Unearned Premium Reserves Change is in the Wind

1. Unearned Premium ReservesChange is in the Wind by Roger M. Hayne Milliman & Robertson, Inc. 1999 CLRS

2. How Easy We Had It “Unearned premium reserves are substantial liabilities on the financial statements of property-liability insurance companies. However, they represent one liability that should be easily determined in amount, without subjectivity and based on the system and method the company elects to use.” Property-Casualty Insurance Accounting, 1994

3. Why Worry?

4. Why the Difference? • Selected companies not representative of industry (to quote the kids … “Duh!”) • Companies have relatively large proportion of multiple year business • Much warranty with short payment tails but long emergence tails • Result: Increased NAIC attention in recent past

5. NAIC Reaction • First separate UEPR treatment for “warranty” coverage (1994) • Next more complex, 3-part calculation for longer-term covers (1995) • Finally inclusion in statement of opinion (in “practices” 1997 & “instructions” 1998)

6. Warranty Rules • UEPR based on written premium • UEPR is percentage of written premium that losses and expenses arising after the valuation date bear to the total • No longer “equity” in the UEPR for prepaid acquisition expenses • Applies to all “warranty” coverages

7. Long-Term Contracts • Special rules for “long-term” contracts • Excludes: • financial guaranty contracts • mortgage guaranty policies • surety contracts • Includes: • terms of 13 months or longer • if insurer cannot cancel or change premium

8. The Rules • Three tests: • Amount refundable on cancellation • Percent losses & expenses to happen in future • Present value of future obligations (net of future premium) • Individually largest for latest 3 policy years • Aggregate largest for all prior policy years • Based on most recent data

9. Test 1 • Amount refundable (at valuation date) on cancellation • Often pro-rata • Parallels earning pattern for other coverages • May end up dominating calculation at unexpected times

10. Test 2 • Written premiums times “a” divided by “b” • Terms defined by: • a is losses and expenses expected to emerge after the valuation date • b is estimated ultimate losses and expenses • Note, expenses included • Designed to match premium inflow (earning) with loss and expense outflow

11. Test 3 • Present value of: • Expected losses and expenses after valuation date minus • Guaranteed future premiums • Discounted from date of emergence not date of payment • Some specification of interest rate used • No reference to premiums written

12. Some Details • All based on direct losses and expenses, reinsurance “later” • Interest rate in Test 3, smaller of: • YTM (yield to maturity) of 5-year treasury bills • Company’s YTM on statutory invested assets less 1.5% • Net of salvage/subrogation but not deductibles (unless secured)

13. Some Basic Observations • Premium earning not completely known when you write a contract • Tests 2 and 3 consider losses and expenses unlike UEPR calculations for other lines • If earned premiums are written minus unearned then it is possible to have negative earned premium in a year • Actual effects depend on nature of contract

14. Some Example Contracts

15. The Contracts • Contract 1 - Similar to a five-year, limited mileage extended service contract on a new car • Contract 2 - Similar to a two-year, limited mileage extended service contract on a used car • Contract 3 - Similar to an appliance warranty or unlimited mileage new-car contract

16. Three Scenarios • Note all have $80 in expected losses and expenses after policy issue • Scenarios: • $100 price, 5.0% underwriting profit • $85 price, 9.1% underwriting loss • $60 price, 48.3% underwriting loss • All actually well within reason for “real world” warranty experience

17. $100 Price - Contract 1

18. $100 Price - Contract 2

19. $100 Price - Contract 3

20. $85 Price - Contract 1

21. $85 Price - Contract 2

22. $85 Price - Contract 3

23. $60 Price - Contract 1

24. $60 Price - Contract 2

25. $60 Price - Contract 3

26. Contract 1 Earned

27. Contract 2 Earned

28. Contract 3 Earned

29. Contract 1 Loss & Expense Ratios

30. Contract 2 Loss & Expense Ratios

31. Contract 3 Loss & Expense Ratios

32. Implications • Tests appear to apply to long-term contracts in the aggregate, so effects of contracts 1, 2, and 3 may offset • For better or worse (better in speaker’s opinion) requires periodic analysis of warranty book • Detailed analysis may help get a better handle on the business

33. Analysis • Tests make distinction between: • Emergence lag (covered by UEPR) • Payment lag (covered by Loss & LAE reserves) • Analysis of experience should then also consider the two separately • Group data by policy period • Standard development still blends the two

34. Analysis (Continued) • “Extended Service Contracts,” 1994 PCAS has an approach • Group current valuation data by policy period and accident period • Most recent “diagonal” is most recent accident period and most immature, etc. • Use accident period analysis to develop diagonals

35. Some Considerations • Policy period emergence depends on contract characteristics (term, mileage, level of coverage, etc.) • Accident period lag probably more uniform across at least portions of book • Accident period lag usually short, but beware exceptions exist (processing lags because of TPA batching, etc.)

36. Some Considerations(Continued) • Know your book • Characteristics can affect analysis and comparison with other sources • In early-to-mid 1980’s changes in manufacturer warranty plagued analysis of auto warranty books • “Extended Eligibility” is latest “wrinkle”

37. Conclusions • More work for opining actuaries • Hopefully a better tool in managing long-term exposures • Although the UEPR may be “conservative” could lead to misleading year-to-year experience • Potential accounting issues when UEPR exceeds written