1. 1 2003 Casualty Loss Reserve Seminar Claudette Cantin 2003 CLRS – September 9, 2003, Chicago, IL Premium Liabilities – U.S. and Canadian Perspectives Canadian Perspective

2. 2 Overview 1. Canadian Requirements 2. OSFI Requirements 3. CIA Standards 4. Actuarial Approach 5. Components of premium liabilities 6. Other issues 1. Canadian Requirements 2. OSFI Requirements 3. CIA Standards 4. Actuarial Approach 5. Components of premium liabilities 6. Other issues

3. 3 Canadian Requirements for Appointed Actuary Role of Appointed Actuary in Canadian Insurance Companies Act since 1985  Value annually the policy liabilities of the company or other matters required by law  Monitor financial condition  Report to the board annually on financial position and future financial condition of the company (DCAT)  Report to the board of directors on any transactions that may jeopardize the financial condition of the company Role of Appointed Actuary in Canadian Insurance Companies Act since 1985  Value annually the policy liabilities of the company or other matters required by law  Monitor financial condition  Report to the board annually on financial position and future financial condition of the company (DCAT)  Report to the board of directors on any transactions that may jeopardize the financial condition of the company

4. 4 Premium Liabilities / OSFI  Policy liabilities in connection with unearned premiums (Gross and Net)  Unearned premiums (Gross and Net) (UPR)  Premium deficiency  Other net liabilities  Deferred policy acquisition expenses (DPAC)  Maximum policy acquisition expenses deferrable  Unearned Commissions  Policy liabilities in connection with unearned premiums (Gross and Net)  Unearned premiums (Gross and Net) (UPR)  Premium deficiency  Other net liabilities  Deferred policy acquisition expenses (DPAC)  Maximum policy acquisition expenses deferrable  Unearned Commissions

5. 5 OSFI memorandum The commentary section of the report on the policy reserves must contained details concerning these items:  (a) the derivation of the gross and net unearned premium liabilities  (b) on the basis of the gross and net business separately, the derivation of the provision for: -all ultimate claims and other obligations expected to arise after the date of the return under the policies in force at the date of the statement return; -all adjustment expenses (including unallocated loss adjustment expenses) expected to be associated with the ultimate claims and other obligations; -all expenses relating to the servicing of the policies in force; and -all reinsurance costs The commentary section of the report on the policy reserves must contained details concerning these items:  (a) the derivation of the gross and net unearned premium liabilities  (b) on the basis of the gross and net business separately, the derivation of the provision for: -all ultimate claims and other obligations expected to arise after the date of the return under the policies in force at the date of the statement return; -all adjustment expenses (including unallocated loss adjustment expenses) expected to be associated with the ultimate claims and other obligations; -all expenses relating to the servicing of the policies in force; and -all reinsurance costs

6. 6 OSFI memorandum  (c) the existence of any premium deficiency on a net basis  (d) the maximum deferrable policy acquisition expenses. This item is the difference between the net unearned premiums and the net policy liabilities in connection with unearned premiums, plus the unearned commissions;  (e) the other net liabilities: -an adjustment for excess of loss treaties where the premium rate varies with the claims experience; -an adjustment for proportional treaties where the ceding commission varies with the claims experience;  (c) the existence of any premium deficiency on a net basis  (d) the maximum deferrable policy acquisition expenses. This item is the difference between the net unearned premiums and the net policy liabilities in connection with unearned premiums, plus the unearned commissions;  (e) the other net liabilities: -an adjustment for excess of loss treaties where the premium rate varies with the claims experience; -an adjustment for proportional treaties where the ceding commission varies with the claims experience;

7. 7 OSFI memorandum  (e) the other net liabilities: -an adjustment relating to an inflation clause; -an adjustment relating to an automatic reinstatement premium; and -any expected increase in profit commissions to agents;  (f) the derivation of the gross deferred policy acquisition expenses and the unearned commissions.  (e) the other net liabilities: -an adjustment relating to an inflation clause; -an adjustment relating to an automatic reinstatement premium; and -any expected increase in profit commissions to agents;  (f) the derivation of the gross deferred policy acquisition expenses and the unearned commissions.

