Actuarial Evaluation of Premium Liabilities

1. Actuarial Evaluation of Premium Liabilities By: Claudette Cantin, FCIA, FCAS, MAAA Partner – KPMG LLP CLRS - Minneapolis September 19th, 2000

2. Overview • Canadian requirements on actuarial opinion • Definition of premium liabilities • Components of premium liabilities • Issues related to the actuarial evaluation of premium liabilities • An actuarial approach

3. Canadian Requirements forActuarial Opinion • Annual evaluation of policy (premium and claim) liabilities • Monitoring financial condition • Report on future financial condition (Dynamic Capital Adequacy Testing – DCAT) • Report to the Board annually on financial position and future financial condition of the company Role of Appointed Actuary as per Canadian InsuranceCompanies Act since 1985

4. Premium Liabilities -- Definition • Cost of running off the unexpired portion of an insurer’s policies and reinsurance contracts • The CIA Standards includes the following definition: -- “Premium liabilities represent all the anticipated net costs to discharge the insurance company’s obligations with respect to its insurance policies and reinsurance contracts except its claim liabilities”(Section 4.01 Recommendations for Property Casualty Insurance Company Financial Reporting)

5. Premium Liabilities -- Definition It includes four large categories: • Future claims and adjustment expenses on inforce policies • Administrative costs of servicing inforce policies (maintenance costs) • Anticipated premium adjustments; and • Anticipated reinsurance expense (or commission) adjustments

6. Premium Liabilities -- Definition Premium Liabilities is the NET TOTAL of: • Unearned Premium • Premium Deficiency Reserve (PDR) • Deferred Policy Acquisition Expenses • Other Related Assets and Liabilities

7. Premium Liabilities -- Components • Unearned premiums (UPR) [Gross and Ceded] • Premium deficiency provision • Deferred policy acquisition expenses (DPAE) • Provision for retro-rated policies • Earned but not recorded premiums (EBNR) • Audit premiums • Unearned reinsurance (ceded) commission • Provision for contingent commission • Items on both sides of balance sheet

8. Premium Deficiency / Equity • Policy Liabilities = Claim and Premium Liabilities • Policy Liabilities = Provision for Past Events and Future Events • Premium Deficiency / Equity = UPR – provision for future events • Future Provision = PV of Cash flow on account of premium adjustment and of claims and expenses to be incurred after the balance sheet date on account of policies inforce at the balance sheet date or earlier

9. Deferred Policy Acquisition Expenses -- DPAC • Equal to premium tax and commissions plus other prepaid expenses • Actuary calculates maximum deferrable expenses • DPAC recoverable for future expected profits? • Is the equity in Unearned Premium sufficient to cover the DPAC? DPAC is limited to 30% of UPR (statutory basis)

10. Deferred Policy Acquisition Expenses • Asset to amortize prepaid expenses over the policy period (GAAP Accounting) • Better match of income and profit • Policy year accounting eliminates the need for DPAC

11. Issues Related toPremium Liabilities Regulatory and Professional Requirements • DPAC • Investment income • Other liabilities vs premium liabilities • All lines vs by line calculation • Subsequent events

12. Issues Related to Premium Liabilities • DPAC • most regulators allow an asset up to the estimated equity in Unearned Premium (UPR) • Alberta allows a liability equal to 80% of the UPR

13. Issues Related to Premium Liabilities • Investment Income • CIA Standards require recognition of time value of money except when conflicting with regulator • OSFI: -- does not allow discounting for claim liabilities except for accident benefits -- may be included in determining equity in UPR -- limited recognition only – valuation date to earning date (3-4 months) • IGIF: -- allow full recognition

14. Other Liabilities vs PremiumLiabilities • “Broad” vs “narrow” definition • Broad definition includes all assets related to costs arising after the balance sheet date whether the contracts are expired or inforce • Narrow definition includes only items related to inforce (OSFI). UPR should not be charged with future costs on already expired contracts (should be in “other liabilities”)

15. Expression of Opinion Premium Liabilities Carried in Actuary’s Annual Return Estimate Gross premium liabilities in connection with unearned premiums: Net premium liabilities in connection with unearned premiums: Gross unearned premiums: Net unearned premiums: Gross deferred policy acquisition expenses: Gross maximum policy acquisition expenses deferrable: Unearned commissions: Premium deficiency: Other net liabilities:

16. Other Liabilities vs Premium Liabilities • Our view: -- future liabilities related to expired policies should not be charged against the inforce policies when calculating the equity in unearned premiums, but these liabilities (assets) should be part of total premium liabilities as they relate to the insurance (reinsurance) contracts of the insurer.

