Unearned Premium Reserve for LongTerm Policies

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

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

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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

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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
• IASAs Property Casualty Insurance Accounting,
  page 4-4.

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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.

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Test 2 - Proportional to losses and expenses
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Test 3 Present value of losses and expenses
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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

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Primary Issues

• Aggregation
• Discounting to occurrence date
• Risk margin
• Application to in-force business

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Issue 1Aggregation

• Not permitted for the first three policy years
• Profits should not be prematurely recognized
• Known deficiencies should not be offset by
  uncertain profits

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Issue 2Discount 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

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Issue 2Surplus Cliff
Policy issued at time 0 1,000 claim incurred at
time 3, paid at time 4
Reserve
Time
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Issue 3Risk 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

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Issue 3Risk Margin

• Interest rate shall not exceed the lesser of the
  Companys 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

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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

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Issue 3Relation between duration and margin,
given 1.5 reduction in interest rate
Margin
Duration
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Issue 4Application 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

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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.

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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

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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.