8. 8 CIA Standards of Practice  CONSOLIDATED STANDARDS OF PRACTICE – PRACTICE-SPECIFIC STANDARDS FOR INSURERS (Section 2000) apply to the valuation of the policy liabilities for an actuary’s report in an insurer’s published financial statements if those statements are in accordance with generally accepted accounting principles.  Policy liabilities include premium and claims liabilities  Canadian statutory reporting is GAAP basis  CONSOLIDATED STANDARDS OF PRACTICE – PRACTICE-SPECIFIC STANDARDS FOR INSURERS (Section 2000) apply to the valuation of the policy liabilities for an actuary’s report in an insurer’s published financial statements if those statements are in accordance with generally accepted accounting principles.  Policy liabilities include premium and claims liabilities  Canadian statutory reporting is GAAP basis

9. 9 Premium Liabilities / CIA Definition  Section 2230.01 of the CIA standards of practice defines premium liabilities as follows: The amount of the premium liabilities (after deducting any deferred policy acquisition expense asset) should be equal to the present value, at the balance sheet date, of cash flow on account of premium development and of claims and expenses to be incurred after that date on account of the policies in force at that date or an earlier date.  Premium development includes additional premiums such as reinstatement premiums and provisions for swing-rated policies.  Section 2230.01 of the CIA standards of practice defines premium liabilities as follows: The amount of the premium liabilities (after deducting any deferred policy acquisition expense asset) should be equal to the present value, at the balance sheet date, of cash flow on account of premium development and of claims and expenses to be incurred after that date on account of the policies in force at that date or an earlier date.  Premium development includes additional premiums such as reinstatement premiums and provisions for swing-rated policies.

10. 10 Relevant Policies  Section 2130.18.19.20 of the CIA standards of practice defines relevant policies as follows:.18 The relevant policies for the valuation are those which are in force at the balance sheet date, including those whose issue is then committed, or which were in force earlier and which will generate cash flow after the balance sheet date. There are no policy liabilities in respect of other policies expected to be issued after that date, whether or not they are expected to be profitable..19 There usually are both premium liabilities and claim liabilities in respect of policies which are in force at the balance sheet date..20 ……There may be premium liabilities in respect of those policies ( not in force) as a result of the right of policyholders to reinstate them, or of their unpaid retrospective premium, commission, and similar adjustments, experience rating refunds, reinsurance ceded, and subrogation and salvage.  Section 2130.18.19.20 of the CIA standards of practice defines relevant policies as follows:.18 The relevant policies for the valuation are those which are in force at the balance sheet date, including those whose issue is then committed, or which were in force earlier and which will generate cash flow after the balance sheet date. There are no policy liabilities in respect of other policies expected to be issued after that date, whether or not they are expected to be profitable..19 There usually are both premium liabilities and claim liabilities in respect of policies which are in force at the balance sheet date..20 ……There may be premium liabilities in respect of those policies ( not in force) as a result of the right of policyholders to reinstate them, or of their unpaid retrospective premium, commission, and similar adjustments, experience rating refunds, reinsurance ceded, and subrogation and salvage.

11. 11 Term of Liabilities  Section 2130.21 of the CIA standards of practice defines term of liabilities as follows: The term of the liabilities of a property and casualty insurance policy ends at its expiry, which usually is within one year of the balance sheet date, unless for example the policy has been cancelled, in which case that term ends at the effective date of cancellation, or the contractual term of the policy exceeds one year; for example, an extended warranty policy which provides coverage for several years after expiry of the basic warranty.  Section 2130.21 of the CIA standards of practice defines term of liabilities as follows: The term of the liabilities of a property and casualty insurance policy ends at its expiry, which usually is within one year of the balance sheet date, unless for example the policy has been cancelled, in which case that term ends at the effective date of cancellation, or the contractual term of the policy exceeds one year; for example, an extended warranty policy which provides coverage for several years after expiry of the basic warranty.

12. 12 Actuarial Approach  Process starts with UPR  Determine the policy liabilities (claims and expenses) in connection with the UPR– gross and net basis  Determine the equity in unearned premium i.e. the difference between the UPR and the premium liabilities  Test premium deficiency and the maximum allowable DPAC  Determine/test other liabilities  Documented in Study Note on the Actuarial Evaluation of Premium Liabilities by C. Cantin and P. Trahan  Process starts with UPR  Determine the policy liabilities (claims and expenses) in connection with the UPR– gross and net basis  Determine the equity in unearned premium i.e. the difference between the UPR and the premium liabilities  Test premium deficiency and the maximum allowable DPAC  Determine/test other liabilities  Documented in Study Note on the Actuarial Evaluation of Premium Liabilities by C. Cantin and P. Trahan

