1. OECD Task Force on the Measurement of Non-life Insurance Production in the context of Catastrophes Final report F. Lequiller, moderator

2. Insurance Task Force: Final Report This is a session for decision This is a session for decision Experts are requested to give their opinion of the recommendations of the report, for further forwarding to the ISWGNA Experts are requested to give their opinion of the recommendations of the report, for further forwarding to the ISWGNA And submission to the February 2004 session of the AEG, for inclusion in the next edition of the SNA And submission to the February 2004 session of the AEG, for inclusion in the next edition of the SNA

3. Introduction The current recommendation of the SNA leads to uninterpretable movements in the current price value of non life insurance output and consumption, in particular in the context of catastrophes The current recommendation of the SNA leads to uninterpretable movements in the current price value of non life insurance output and consumption, in particular in the context of catastrophes In general, NA compilers neutralise this unwelcome impact on volume measures. In general, NA compilers neutralise this unwelcome impact on volume measures. However, the impact is as unwelcome on price indices of output or consumption. However, the impact is as unwelcome on price indices of output or consumption.

4. Introduction In the USA, in the third quarter of 2001 (9/11 terrorist attack), the implementation of the current SNA recommendation led to a decrease to the price index of household consumption of 0.3%, and an increase of 0.2% of the price of GDP: ??? In the USA, in the third quarter of 2001 (9/11 terrorist attack), the implementation of the current SNA recommendation led to a decrease to the price index of household consumption of 0.3%, and an increase of 0.2% of the price of GDP: ??? In France, the implementation of the current recommendation on the fourth quarter on 1999 (exceptional storm) would have decreased total household consumption by 1.3%: ???? In France, the implementation of the current recommendation on the fourth quarter on 1999 (exceptional storm) would have decreased total household consumption by 1.3%: ???? The objective of the task force is to avoid such uninterpretable results The objective of the task force is to avoid such uninterpretable results

5. General principle In the SNA the output of insurance is to « provide financial protection against the occurence of specified events », In the SNA the output of insurance is to « provide financial protection against the occurence of specified events », However, the SNA recognises that there is no explicit charge for this output, However, the SNA recognises that there is no explicit charge for this output, Therefore one must use an indirect estimate based on the formula (1): actual premiums earned plus premium supplements minus claims due. Therefore one must use an indirect estimate based on the formula (1): actual premiums earned plus premium supplements minus claims due. The task force confirmed that, conceptually, the SNA should not be changed. In particular it rejected other conceptually based measures of output (such as premiums). The task force confirmed that, conceptually, the SNA should not be changed. In particular it rejected other conceptually based measures of output (such as premiums).

6. General principle (continued..) However, the task force rejected the mechanical implementation of formula (1) However, the task force rejected the mechanical implementation of formula (1) The measure of the concept of insurance output should not be affected by the occurence of the risk. The measure of the concept of insurance output should not be affected by the occurence of the risk. The unusual difference between premium and claims in a given period is not to be attributed to a movement of output in this period. The unusual difference between premium and claims in a given period is not to be attributed to a movement of output in this period. The volatility of claims should not affect the measure of production The volatility of claims should not affect the measure of production

7. Recommendation 1 The concept of insurance service in the SNA should be preserved. However, it should be made clearer that the formula proposed in the SNA is only the basis for an indirect estimate of the value of the insurance service. The measure of the production of insurance services should not be affected by the volatility of claims. Conceptually, neither the volume nor the price of insurance services is affected by the volatility of claims. The concept of insurance service in the SNA should be preserved. However, it should be made clearer that the formula proposed in the SNA is only the basis for an indirect estimate of the value of the insurance service. The measure of the production of insurance services should not be affected by the volatility of claims. Conceptually, neither the volume nor the price of insurance services is affected by the volatility of claims.

8. The principle of using expectations Insurers fix their premiums based on their expectations of the occurence of risks, and of their other revenues (of which premium supplements). Insurers fix their premiums based on their expectations of the occurence of risks, and of their other revenues (of which premium supplements). Based on these expected claims and expected premium supplements, the insurer is capable of fixing the level of premium that will normally cover its administrative costs and its normal profit. Based on these expected claims and expected premium supplements, the insurer is capable of fixing the level of premium that will normally cover its administrative costs and its normal profit. The task force was therefore convinced that the measurement of the SNA service margin (premiums plus supplements minus claims) should be based on such expectations. The task force was therefore convinced that the measurement of the SNA service margin (premiums plus supplements minus claims) should be based on such expectations. This is the best way to obtain a measure of output and consumption consistent with the concept aimed by the SNA. This is the best way to obtain a measure of output and consumption consistent with the concept aimed by the SNA.

