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Unearned Premium Reserve for Long-Term Policies

This article discusses the history, purposes, and requirements of the Unearned Premium Reserve (UPR) for long-term insurance policies. It explores the issues related to earned premium, aggregation, discounting, and risk margin. The UPR is an important financial tool for valuation and recognition of revenue in the insurance industry.

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Unearned Premium Reserve for Long-Term Policies

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  1. Unearned Premium Reserve for Long-Term Policies Victoria S. Lusk, ACAS, MAAA

  2. Introduction • History of the Rule • Purposes of an Unearned Premium Reserve • Description of the Rule • Discussion of Issues • Effect on Earned Premium • Conclusions

  3. History • Statutory Rule • Originally adopted by NAIC in 1995 • Amended to current wording in 1997 • Developed to provide guidance in valuing deficient long-term policies • Intended to be as consistent as practical with UPR for short-term policies

  4. Purposes of an Unearned Premium Reserve • To comply with governmental requirements • To refund premiums to policyholders • To fund the payment of future losses • To maintain an amount available for the purchase of reinsurance • To determine proper recognition of revenue IASA’s Property &Casualty Insurance Accounting, page 4-4.

  5. Description of the Rule The UPR must be the greater of three separate tests: • Test 1: Refund of premium • Test 2: Proportional to losses and expenses • Test 3: Present value of the future losses and expenses For the first three policy years, the UPR must be the greatest of the three tests. Other policy years may be aggregated.

  6. Test 2 - Proportional to losses and expenses

  7. Test 3: Present value of losses and expenses

  8. Description of the Rule • Requires securitization of deductibles • Requires UPR to be included in the Statement of Actuarial Opinion • Requires midpoint or best estimate ------------------------ • Permits discounting • Permits recognition of income to match expenses

  9. Primary Issues • Aggregation • Discounting to occurrence date • Risk margin • Application to in-force business

  10. Issue 1:Aggregation • Not permitted for the first three policy years • Profits should not be prematurely recognized • Known deficiencies should not be offset by uncertain profits

  11. Issue 2:Discount to date of occurrence • Test 3 permits discounting to date of occurrence, not date of payment • Consistency with loss reserves • Eliminates inappropriate surplus reduction at time of loss occurrence

  12. Issue 2:Surplus Cliff Policy issued at time 0 $1,000 claim incurred at time 3, paid at time 4 Reserve Time

  13. Issue 3:Risk Margin • Discounting requires an implicit or explicit risk margin • Risk margin should vary directly with the uncertainty of the estimate • Claims Risk and Asset Risk

  14. Issue 3:Risk Margin Interest rate shall not exceed the lesser of the Company’s Schedule D rate less 1.5% or a 5 year T-Bill • Claims risk margined through a 1.5% reduction to the discount interest rate • Asset risk margined through “lesser of” requirement

  15. Issue 3: Advantages of Risk Margin through reduction of interest rate • A fixed percentage reduction of the discount rate results in a larger margin for policies with longer average duration • Results in approximately the same amount of margin at 4% as at 7% • It is consistent and determinable

  16. Issue 3:Relation between duration and margin, given 1.5% reduction in interest rate Margin Duration

  17. Issue 4:Application to in-force business • Statutory accounting has always required an insurer to establish all known liabilities • Until 1995, statutory accounting was silent as to how to value the liability associated with deficient long term policies • This rule provides the needed guidance

  18. Effect of the Rule on Earned Premium The UPR must be re-estimated at least annually, and the originally projected payout pattern and ultimate incurred amount may change. Therefore, since earned premium is a function of unearned premium, earned premiums may be zero or negative in a year in which incurred claims are positive.

  19. Summary • Statutory Rule • Reasonably conservative • Can be consistently enforced • Compliance is determinable • Allows immediate recognition of income sufficient to cover immediate expenses • Permits discounting • Requires establishment of a risk margin • Requires non-aggregation for the first three years

  20. Evaluation of the rule is not just an actuarial and technical issue, but requires consideration of statutory accounting practices, consistency with the treatment of other types of insurance, and regard for the statutory principles of conservatism as well as attention to purely actuarial issues.

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