13. 13 Unearned Premium  Actuaries need to comment on the determination of UPR by company  Most lines of business, pro-rata over term of the liabilities usually one-year  Most involved when the contractual term exceeds one-year such as warranty business, RVI, mortgage -UPR proportional to the duration of the protection provided and related to the expected payout -Issue is obtaining information on these contracts -Sometimes earned over one-year and liabilities reported as claims liabilities  Other exceptions – excess-of-loss, special programs  Actuaries need to comment on the determination of UPR by company  Most lines of business, pro-rata over term of the liabilities usually one-year  Most involved when the contractual term exceeds one-year such as warranty business, RVI, mortgage -UPR proportional to the duration of the protection provided and related to the expected payout -Issue is obtaining information on these contracts -Sometimes earned over one-year and liabilities reported as claims liabilities  Other exceptions – excess-of-loss, special programs

14. 14 Policy Liabilities in connection with UPR Actuarial valuation includes:  Future claims and adjustment expenses on inforce policies (expected loss ratio) – based on most recent accident-years adjusted for trend, rate changes, seasonality  Unallocated claims adjustment expenses – same % of claims liabilities  Costs of servicing inforce policies (maintenance costs) – commonly approximated as 1/3 of general admin expenses  Reinsurance Costs  Investment income to be fully recognized for 2003 Actuarial valuation includes:  Future claims and adjustment expenses on inforce policies (expected loss ratio) – based on most recent accident-years adjusted for trend, rate changes, seasonality  Unallocated claims adjustment expenses – same % of claims liabilities  Costs of servicing inforce policies (maintenance costs) – commonly approximated as 1/3 of general admin expenses  Reinsurance Costs  Investment income to be fully recognized for 2003

15. 15 Overall Calculation

16. 16 Overall Calculation

17. 17 Deferred Policy Acquisition Expenses  Asset to amortize prepaid expenses over the policy period (GAAP Accounting)  GAAP imposes some constraints on deferability of expenses  DPAC is limited to 30% of UPR (statutory basis)  Gross DPAC equals premium tax and commissions plus other prepaid expenses  Net DPAC equals gross DPAC less unearned commissions  Actuaries to comment on derivation of the DPAC and unearned commissions in report to regulator  Asset to amortize prepaid expenses over the policy period (GAAP Accounting)  GAAP imposes some constraints on deferability of expenses  DPAC is limited to 30% of UPR (statutory basis)  Gross DPAC equals premium tax and commissions plus other prepaid expenses  Net DPAC equals gross DPAC less unearned commissions  Actuaries to comment on derivation of the DPAC and unearned commissions in report to regulator

18. 18 Deferred Policy Acquisition Expenses  Actuarial Involvement -Is the equity in Unearned Premium sufficient to cover the DPAC? DPAC recoverable for future expected profits? -Calculate maximum deferrable expenses - difference between the net unearned premiums and the net policy liabilities in connection with unearned premiums, plus the unearned commissions -May become the figure recorded by management  Line Groupings ???  Actuarial Involvement -Is the equity in Unearned Premium sufficient to cover the DPAC? DPAC recoverable for future expected profits? -Calculate maximum deferrable expenses - difference between the net unearned premiums and the net policy liabilities in connection with unearned premiums, plus the unearned commissions -May become the figure recorded by management  Line Groupings ???

19. 19 Premium Deficiency  Premium deficiency exists when the equity in UPR is negative  When UPR is less than the policy liabilities related to the unearned premium  If equity < 0 i.e. premium deficiency exists DPAC is reduced by the amount of deficiency  If deficiency > DPAC, a premium deficiency provision must be booked and DPAC = 0  Line Groupings ????  Premium deficiency exists when the equity in UPR is negative  When UPR is less than the policy liabilities related to the unearned premium  If equity < 0 i.e. premium deficiency exists DPAC is reduced by the amount of deficiency  If deficiency > DPAC, a premium deficiency provision must be booked and DPAC = 0  Line Groupings ????