9. The principle of using expectations Recommendation 2: expected claims and expected premium supplements should replace actual claims and actual investment income in the calculation of the output and consumption of non-life insurance services. This applies for all claims – regular, catastrophic and unexpected – and for all years. This applies for all investment income. Formula (1) should be adapted to this recommendation and become: Recommendation 2: expected claims and expected premium supplements should replace actual claims and actual investment income in the calculation of the output and consumption of non-life insurance services. This applies for all claims – regular, catastrophic and unexpected – and for all years. This applies for all investment income. Formula (1) should be adapted to this recommendation and become: Formula (2): [Actual premiums earned [i.e. premiums receivable less changes in the reserves due to pre-payment of premiums] + Expected premiums supplements - Expected claims due. Formula (2): [Actual premiums earned [i.e. premiums receivable less changes in the reserves due to pre-payment of premiums] + Expected premiums supplements - Expected claims due.

10. Estimation of expected claims If insurers were willing to transmit the amount of their (confidential) expected claims, it could be used by national accounts compilers If insurers were willing to transmit the amount of their (confidential) expected claims, it could be used by national accounts compilers However, a macro estimate is more realistic However, a macro estimate is more realistic Several methods were discussed to estimate expected claims Several methods were discussed to estimate expected claims

11. Estimation of expected claims: the statistical method The objective was to find a good and practical way of estimating the mathematical expectation of claims The objective was to find a good and practical way of estimating the mathematical expectation of claims The most natural way is to use past claims (including the year under review) to forecast future claims The most natural way is to use past claims (including the year under review) to forecast future claims A practical statistical method is to use smoothed past claims, A practical statistical method is to use smoothed past claims, The use of a non centered moving average was recommended, so that the method does not by itself lead into systematic revisions The use of a non centered moving average was recommended, so that the method does not by itself lead into systematic revisions The use of geometric weighted moving average is a workable solution The use of geometric weighted moving average is a workable solution In the USA, the BEA implemented a method based on smoothing loss ratios rather than smoothing directly claims. Expected claims are obtained by applying the smoothed loss ratio to actual premiums. This method gave better results regarding the quality of the prediction than by smoothing directly claims. In the USA, the BEA implemented a method based on smoothing loss ratios rather than smoothing directly claims. Expected claims are obtained by applying the smoothed loss ratio to actual premiums. This method gave better results regarding the quality of the prediction than by smoothing directly claims. However, some participants of the task force found drawbacks in the use of smoothed loss ratios, and prefer smoothing directly claims. However, some participants of the task force found drawbacks in the use of smoothed loss ratios, and prefer smoothing directly claims.

12. Estimation of expected claims: the statistical method These smoothing methods can cope with the « routine » irregularity of claims These smoothing methods can cope with the « routine » irregularity of claims However, they cannot cope with catastrophe claims However, they cannot cope with catastrophe claims In the case of catastrophe claims, these claims should be (1) estimated, (2) taken out of the data, (3) split over a very long period (20 years) (4) re-included manuallly in the statistical time series of expected claims (ahead of the current year), taking account of inflation. In the case of catastrophe claims, these claims should be (1) estimated, (2) taken out of the data, (3) split over a very long period (20 years) (4) re-included manuallly in the statistical time series of expected claims (ahead of the current year), taking account of inflation. Overall, the statistical method includes therefore two steps: (1) the exclusion of major exceptional claims (which will be reincluded at the end), (2) the smoothing of past claims or loss ratios. Overall, the statistical method includes therefore two steps: (1) the exclusion of major exceptional claims (which will be reincluded at the end), (2) the smoothing of past claims or loss ratios.

