Premium Deficiency Reserves under U.S. Statutory Accounting rules Ralph Blanchard

1. Premium Deficiency Reserves under U.S. Statutory Accounting rules Ralph Blanchard

2. Overview GAAP vs. Stat. requirements Statutory calculation Major Issues Risk margin/conservatism Investment income “controversy” Actual costs versus expected costs Grouping Reinsurance EBUB Residual Markets Multi-Tier test Slide 1 of 19

3. GAAP vs. Statutory requirements 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 2 of 19

4. Statutory Calculation • Same as GAAP calculation, • only the parameters and scope are different • Parameters • No Deferred Acquisition Costs (DAC) • No policyholder dividend projection • Other misc. GAAP/Stat. differences (e.g., bad debt, such as Agents Bal.) • Point to remember – • PDR represents deficiency in UPR that has yet to be otherwise booked. • It works off of existing balance sheet, not economic profit/loss of policy. • If net loss expected, but already booked, then no PDR. • So need to know what was booked already! Slide 3 of 19

5. Statutory Calculation (cont.) • Scope (and parameters) • One calculation per legal entity, • per line grouping (same as GAAP grouping?) • Legal entity complication can be large • Items that can differ by legal entity • line mix • loss ratio • payment pattern • expense ratio • investment yield Slide 4 of 19

6. 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 5 of 19

7. 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 up to loss payment • (if reflection disclosed) • Statutory rules currently consistent with GAAP Slide 6 of 19

8. Major issues - investment income – part 2 • Fund balance based on Accounting method • (Starting fund equals net liabilities established) OR • Fund balance based on funds generated (Starting fund equals premiums received less losses, expenses paid) • My interpretation – Accounting method is most consistent with guidance • (i.e., funds generated approach ignores the extent that • the deficiency is already recognized) Slide 7 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 8 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 9 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 10 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 11 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 12 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 13 of 19

15. Major Issue – Reinsurance • PDR is calculated net of reinsurance. • But is booked UPR net or gross of reinsurance? • Don’t answer too soon! • If all reinsurance is facultative, • UPR may equal future earned on unexpired policies • If some reinsurance is treaty, covering calendar year • UPR may be implicitly gross, not reflecting future cedes as % of future gross earned premium • Beware, and know how reinsurance affects your runoff! Slide 14 of 19

16. Major Issue – EBUB (Earned But Unbilled, or “audit” premium) • Where audit premiums exist, EBUB must be booked. • (SSAP 53, paragraphs 9 – 12) • Two alternative ways to book • Through WP • Through Earned Premium • Example • Initial premium of 100, estimated audit of 20, results at 6 mos. • EBUB method WP pure UPR EBUB ttl UPR • WP method 120 60 0 60 • EP method 100 50 -10 40 • Pure UPR on page 3, ttl UPR on page 8, 15 (state page) Slide 15 of 19

17. Major Issue – EBUB (cont.) • Is EBUB material for you? (If not, go to sleep.) • If material, how do you book it? • If as written, then business as usual. (i.e., go to sleep) • If as earned, then more work. • If as earned, • Which UPR are you using? (page 3 or page 8) • Anticipate audit on unexpired portion of policy • Apply loss, expense ratios to pure UPR plus audit • Anticipate cash inflow when audit collected Slide 16 of 19

18. Major Issues – Residual Markets • Residual Markets subsidies resulting from unexpired policies? • If residual market assignment already in UPR (e.g., WC pool) • then business as usual. • If not in UPR, but not material, go to sleep. • If not in UPR, and material, you may have work to do • Can be very large for some states, lines • May be bigger issue for monoline, monostate companies Slide 17 of 19

19. 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

20. Observations • May be more work for stat. than GAAP (due to legal entity issue) • Stat. reserve may be more likely to be zero (due to no DAC for stat.) • Grouping is a big issue • Investment income reflection to payment date seems to be allowed. • Work can be cut down via multi-tier approach Slide 19 of 19