20. 20 Line Groupings  Actuarial Evaluation Equity is calculated on an “all lines combined” basis Deficiencies offset redundancies in premiums  GAAP basis (AcG-3) DPAC should be determined by reasonable groupings of business, consistent with an insurer’s manner of acquiring, servicing and measuring profitability of its business. ……Total aggregation might be considered unless particular lines are sold and administered in an entirely different fashion one from the other. Premium deficiency should be determined by reasonable groupings of business  Actuarial Evaluation Equity is calculated on an “all lines combined” basis Deficiencies offset redundancies in premiums  GAAP basis (AcG-3) DPAC should be determined by reasonable groupings of business, consistent with an insurer’s manner of acquiring, servicing and measuring profitability of its business. ……Total aggregation might be considered unless particular lines are sold and administered in an entirely different fashion one from the other. Premium deficiency should be determined by reasonable groupings of business

21. 21 Line Groupings  Warranty business and other such long duration contracts are at times treated separately and, premium deficiency recorded if needed  Reinsurance Assumed as opposed to direct writing  Treaty vs. Facultative  Quota share vs. proportional  Warranty business and other such long duration contracts are at times treated separately and, premium deficiency recorded if needed  Reinsurance Assumed as opposed to direct writing  Treaty vs. Facultative  Quota share vs. proportional

22. 22 Other Liabilities  Earned but not recorded premiums (EBNR)  Audit premiums  Provision for contingent commission  Swing-rated policies  Reinstatement premiums  Retro-rated policies  Not charged against the inforce policies when calculating the equity in unearned premiums, but part of total premium liabilities  Actuarial involvement depends on the materiality  Often limited to assess reasonableness of management determination  Earned but not recorded premiums (EBNR)  Audit premiums  Provision for contingent commission  Swing-rated policies  Reinstatement premiums  Retro-rated policies  Not charged against the inforce policies when calculating the equity in unearned premiums, but part of total premium liabilities  Actuarial involvement depends on the materiality  Often limited to assess reasonableness of management determination

23. 23 Other Issues  Reservation on Reporting  Investment income  Subsequent events  IASC  Reservation on Reporting  Investment income  Subsequent events  IASC

24. 24 Reservation in Reporting Section 2140, Reservation on Reporting, of the Consolidated Standards of Practice – Practice Specific Standards for Insurers Liabilities Specifically, section 2140.28 states that If the financial statements of an insurer report policy liabilities, which are greater than, those calculated by the actuary, and if the notes to those financial statements do not provide sufficient disclosure of the rationale for the greater liabilities, then the actuary would report as follows: I have valued the policy liabilities of [the Company] for its [consolidated] balance sheet at [31 December XXXX] and their change in the statement of income for the year then ended in accordance with accepted actuarial practice, …………. In my valuation, the amount of policy liabilities is $[X]. The corresponding amount in the [consolidated] financial statements is $[Y]. In my opinion, the amount of policy liabilities of $[X] makes appropriate provision for all policyholder obligations and, except as described in the preceding paragraph, the consolidated financial statements fairly present the result of the valuation. Section 2140, Reservation on Reporting, of the Consolidated Standards of Practice – Practice Specific Standards for Insurers Liabilities Specifically, section 2140.28 states that If the financial statements of an insurer report policy liabilities, which are greater than, those calculated by the actuary, and if the notes to those financial statements do not provide sufficient disclosure of the rationale for the greater liabilities, then the actuary would report as follows: I have valued the policy liabilities of [the Company] for its [consolidated] balance sheet at [31 December XXXX] and their change in the statement of income for the year then ended in accordance with accepted actuarial practice, …………. In my valuation, the amount of policy liabilities is $[X]. The corresponding amount in the [consolidated] financial statements is $[Y]. In my opinion, the amount of policy liabilities of $[X] makes appropriate provision for all policyholder obligations and, except as described in the preceding paragraph, the consolidated financial statements fairly present the result of the valuation.

25. 25 Reservation in Reporting  Implications -premium liabilities not shown explicitly in the financial statements -several items on the balance sheet: UPR, premium deficiency (if any), DPAC, unearned commission and other related assets and liabilities -Equity in unearned premium as calculated by the actuary - the maximum amount deferrable. -CICA accounting guideline AcG-3 sets out criteria/limitations on DPAC  Implications -premium liabilities not shown explicitly in the financial statements -several items on the balance sheet: UPR, premium deficiency (if any), DPAC, unearned commission and other related assets and liabilities -Equity in unearned premium as calculated by the actuary - the maximum amount deferrable. -CICA accounting guideline AcG-3 sets out criteria/limitations on DPAC

26. 26 Reservation in Reporting  Implications -For many insurers, premium liabilities recorded in the financial statements are higher than those calculated by the actuary -Overstatement of premium liabilities created by limitations on the deferability of expenses under GAAP is not considered an unfair presentation. -Notes to the financial statements must appropriately disclose the existence of a difference between the recorded amount and the actuary’s estimate of premium liabilities.  Implications -For many insurers, premium liabilities recorded in the financial statements are higher than those calculated by the actuary -Overstatement of premium liabilities created by limitations on the deferability of expenses under GAAP is not considered an unfair presentation. -Notes to the financial statements must appropriately disclose the existence of a difference between the recorded amount and the actuary’s estimate of premium liabilities.