13. Estimation of expected claims: the statistical method Recommendation 3: In the absence of actual expected data from insurers, the first method for measuring expected claims is a statistical method based on the smoothing of past claims either through the calculation of an expected loss ratio derived from smoothed past loss ratios, and applicable to actual premiums, or the direct smoothing of past claims. The smoothing method must include a prior step which excludes major exceptional claims. These exceptional claims should be reintroduced ahead of the current year by splitting them evenly over a very long period of time, taking account of inflation. The task force recommended that the method should not lead to built-in revisions of the data. It should use past data available at the moment of the theoretical decision by insurers of the level of their premiums. This includes the year under study. Recommendation 3: In the absence of actual expected data from insurers, the first method for measuring expected claims is a statistical method based on the smoothing of past claims either through the calculation of an expected loss ratio derived from smoothed past loss ratios, and applicable to actual premiums, or the direct smoothing of past claims. The smoothing method must include a prior step which excludes major exceptional claims. These exceptional claims should be reintroduced ahead of the current year by splitting them evenly over a very long period of time, taking account of inflation. The task force recommended that the method should not lead to built-in revisions of the data. It should use past data available at the moment of the theoretical decision by insurers of the level of their premiums. This includes the year under study.

14. Technical provisions Some delegates in the task force thought that the use of the full range of « provisions » included in the insurance companies’ accounts could help to avoid to use a statistical method. Some delegates in the task force thought that the use of the full range of « provisions » included in the insurance companies’ accounts could help to avoid to use a statistical method. The report first discusses these « provisions ». The report first discusses these « provisions ». It recommends (1) to change the terminology of the SNA, (2) to extend the range of provisions included in formula (1). It recommends (1) to change the terminology of the SNA, (2) to extend the range of provisions included in formula (1).

15. Technical provisions Recommendation 4: It is proposed to align with the general accounting principles and to label, in the SNA, the technical liabilities of insurers as “ insurance technical provisions ”. Recommendation 4: It is proposed to align with the general accounting principles and to label, in the SNA, the technical liabilities of insurers as “ insurance technical provisions ”. Recommendation 5: It is proposed to include in the SNA ’ s definition of provision for unearned premiums and provisions for claims outstanding the other special provisions recorded by the insurance companies. i.e: equalisation provision, provision for bonuses and rebates, provision for claims outstanding, provision for incurred but not (enough) reported incident Recommendation 5: It is proposed to include in the SNA ’ s definition of provision for unearned premiums and provisions for claims outstanding the other special provisions recorded by the insurance companies. i.e: equalisation provision, provision for bonuses and rebates, provision for claims outstanding, provision for incurred but not (enough) reported incident

16. The accounting approach Some delegates in the task force thought that use of formula (1) using an extended definition of provisions would be a possible way of approaching the measure of output and consumption, without having to use an indirect statistical estimate. Some delegates in the task force thought that use of formula (1) using an extended definition of provisions would be a possible way of approaching the measure of output and consumption, without having to use an indirect statistical estimate. However, there is no practical experience of this method for the moment. Also, it is recognised that equalisation provisions are used sometimes more for fiscal reasons than for equalisation reasons. However, there is no practical experience of this method for the moment. Also, it is recognised that equalisation provisions are used sometimes more for fiscal reasons than for equalisation reasons. Also, equalisation provisions will be unsufficient to cover catastrophe claims. Companies have therefore to use their own-funds. Then the formula should be extended to own-funds. However, there is no practical rule to analyse when the formula should be extended to own-funds. Also, equalisation provisions will be unsufficient to cover catastrophe claims. Companies have therefore to use their own-funds. Then the formula should be extended to own-funds. However, there is no practical rule to analyse when the formula should be extended to own-funds.

17. The accounting approach Recommendation 5: SNA ’ s formula (1), which defines the indirect measure of production from an accounting perspective, should extend the scope of the provisions to include equalization provisions and other special provisions destined to cover unusual claims. Where it can be proved that movements in these special provisions compensate the volatility of claims, an alternative method to estimate the production of insurance would be to use this extended formula: [Premiums earned + premium supplements] – [claims due + addition to, less withdrawal from, equalization provisions + addition to, less withdrawal from own funds, when necessary]. Recommendation 5: SNA ’ s formula (1), which defines the indirect measure of production from an accounting perspective, should extend the scope of the provisions to include equalization provisions and other special provisions destined to cover unusual claims. Where it can be proved that movements in these special provisions compensate the volatility of claims, an alternative method to estimate the production of insurance would be to use this extended formula: [Premiums earned + premium supplements] – [claims due + addition to, less withdrawal from, equalization provisions + addition to, less withdrawal from own funds, when necessary].

18. Premium supplements The discussion on premium supplements covered three issues: The discussion on premium supplements covered three issues: 1 Should expected premium supplements replace observed premium supplements? 2 Should premiums supplements include income from special reserves and own funds? 3 Should premium supplements include holding gains?

