involvement in Estimating Technical Provisions Actuaries are involved in estimating the provision for warranty claims associated with automobiles, white goods (like TV, washing machine, etc.) consumer electronic appliances and medical equipment. The frequency -severity approach is used to determine the expected aggregate claim cost associated with the inforce contracts/transactions on the valuation date. The frequency rates and the severity amounts tend to vary [usually increase] over the warranty term. The severity amounts are adjusted for inflation if the warranty term extends beyond one year from the date of valuation.

17. Current Actuarial Involvement in Estimating Technical Provisions Practice of discounting is not widely prevalent Inputs made available by the client are often in the form of the raw data like number of claims reported, exposure data In terms of sales volume, past data on failures over the warranty term; the unit costs (like raw material, direct labour and direct expenses) of repairing the products. The actuary needs to convert these inputs into frequency rates and severity amounts over the warranty term.

18. Concluding Thoughts: Where Actuaries Can Add Value Estimating IBNR Reserves for Warranty Claims Data Management: Capturing correct data including transactional level data is important not only to estimate warranty costs, but also to support quality control reviews and monitor the performance of the key business partners like the service providers. Homogenising the data will be an important consideration. Generating information on how often products break (frequency) and how much each breakage costs(severity). For large warranty programs such as those run by auto manufacturers, such analyses can help in identifying trends in frequency and severity over the life of the warranty. For example, the frequency of auto warranty claims generally increases as the warranty ages and the resulting claim severity also may increase

19. Concluding Thoughts: Where Actuaries Can Add Value Refining the methodologies used for calculating the best estimate provisions. Where credible past data on warranty claims is available it may be possible to fit appropriate statistical distributions for claim cost distributions can be used to estimate the expected aggregate claim cost and the volatility of such claims costs. Addressing sources of volatility in claims costs and their impact on the provision for claims -the introduction of new products modifications of existing products, regulatory changes and coverage modifications are some of the key drivers which increase the variability and uncertainty of warranty costs.

20. References Richard l. Vaughan, The Unearned Premium Reserve for Warranty Insurance, Casualty Actuarial Society E – Forum, Fall 2014 – Volume 1 Indian Accounting Standard (Ind AS) 37: Provisions Contingent Liabilities and Contingent Assets Education Material on Indian Accounting Standards (Ind AS) 37, The Institute of Chartered Accountants of India Indian Accounting Standard (Ind AS) 115 :Revenue from Contracts with Customers

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