1. Unearned Premium Reserves Change is in the Windby
Roger M. Hayne
Milliman & Robertson, Inc.
1999 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?
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

5. 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)

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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)

13. 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

14. Some Example Contracts

15. 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

16. 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

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
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

33. 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

34. 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

35. 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.)

36. 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”

37. 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