19. Expected premium supplements There are arguments in favor of expected premium supplements but also against. There are arguments in favor of expected premium supplements but also against. Recommendation 6: Expected premium supplements should replace actual premium supplements in the formula used to estimate insurance production. The method used to estimate expected premium supplements should be the best statistical predictor of premium supplements. Recommendation 6: Expected premium supplements should replace actual premium supplements in the formula used to estimate insurance production. The method used to estimate expected premium supplements should be the best statistical predictor of premium supplements.

20. Special reserves and own funds Special reserves and own funds bring revenues that insurers take into account to fix their premiums. Special reserves and own funds bring revenues that insurers take into account to fix their premiums. In consequence, and in accordance with the task force on financial services, it is proposed to extend the calculation of premium supplements to all special reserves and own funds. In consequence, and in accordance with the task force on financial services, it is proposed to extend the calculation of premium supplements to all special reserves and own funds. This does not mean that they are to be considered as assets of the insurance policy holders. This does not mean that they are to be considered as assets of the insurance policy holders.

21. Special reserves and own funds Recommendation 7: Investment income from special reserves and own funds should be included in the formula that determines expected investment income. However, this would not lead own funds to be classified as owned by policy holders. Recommendation 7: Investment income from special reserves and own funds should be included in the formula that determines expected investment income. However, this would not lead own funds to be classified as owned by policy holders.

22. Holding gains and losses The issue was a secondary one for this task force, but an essential one for the task force on financial services. The issue was a secondary one for this task force, but an essential one for the task force on financial services. The task force on financial services did not recommend to extend the formula of FISIM to holding gains and losses. The task force on financial services did not recommend to extend the formula of FISIM to holding gains and losses. Recommendation 8: In accordance with the conclusions of the task force on financial services holding gains/losses should not be included in premium supplements. Recommendation 8: In accordance with the conclusions of the task force on financial services holding gains/losses should not be included in premium supplements.

23. Incorporating the new measure of output in the sector accounts The move to a measure of output based on expected claims rather than observed claims creates an unbalance in the institutional sector accounts. The move to a measure of output based on expected claims rather than observed claims creates an unbalance in the institutional sector accounts. In the current SNA, there are two identities: In the current SNA, there are two identities: D44 property income distributed to policy holders is identically equal to D4 property income earned by the insurance companyD44 property income distributed to policy holders is identically equal to D4 property income earned by the insurance company D72 non life insurance claims is identically equal to D71, net non life insurance premiumsD72 non life insurance claims is identically equal to D71, net non life insurance premiums Combined with the current measure of production, this ensures that the balancing items (savings, net lending/borrowing) are relevant. Combined with the current measure of production, this ensures that the balancing items (savings, net lending/borrowing) are relevant. Without the addition of adjustement items, the change in the measure of production proposed by the task force would lead to irrelevant balancing items. Without the addition of adjustement items, the change in the measure of production proposed by the task force would lead to irrelevant balancing items.

24. The simplest solution The simplest solution is to accept to decouple one of the accounting identities: D72 would no more be equal to D71; The simplest solution is to accept to decouple one of the accounting identities: D72 would no more be equal to D71; D72 would remain unchanged, equal to actual non life insurance claims received by policy holders. D72 would remain unchanged, equal to actual non life insurance claims received by policy holders. Only D71 would be changed: rather than be equal to actual non life insurance claims, it will be equal to expected non life insurance premiums plus the difference between actual premium supplements and expected premium supplements. Only D71 would be changed: rather than be equal to actual non life insurance claims, it will be equal to expected non life insurance premiums plus the difference between actual premium supplements and expected premium supplements. With this simple solution, an implicit (positive or negative) transfer is made in the current accounts to policy holders, equal to the difference between D72 and D71. With this simple solution, an implicit (positive or negative) transfer is made in the current accounts to policy holders, equal to the difference between D72 and D71.

25. A possible sophistication, involving capital transfers The implicit transfer to policy holders affect their disposable income (while saving will be equal to the saving of the current system) The implicit transfer to policy holders affect their disposable income (while saving will be equal to the saving of the current system) This was seen by some participants as a drawback, specially when major catastrophes occur. It is indeed strange that disposable income, which is a measure of current income, is affected by exceptional differences between expected claims and observed claims. This was seen by some participants as a drawback, specially when major catastrophes occur. It is indeed strange that disposable income, which is a measure of current income, is affected by exceptional differences between expected claims and observed claims. The exceptional nature of this difference would point out in the direction of a capital transfer. The exceptional nature of this difference would point out in the direction of a capital transfer.

