Premium Liabilities – U.S. and Canadian Perspectives U.S. Perspective Ralph Blanchard 2003 CLRS – September 9, 2003, Chicago, IL 2003 Casualty Loss Reserve Seminar

2003 CLRS – September 9, Premium Liabilities in the U.S. - Overview Applicable to all 1. Unearned Premiums – normal pro rata 2.Premium Deficiency Reserve Applicable to many 3.Earned but Unbilled (EBUB) Applicable to some 4. Retro Premium Reserve 5. Long Duration UPR 6. “Extended Loss and Loss Expense Reserve” 7.“Reserve for Rate Credits” Caveat: Unless explicitly stated otherwise any views stated are strictly my own, hence such views are not guidance, not authoritative and not binding.

2003 CLRS – September 9, Premium Liabilities in the U.S. – Overview (cont.) Miscellaneous Reinstatement Premiums, Financial Guaranty Contingency Reserves, Reinsurance with inadequate risk transfer Income Statement Balance Sheet Fair value implications Caveat: Unless explicitly stated otherwise any views stated are strictly my own, hence such views are not guidance, not authoritative and not binding.

2003 CLRS – September 9, Applicable to all 1. Unearned Premiums – normal pro rata US GAAP (FAS 60, paragraph 13) Premiums from short-duration contracts 1 ordinarily shall be recognized as revenue over the period of the contract in proportion to the amount of insurance protection provided. For those few types of contracts for which the period of risk differs significantly from the contract period, premiums shall be recognized as revenue over the period of risk in proportion to the amount of insurance protection provided. That generally results in premiums being recognized as revenue evenly over the contract period (or the period of risk, if different), …. [1] Short duration is not defined except in qualitative terms. For short duration contracts, revenue is defined as earned premium. Nearly all property/casualty contracts are treated as “short duration” for US GAAP purposes. For US GAAP, long duration contracts define revenue as the same as billed premium, with no UPR. (FAS 97, paragraph 30 says “Premiums from long-duration contracts, such as whole-life contracts, guaranteed renewable term life contracts, and title insurance contracts, shall be recognized as revenue when due from policyholders. “ For such contracts, a “policy reserve” is established for the portion of the policy covering periods that have yet to happen. The “definition of short duration in FAS 60, paragraph 7, is “[A contract that] provides insurance protection for a fixed period of short duration and enables the insurer to cancel the contract or to adjust the provisions of the contract at the end of any contract period, such as adjusting the amount of premiums charged or coverage provided.”

2003 CLRS – September 9, Applicable to all 1. Unearned Premiums – normal pro rata (cont.) US Stat (SSAP 53, paragraphs 5 and 6) 6. [in most contracts the premium shall be earned pro-rata over time] … Certain [SSAPs] provide for different methods of recognizing premium … for specific types of contracts. For contracts not separately identified in specific statements where the reporting entity can demonstrate the period of risk differs significantly from the contract period, premiums shall be recognized as revenue over the period of risk in proportion to the amount of insurance protection provided.

2003 CLRS – September 9, Applicable to all 1. Unearned Premiums – normal pro rata (cont.) Normally, pro rata over time, but doesn’t have to be. Counterexamples – Aggregate Excess, Seasonal coverage (Y2K, windstorm??) Performance Bond? Material? (significant portion potentially not pro rata over time? ) Actuarial involvement (minor to non-existent) How does risk run off? Should it be pro rata over time, and if not, runoff pattern? Regulator involvement (minor to non-existent) Any not pro rata over time? Justified? Pattern reasonable?

2003 CLRS – September 9, Applicable to all 2. Premium Deficiency Reserve US GAAP (FAS 60, paragraphs 33, 34) 33. 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. US Stat (SSAP 53, paragraph 15, 16) 15. 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…”

2003 CLRS – September 9, Applicable to all 2. Premium Deficiency Reserve (cont.) In other words: Is the UPR big enough to cover the runoff of unexpired policy term? Investment income can be reflected, but such reliance must be disclosed Overhead should not be included in the UPR runoff “burden” Grouping is a big issue, as redundancy in one level cannot offset another. “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)

2003 CLRS – September 9, Applicable to all 2. Premium Deficiency Reserve (cont.) Different Stat and GAAP calculations GAAP Not by legal entity (but probably by reporting segment) Deferred Acquisition Cost (DAC) UPR has more costs to cover under GAAP “Deficiency” first charged against DAC, remainder used to set up new liability Stat. By legal entity No DAC, hence fewer costs to cover Write-in liability

2003 CLRS – September 9, Applicable to all 2. Premium Deficiency Reserve (cont.) Actuarial involvement (likely, but not required) For the unexpired portion of current policies Project future loss ratio Project future expenses Project future cash flows (of above expenses, losses, et al) Document your calculation (usually zero reserve) Don’t include in loss reserve opinion scope Regulator involvement (probably not high) compliance review

2003 CLRS – September 9, Applicable to many 3. Earned but Unbilled (EBUB) If you have material premium audits, you probably should have an EBUB US GAAP (FAS 60, paragraph 14) If premiums are subject to adjustment (for example, retrospectively rated or other experience-rated insurance contracts for which the premium is determined after the period of the contract based on claim experience or reporting-form contracts for which the premium is adjusted after the period of the contract based on the value of insured property), premium revenue shall be recognized as follows: a. If, as is usually the case, the ultimate premium is reasonably estimable, the estimated ultimate premium shall be recognized as revenue over the period of the contract. The estimated ultimate premium shall be revised to reflect current experience.