17. All Lines Combined vs By Line • Equity is calculated on an “all lines combined” basis for regulatory purposes • Deficiencies offset redundancies in premiums • On-going concerns • No significant changes to mix of business from year to year • GAAP requires more rigorous evaluation of the equity by line of business, split in a manner consistent with the way the insurer acquires business and measures profitability (by line) • Issue with by line calculation for long tail lines because of recognition of investment income

18. 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 accountin the selection of methods and assumptions for acalculation, other than a pro forma calculation, if thesubsequent event: -- provides information about the entity as it was at the calculation date, or -- retroactively makes the entity a different entity at the calculation date, or -- makes the entity a different entity after the calculation date and a purpose of the work is to report on the entity as it will be as a result of the event

19. Subsequent Events • 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.

20. Subsequent Events • No general rule • Three criteria1. 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?

21. Subsequent Events – Two Examples • Ice Storm of January 1998Premium liabilities calculation did not reflect this event. Why?-- 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, 1994Calculation did reflect the impact of Bill 164-- known in advance-- did impact future losses on unearned premiums

22. An Actuarial Approach • Documented in Study Note on the Actuarial Evaluation of Premium Liabilities by C. Cantin and P. Trahan • Representative of approaches currently used • Process starts with UPR, then the Equity in UPR is calculated to determine premium deficiency and the maximum allowable DPAC • Considerations are given to all components of premium liabilities in the process

23. Equity in Unearned Premiums • Expected future profits • Equals UPR less expected losses and expenses to be incurred after the statement date • Equals max allowable DPAC • If equity < 0 i.e. premium deficiency exists DPAE is reduced by the amount of deficiency • If deficiency > DPAC, a premium deficiency provision must be booked and DPAC = 0

24. Overall Calculation

25. Overall Calculation

26. Estimated Ultimate LossRatios • seasonality • premium level • catastrophe • trend • premium development • benefit changes • policy terms • reinsurance program

28. Seasonality

29. Maintenance Expenses orServicing Costs Costs associated with maintaining records relating to contracts, processing endorsements, premiums, mid-term cancellations, reinsurance contracts . . . Consideration: • Insurer’s distribution method • Automation

30. Maintenance Expenses orServicing Costs • May be difficult and expensive to obtain • Requires detailed expense study • Can be estimated from P&C Annual Statement Expense Exhibit by applying a % to each category of expenses

31. Maintenance Expenses or Servicing Costs Maintenance Expense on Inforce Polices Net Unearned Premium . . 33% x General Expenses Net Unearned Premium

32. Net Reinsurance Costs • Reinsurance Commission-- may be significant on quota share-- usually added to equity-- actuary usually reviews company’s calculation • Premium Adjustment Based on Experience Level • Excess of Loss Protection

33. Discounting • Not allowed on a statutory basis • For statutory purposes (and except for Quebec provincially registered insurers) the calculation of premium liabilities should recognize investment income on the unearned premium only for the period between the valuation date and the average earning date (or the average occurrence date of losses on the unexpired policies), i.e., three to four months

34. Discounting • OSFI in practice accepts discounting to calculate Equity in UPR as long as no premium deficiency exists • CIA Standards require recognition of time value of money • Provision for adverse deviation must be included:-- claim development-- reinsurance recovery-- interest rate

35. Discounting Issues • Payout patterns:-- payout on future losses similar to historical data • Interest rate • Agents balances reduce the investment on UPR • Contingent commissions:-- Over which period does the discount apply?-- What is appropriate PFAD?

37. Discounting Paradigm • Relates to gross liabilities • Discount rate on ceded business? -- same as direct insurer -- reinsurer’s investment returns, policies? • Interest rate margin on ceded business? • Claims development margin on ceded business? This dilemma also extends to accounting differencebetween gross vs net business • Ceded UPR = 0 while significant direct UPR

38. Conclusions • This is still an evolving process • The IASC project • The US requirement