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Considerations in the Calculation of Premium Deficiency Reserves (Under U.S. Accounting Rules) by

Considerations in the Calculation of Premium Deficiency Reserves (Under U.S. Accounting Rules) by Ralph Blanchard. Overview What are PDR reserves? Why do I care? Simple example Major Issues Risk margin/conservatism Investment income “controversy”

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Considerations in the Calculation of Premium Deficiency Reserves (Under U.S. Accounting Rules) by

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  1. Considerations in the Calculation of Premium Deficiency Reserves (Under U.S. Accounting Rules) by Ralph Blanchard

  2. Overview What are PDR reserves? Why do I care? Simple example Major Issues Risk margin/conservatism Investment income “controversy” Actual costs versus expected costs Grouping Maintenance costs GAAP versus statutory differences Multi-Tier test Slide 2 of 19

  3. What are PDR reserves? Reserves that reflect an inadequacy of the unearned premium to cover the associated runoff. GAAP definition “A premium deficiency shall be recognized if the sum of expected claim costs and claim adjustment expenses, expected dividends to policyholders, unamortized acquisition costs, and maintenance costs exceeds related unearned premiums” (FAS 60, short duration contracts, paragraph 33) Statutory definition “When the anticipated losses, loss adjustment expenses, commissions and other acquisition costs, and maintenance costs exceed the recorded unearned premium reserve, and any future installment premiums on existing policies, a premium deficiency reserve shall be recognized…” (SSAP 53 - Property Casualty Contracts - Premiums, paragraph 15) Slide 3 of 19

  4. Why did I care? New statutory requirement (effective 1Q2000). Even if zero, it must be “calculated” Slide 4 of 19

  5. Slide 5 of 19

  6. Slide 6 of 19

  7. Major issues - Risk margin / conservatism PDR is not the “possible” deficiency, it is the “expected” (GAAP) or “anticipated” (Statutory) deficiency. Use expected values, not conservative values. (my interpretation) Slide 7 of 19

  8. Major issues - investment income “controversy” • Reflect the expected profit at the time the Unearned Premium Reservewill be earned (when undiscounted reserves will be set up)? OR • Reflect the expected profit through the runoff of policy obligations(i.e., anticipate investment income up to loss payment)? • GAAP rules allow consideration of investment income (if reflection disclosed) • Statutory rules currently consistent Slide 8 of 19

  9. Major Issues - actual versus expected costs Q: If an earthquake occurs on January 2nd, could it trigger a positive PDR as of the prior December 31st? A: No. (earthquake on January 2nd was probably not “anticipated” as of the prior December 31st.) Q: If a hurricane is threatening on September 30th, could it trigger a positive PDR as of that date, even if it later avoided landfall? A: Maybe. Slide 9 of 19

  10. Major Issues - Grouping Statutory “For purposes of determining if a premium deficiency exists, insurance contracts shall be grouped in a manner consistent with how policies are marketed, serviced and measured. A liability shall be recognized for each grouping where a premium deficiency is indicated. Deficiencies shall not be offset by anticipated profits in other policy groupings.” (SSAP 53, paragraph 15) GAAP “Insurance contracts shall be grouped consistent with the enterprise’s manner of acquiring, servicing, and measuring the profitability of its insurance contracts to determine if a premium deficiency exists.” (FAS 60, paragraph 32) Slide 10 of 19

  11. Major Issues - Grouping - scenario 1 Assume Unit A B C D “Deficiency” 10 20 -80 30 Units A, B, C, D are various products marketed to the same customers, with management measured based on combined profitability, and aggressive marketing of full product slate to customers PDR = 0 (Q: How would you “allocate” this zero to the various units?) Slide 11 of 19

  12. Major Issues - Grouping - scenario 2 Assume Unit A B C D “Deficiency” 10 20 -80 30 Units A and B are products sold to same market, Units C and D are sold to a second market. Company groups A&B together, and C&D together. PDR = 30 Slide 12 of 19

  13. Major Issues - Grouping - scenario 3 Assume Unit A B C D “Deficiency” 10 20 -80 30 Units A and B are products sold to same market, Units C and D are sold to a second market. Company treats each product as a separate market, with separate management responsibility, even though ultimate customers may overlap. PDR = 60 Slide 13 of 19

  14. Major Issues - Grouping - scenario results Assume Unit A B C D “Deficiency” 10 20 -80 30 ScenarioPDR 1 0 2 30 3 60 Slide 14 of 19

  15. Major Issue - Maintenance costs “When anticipated losses, loss adjustment expenses, commissions and other acquisition costs, and maintenance costs exceed the recorded unearned premium reserve…” SSAP 53, paragraph 15. Definition of maintenance costs (FAS 60 appendix) “Costs associated with maintaining records relating to insurance contracts and with the processing of premium collections and commissions” Slide 15 of 19

  16. Major Issue - Maintenance costs How big could they be? Total expense ratio 27.6% less Commissions (11.3%) - largely prepaid 16.3% less Other Acquisition (7.4%) - largely prepaid 8.9% less Taxes (2.6%) - already incurred when prem. written 6.4% They do not include overhead (one firm’s interpretation) Less than 1%? Slide 16 of 19

  17. Major Issues - GAAP versus Statutory difference • Deferred Acquisition Cost asset - Already expensed for Statutory - fewer costs for UPR to cover • Consolidated versus Legal Entity - GAAP calculation is at corporate consolidated level - Statutory calculation is by legal entity • Policyholder dividends - GAAP requires consideration of “expected” policyholder dividends - Statutory doesn’t • Miscellaneous - Bad debt rules, other? Slide 17 of 19

  18. Multi-Tier test 1. Combined ratios consistently below 1.0 - STOP 2. Runoff of UPR - positive profits before investment income - STOP 3. Solve for minimum interest rate such that PDR = 0. If rate low enough - STOP 4. Conservative assumptions for values result in PDR = 0. STOP. 5. Full Analysis May want to state that your method is the full tiered process, with stopping points. Otherwise, a change in stopping points may trigger extra disclosure (or worse?) Slide 18 of 19

  19. Conclusion • Investment income reflection currently allowed • Grouping is a big issue • Statutory calculation may be more work • Reserve will frequently be zero • Work can be cut down via multi-tier approach Slide 19 of 19

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