2003 CLRS – September 9, Applicable to many 3. Earned but Unbilled (EBUB) (cont.) US Stat (SSAP 53, paragraph 9-12) 9. … Reporting entities shall estimate audit premiums, the amount generally referred to as earned but unbilled (EBUB) premiums, and shall record the amounts as an adjustment to premium, either through written premium or as an adjustment to earned premium. The estimate for EBUB may be determined using actuarially or statistically supported aggregate calculations using historical company unearned premium data, or per policy calculations. …

2003 CLRS – September 9, Example: One year WC policy, effective 7/1/X Up-front premium is $100, estimated audit is $20. Commission rate of 15% Premium tax rate of 5% EBUB recorded through WP EBUB through EP CY X 12/31/X CY X+1 CY X 12/31/X CY X+1 12/31/X WP EP Commissions Taxes UPR Comm. O/S 3 3 Tax O/S 0 1 WP includes 20 of EBUB UPR contains -10 of EBUB Premium taxes paid up front Premium taxes follow WP Applicable to many 3. Earned but Unbilled (EBUB) (cont.)

2003 CLRS – September 9, Applicable to many 3. Earned but Unbilled (EBUB) (cont.) Actuarial involvement (should be high) Track Audit premium history, triangles Determine EBUB indication (by line, segment?) Monitor for changing trends Possible assistance for Schedule P, Part 6 Regulator involvement (potentially high) Monitor for materiality Compliance

2003 CLRS – September 9, Applicable to Some 4. Retro Premium Reserve If you sell retrospectively rated policies, you probably should see if you need a retrospective premium reserve US GAAP (FAS 60, paragraph 14) If premiums are subject to adjustment (for example, retrospectively rated … premium revenue shall be recognized as follows: a. If, as is usually the case, the ultimate premium is reasonably estimable, the estimated ultimate premium shall be recognized as revenue over the period of the contract. The estimated ultimate premium shall be revised to reflect current experience.

2003 CLRS – September 9, Applicable to Some 4. Retro Premium Reserve (cont.) US Stat (SSAP 66, paragraph 6) … restropective premium adjustments shall be estimated based on the experience to date using one of the following methods: … i. Use of actuarially accepted methods … This method results in the calculation of one amount which is either a net asset or a net liability; ii. Reviewing each individual … to arrive at a best estimate of return or additional premium … for each risk. The total of all receivables shall be recorded as an asset and the total of all return premiums shall be recorded as a liability.

2003 CLRS – September 9, Applicable to Some 4. Retro Premium Reserve (cont.) Future retro premiums projected using assumptions consistent with losses Project earned portion for policies still in force Actuarial involvement (can be high) Actuarial calculation (CAS papers as references) Can be very sophisticated, depending on materiality Regulator involvement (can be high) Monitor materiality If material, compliance and reasonability testing Collectibility

2003 CLRS – September 9, Applicable to Some 5. Long Duration UPR (NOTE: TALKING ABOUT STAT. P&C LONG DURATION, NOT LIFE POLICIES) SPECIAL STAT. RULES RESTRICTED TO FOLLOWING CONTRACTS: 13 or more months long Insurer can’t cancel or increase the prem. over the policy term Excluding financial/mortgage guaranty and surety contracts Examples - Auto warranty, homeowners warranty Not an example – multi-year policy with cancellation provision US GAAP (FAS 60, paragraph 13) Same as normal UPR

2003 CLRS – September 9, Applicable to Some 5. Long Duration UPR (cont.) US Stat (SSAP 65, paragraphs 21-33) Perform 3 tests, book largest of three Test 1 – amount subject to refund Test 2 – Premium x (future l&lae)/(total l&lae) Test 3 – Future l&lae less (haircut) investment income to incurred date Test 2 – Runoff of written premium in relation to risk Test 3 – Similar to premium deficiency reserve calculation. Do the tests by policy year for the 3 most recent years, and in aggregate for all prior policy years. Note that UPR under Test 3 could be greater than written premium

2003 CLRS – September 9, Applicable to Some 5. Long Duration UPR (cont.) Actuarial involvement (high) Perform the required three tests Actuarial opinion response (REQUIRED if material) Regulator involvement (could be high – past insolvency) Monitor for materiality If material, compliance and reasonability