27. 27 Investment Income  No longer an issue starting with 2003 reporting  OSFI requires company to report claims liabilities on a discounted basis  Will be included in determining policy liabilities in connection with UPR (future cash flow)  UPR itself will not be on a discounted basis  Other assets/liabilities which are components of premium liabilities will not be discounted  No longer an issue starting with 2003 reporting  OSFI requires company to report claims liabilities on a discounted basis  Will be included in determining policy liabilities in connection with UPR (future cash flow)  UPR itself will not be on a discounted basis  Other assets/liabilities which are components of premium liabilities will not be discounted

28. 28 Discounting Issues  CIA Standards require recognition of time value of money except when conflicting with the law  Provision for adverse deviation must be included: -- claim development -- reinsurance recovery -- interest rate  Payout patterns: -- payout on future losses similar to historical data  Interest rate  CIA Standards require recognition of time value of money except when conflicting with the law  Provision for adverse deviation must be included: -- claim development -- reinsurance recovery -- interest rate  Payout patterns: -- payout on future losses similar to historical data  Interest rate

29. 29 Discounting Issues  Agents balances reduce the investment on UPR  Contingent commissions: -- Over which period does the discount apply? -- What is appropriate PFAD?  Relates to gross liabilities  Discount rate on ceded business? -- same as direct insurer -- reinsurer’s investment returns, policies ?  Agents balances reduce the investment on UPR  Contingent commissions: -- Over which period does the discount apply? -- What is appropriate PFAD?  Relates to gross liabilities  Discount rate on ceded business? -- same as direct insurer -- reinsurer’s investment returns, policies ?

30. 30 Subsequent Events – CIA Guidelines  The actuary should correct any data defect or calculation error, which a subsequent event reveals.  The actuary should take a subsequent event into account in the selection of methods and assumptions for a calculation, other than a pro forma calculation  No general rule  The actuary should correct any data defect or calculation error, which a subsequent event reveals.  The actuary should take a subsequent event into account in the selection of methods and assumptions for a calculation, other than a pro forma calculation  No general rule

31. 31 Subsequent Events  Three criteria 1.Does it provide information about the entity as it was? 2.Does it retroactively make the entity different? 3.Does it make the entity different after the calculation date?  The actuary should not so take the subsequent event into account if it makes the entity a different entity after the calculation date and a purpose of the work is to report on the entity as it was at the calculation date, but the actuary should report that event.  Three criteria 1.Does it provide information about the entity as it was? 2.Does it retroactively make the entity different? 3.Does it make the entity different after the calculation date?  The actuary should not so take the subsequent event into account if it makes the entity a different entity after the calculation date and a purpose of the work is to report on the entity as it was at the calculation date, but the actuary should report that event.

32. 32 Subsequent Events Two Examples  Ice Storm of January 1998  Premium liabilities calculation did not reflect this event. -- did not make insurer different -- actuarial report on company as it was at 12/31 -- could not be expected -- but disclosure was required  Implementation of Bill 164 on January 1, 1994 Calculation did reflect the impact of Bill 164 --known in advance --did impact future losses on unearned premiums  Ice Storm of January 1998  Premium liabilities calculation did not reflect this event. -- did not make insurer different -- actuarial report on company as it was at 12/31 -- could not be expected -- but disclosure was required  Implementation of Bill 164 on January 1, 1994 Calculation did reflect the impact of Bill 164 --known in advance --did impact future losses on unearned premiums

33. 33 IASC  UPR and DPAC disappears  Concept similar to current policy liabilities in connection to UPR  present value, at the balance sheet date, of cash flow on account of premium development and of claims and expenses to be incurred after that date on account of the policies in force at that date or an earlier date. (CIA standards)  Fair value – market rate ??  UPR and DPAC disappears  Concept similar to current policy liabilities in connection to UPR  present value, at the balance sheet date, of cash flow on account of premium development and of claims and expenses to be incurred after that date on account of the policies in force at that date or an earlier date. (CIA standards)  Fair value – market rate ??