Premium Deficiency Reserves under U.S. GAAP John G. Aquino FCAS MAAA Executive Vice President

2002 CLRS - September 24th

Premium Deficiency Reserves - GAAP

1

Premium Deficiency Reserves

under

U.S. GAAP

John G. Aquino FCAS MAAAExecutive Vice President

Aon Re Services, Inc.



2

Overview

• Definition• Calculation Scope• Calculation Methodology



3

Definition - FAS 60

• Paragraph 32: Definition• Paragraph 33: Calculation• Paragraph 34: Recognition• Paragraph 60: Disclosure Of Investment Income



4

FAS 60, Paragraph 32

• “A probable loss on insurance contracts exists if there is a premium deficiency relating to short-duration or long-duration contracts. 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.”



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• “A premium deficiency shall be recognized if the sum of the expected claim costs and claim adjustment expenses, expected dividends to policyholders, unamortized acquisition costs, and maintenance costs exceeds related unearned premiums.”



6

• “A premium deficiency shall first be recognized by charging any unamortized acquisition costs to expense to the extent required to eliminate the deficiency. If the premium deficiency is greater than the unamortized acquisition costs, a liability shall be accrued for the excess deficiency.”




7

FAS 60, Paragraph 60. e.

• “Insurance enterprises shall disclose the following in their financial statements … e. whether the insurance enterprise considers anticipated investment income in determining if a premium deficiency relating to short-term contracts exists.”



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Calculation Scope

• Grouping Criterion– “Acquiring, Servicing & Measuring”

• Interpretations– GAAP Reporting Segments

– GAAP Segments May Be Inadequate

– FAS 60, Paragraph 37• Applies To Long Duration Contracts

• Specifies “Line Of Business” Recognition



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FAS 131: Disclosures about Segments

• 10. An operating segment is a component of an enterprise: – a. That engages in business activities from which it may earn

revenues and incur expenses (including revenues and expenses relating to transactions with other components of the same enterprise),

– b. Whose operating results are regularly reviewed by the enterprise's chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance, and

– c. For which discrete financial information is available.

• Also see paragraph 17, “Aggregation Criteria”



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Calculation Methodology

• Components• Time Value Of Money Alternatives• Reinsurance• Refinements



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Components

• Unearned Premium Reserve• Related Costs

– Acquisition Costs

– Maintenance Costs

– Loss and LAE Costs

– Policyholder Dividends



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FAS 60: Maintenance Costs

• “Costs associated with maintaining records relating to insurance contracts and with the processing of premium collections and commissions”

• Lower than total other underwriting expense• Examples: Aquino - 0.83%, Blanchard - 5%



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Time Value Of Money Alternatives

• Unearned Exposures Or In-Force Exposures• Investment Income Or Present Value• Initial Election To Discount

– May Be Considered A Change In Accounting Principle

– APB 20 Rules Then Apply



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Inv.Fund balance inc. @

begin end avg 5%(a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k)

ultimate 100 100 5 20 5present value 100 92.1 4.9 20.0 4.9 present value method 21.9

expected investment income method

balances

valuation date 100 0 0 20 0 80.0 80.0 21.9

combinedcash PDR fund fund

1 0 30 5 0 5 80.0 40.0 60.0 3.0 43.0 23.0 66.02 0 30 0 0 0 43.0 13.0 28.0 1.4 14.4 24.1 38.53 0 30 0 0 0 14.4 -15.6 -0.6 0.0 -15.6 25.4 9.74 0 10 0 0 0 -15.6 -25.6 -20.6 -1.0 -26.7 26.6 0.0

Assumptions1. No cash removed by owners until last claim paid2. Initial fund balance equals unearned premium reserve less unamortized acquisition costs3. All payments made mid-year

Source:(f) = prior year's value for (j)(g) = (f) - (b) - ( c) - (d) - (e) (h) = 0.5 x [ (f) + (g) ](i) = (h) x [interest rate shown above](j) = (g) + (i)(k) = for present value row: (a) - (b) - ( c) - (d) - (e) for valuation date row: an estimate (solved for iteratively, or from present value calculation). for future year rows: ( 1 + interest rate ) x ( prior year value for column (k) )

Premium Deficiency Reserve

Expected policyholder

dividends

Unamortized acquisition

costsMaint. costsYear

Unearned premiums

Expected L&LAE

Ending fund after inv. inc.

Calculation Details



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Reinsurance

• GAAP Balance Sheet Is Gross• Liabilities Are Gross• Reinsurance Recoverables Are An Asset



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Reinsurance Offset Condition

• FAS 113, Paragraph 15• “Amounts receivable and payable between the

ceding enterprise and an individual reinsurer shall be offset only when a right of setoff exists, as defined in Interpretation 39.”– APB Opinion 10: "it is a general principle of

accounting that the offsetting of assets and liabilities in the balance sheet is improper except where a right of setoff exists."



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Refinements

• Contingent Commissions• Agents’ Balances• Installment Premiums• Audit Premiums• Federal Income Taxes

Documents

Premium Deficiency Reserves under U.S. GAAP John G. Aquino FCAS MAAA Executive Vice President