26. A consensual recommendation Recommendation 9: the introduction of expected claims and expected premium supplements in the calculation of production will result in a decoupling of non-life insurance claims (D72) and the corresponding imputed net non-life insurance premiums (D71). D71 will be equal to expected claims plus the difference between actual premium supplements and expected premium supplements. In the case of catastrophes, where the difference between D71 and D72 may be deemed too important to affect current disposable income of policy holders, the difference attributed to the catastrophe can be treated as a capital transfer, to avoid affecting disposable income. Recommendation 9: the introduction of expected claims and expected premium supplements in the calculation of production will result in a decoupling of non-life insurance claims (D72) and the corresponding imputed net non-life insurance premiums (D71). D71 will be equal to expected claims plus the difference between actual premium supplements and expected premium supplements. In the case of catastrophes, where the difference between D71 and D72 may be deemed too important to affect current disposable income of policy holders, the difference attributed to the catastrophe can be treated as a capital transfer, to avoid affecting disposable income.

27. Re-insurance Reinsurance is a major way for direct insurers to deal with exceptional claims. Reinsurance is a major way for direct insurers to deal with exceptional claims. It was therefore obvious that the treatment of reinsurance was to be discussed by the task force. It was therefore obvious that the treatment of reinsurance was to be discussed by the task force. Also, the current SNA needed some clarification on the treatment of reinsurance Also, the current SNA needed some clarification on the treatment of reinsurance

28. Reinsurance: main findings The current SNA « consolidated » treatment of reinsurance has drawbacks The current SNA « consolidated » treatment of reinsurance has drawbacks There are two workable solutions to treat reinsurance: the full net approach, the full gross approach. There are two workable solutions to treat reinsurance: the full net approach, the full gross approach. However none of these two approaches resolve, by themselves the problem of catastrophic losses in the measure of production However none of these two approaches resolve, by themselves the problem of catastrophic losses in the measure of production The only solution is to apply the method of expected claims to both direct insurers and reinsurers The only solution is to apply the method of expected claims to both direct insurers and reinsurers In this context, the gross method appears to be the most practical one In this context, the gross method appears to be the most practical one

29. Reinsurance Recommendation 10: The treatment of re- insurance in the SNA has to be revised. The consolidated approach for re-insurance transactions of the current SNA should be replaced by an approach which treats direct insurers and re-insurers exactly in the same way. In particular, the formulae to compile production in both cases should be identical in their principles. Both should use expected claims and expected premium supplements. The gross presentation, where the production of re-insurance is consumed by direct insurers, is preferred to the net approach, where this production is netted out. Recommendation 10: The treatment of re- insurance in the SNA has to be revised. The consolidated approach for re-insurance transactions of the current SNA should be replaced by an approach which treats direct insurers and re-insurers exactly in the same way. In particular, the formulae to compile production in both cases should be identical in their principles. Both should use expected claims and expected premium supplements. The gross presentation, where the production of re-insurance is consumed by direct insurers, is preferred to the net approach, where this production is netted out.

30. Additional recommendations Recommendation 11: The commissions paid by the reinsurer to the direct insurer and the rebates paid by the direct insurer to the policyholders should be classified as a negative component of the premiums earned. The profit sharing paid by the reinsurer to the direct insurer and the bonuses paid by the direct insurer to the policyholders should be classified as a form of other income transfers. Recommendation 11: The commissions paid by the reinsurer to the direct insurer and the rebates paid by the direct insurer to the policyholders should be classified as a negative component of the premiums earned. The profit sharing paid by the reinsurer to the direct insurer and the bonuses paid by the direct insurer to the policyholders should be classified as a form of other income transfers. Recommendation 12: the terminology used in the SNA should be made closer to the one used in the insurance industry. In particular, “ Net premiums ” should be changed to “ Risk premiums ” and ¨Claims due ” to ¨Claims incurred ”. Recommendation 12: the terminology used in the SNA should be made closer to the one used in the insurance industry. In particular, “ Net premiums ” should be changed to “ Risk premiums ” and ¨Claims due ” to ¨Claims incurred ”.

31. Conclusion Experts from OECD countries are requested to comment these recommendations, and in priority: Experts from OECD countries are requested to comment these recommendations, and in priority: 1 Principles (recommendations 1&2) 2 Estimation of expected claims (recommendation 3) 3 Integration in the accounting framework (recommendation 9)