2003 CLRS – September 9, Applicable to Some 6. “Extended Loss and Loss Expense Reserve” Includes “Extended tail”and/or DDR Extended reporting endorsements Examples: Med Malp. Claims Made – Death, Disability, Retirement coverage Med Malp. Claims Made – free tail D&O – extended reporting endorsement

2003 CLRS – September 9, Applicable to Some 6. “Extended Loss and Loss Expense Reserve” (cont.) US GAAP (FAS 60, paragraph 13) … For those few types of contracts for which the period of risk differs significantly from the contract period, premiums shall be recognized as revenue over the period of risk in proportion to the amount of insurance protection provided. …

2003 CLRS – September 9, Applicable to Some 6. “Extended Loss and Loss Expense Reserve” (cont.) US Stat (SSAP 65, paragraph 4-9) 6. Extended reporting endorsements, commonly referred to as tail coverage, allow reporting of insured events after the termination of the coverage. … 7. … For indefinite reporting periods, premiums shall be fully earned [at expiration of the policy] and loss and expense liability associated with unreported claims shall be recognized immediately. For coverage for a fixed period, premium shall be earned over the term of the fixed period, [the company] shall establish an unearned premium reserve for the unexpired portion … and shall record losses as reported. 8. Some claims made policies provide extended reporting coverage at no additional charge in the event of death, disability or retirement of a natural person insured. In such instance, a policy reserve is required … The reserve, entitled “extended reporting endorsement policy reserve” shall be classified as a component part of the unearned premium reserve considered to run more than one year from the date of the policy.”

2003 CLRS – September 9, Applicable to Some 6. “Extended Loss and Loss Expense Reserve” (cont.) Can be an involved calculation, if material Actuarial involvement (can be high) Evaluate if reserve potential exists Determine if material Produce indication Regulator involvement (?) Monitor for materiality, applicability If potentially material, compliance and reasonability checks

2003 CLRS – September 9, Applicable to Some 7. “Reserve for Rate Credits” Seems to exist for some health insurance contracts. Underwriting & Investment Exhibit – Part 2A – (current UPR detail) Column 4 – “Reserve for Rate Credits and Retrospective Adjustments …” Should match Schedule H, Part 2, line A3 (per NAIC instructions) What are “Rate Credits”? No special GAAP, Statutory guidance found. (Not even in health insurance SSAPs)

2003 CLRS – September 9, Miscellaneous Reinstatement Premiums Example – Catastrophe reinsurance, to reinstate coverage after a loss Consistent with loss valuation Treat like audits? Financial Guaranty / Mortgage Guaranty Contingency Reserves Stat. only. Function of written premium and/or principal guaranteed

2003 CLRS – September 9, Miscellaneous (cont.) Reinsurance with inadequate risk transfer (FAS 113, paragraph 18a) To the extent that a reinsurance contract does not, despite its form, provide for indemnification of the ceding enterprise by the reinsurer against loss or liability, the premium paid less the premium to be retained by the reinsurer shall be accounted for as a deposit by the ceding enterprise. A net credit resulting from the contract shall be reported as a liability by the ceding enterprise. A net charge resulting from the contract shall be reported as an asset by the reinsurer. AICPA Statement of Position 98-7 Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk SSAP 75 – Reinsurance Deposit Accounting (Amendment to SSAP, Paragraph 34) Older contracts are grandfathered

2003 CLRS – September 9, Income Statement Earned Premium = Written Premium – Change in UPR UPR for Earned Premium Calculation includes Normal pro rata (page 7, col. 1-2 in part) Earned but Unbilled (EBUB) (page 7, col. 3) Retro Premium Reserve (page 7, col. 4 in part) Long Duration UPR (page 7, col. 1-2 in part) “Extended L&LAE Reserve” (page 7, col. 1-2 in part, AND Schedule P interrogatory #1, in part) Rate Credits (page 7, col. 4 in part) Does NOT include premium deficiency reserve

2003 CLRS – September 9, Balance Sheet Liabilities - UPR Normal pro rata (net, cede) EBUB – returns only Retro Premium Reserve – returns only Long Duration Extended L&LAE Reserve Liabilities – Write-in Premium Deficiency Assets – Agents Balances (with 10% non-admit) EBUB - additional premiums Retro Premium Reserve - additional premiums Income Statement UPR ≠ Balance Sheet UPR

2003 CLRS – September 9, Fair Value implications International Accounting Standards Board (IASB) working on a new insurance accounting standard Applicable in US if Accepted by US SEC as meeting filing requirements, OR Implemented in new FASB standards. FASB has committed to convergence with IASB.

2003 CLRS – September 9, Fair Value implications (cont.) Under current IASB indicated proposals: UPR disappears, replaced by something similar to a “policy reserve”. Fair value standard, with discounting and risk provision. Fair value estimate = market “entry” price (?) = UPR (?) Could end up similar to current US GAAP (but with different labels) due to concern with “profit at issue”. Stat. unlikely to change soon.