AEG recommendations on Non-life insurance services (Issue 5) Workshop on National Accounts December 2006, Cairo 1 Gulab Singh UN STATISTICS DIVISION Economic Statistics Branch National Accounts Section

Background  SNA defines the activity of insurance as “providing individual institutional units exposed to certain risks with financial protection against the consequences of the occurrence of specified events” (1993 SNA para 6.135)  However, it recognizes that insurance enterprises do not make a separate charge for providing insurance services to consumers of these services thus obliging national accountants to estimate indirectly this service (1993 SNA para 6.136) The estimate of insurance production is obtained using the following formula, based on accounting results that are derived from insurance companies’ accounts:

Background Insurance services Output = Actual premiums earned + Premium supplements - Claims due Actual premiums earned = premiums receivable less changes in the reserves due to pre-payment of premiums. Premium supplements =income from investments Claims due = claims payable during the period plus changes in reserves against outstanding claims

Background  SNA explains that this difference between total resources and total technical charges represents an estimate of the amount available to an insurance enterprise to cover its costs and provide for an operating surplus. It is therefore, taken as measuring the output of services produced by the enterprise (1993 SNA para 6.139).  Catastrophic events generate massive claims on non-life insurance companies.  Mechanical use of the current SNA formula for non-life insurance services may lead to absurd movements in production and consumption of insurance services in current prices in the national accounts.

Non-life insurance services The concept of insurance service is the service of covering risk. As such its measurement should not be affected by the volatility of the occurrence of risk. Conceptually neither the volume nor the price of insurance services should be directly affected by the volatility of the claims. A Task Force constituted by the OECD considered the issues relating to the measurement of the non- insurance services. The AEG considered proposals of the Task force and made following recommendations.

AEG Recommendations Continue to use the same formula for output but with adjusted premium earned and adjusted claims incurred to correct for the volatility of observed flows or negative output. Output = Actual premiums earned + Adjusted premium supplements - Adjusted claims incurred. As a consequence net premium receivable and adjusted claims due will no longer be necessarily equal period by period. For exceptionally large claims, the payment for the claim might be recorded as Capital transfer rather than, as normal, a current transfer.

Estimating adjusted claims and adjusted premium supplements Three possible solutions: Expectation approach Accounting approach Sum of costs plus ‘normal’ profit approach The AEG recommends reference to these three solutions in the updated SNA.

Expectation approach Replicating ex-ante models used by the insurers to price premiums, based on expectations for claims and income. This reflects the actual way insurers decide on the level of actual premium, rather than on an ex-post basis (which is the thrust of the current formula for estimating the output. When accepting risks and setting premiums, insurers consider their expectation of loss (claims) and of income (premium supplements). Expected margin is a better measure of the insurance service. Formula for output Actual premiums earned ( premiums receivable less changes in the reserves due to pre-payment of premiums) + Expected premium supplements – Expected claims incurred. In this formula expected claims and expected premium supplements are estimated using the past micro data and smoothed past data and applying a special treatment in case of major catastrophes.

Expectation approach Estimation of expected claims Methodology employed by insurance companies to evaluate expected claims not available to NAs. Measure expected claim using statistical methods based on smoothing of past claims either through: the calculation of an expected loss ratio derived from smoothed past loss ratios, and applicable to actual premiums, or the direct smoothing of past claims The smoothing method must include a prior step which excludes major exceptional claims. These exceptional claims should be reintroduced ahead of the current year by splitting them evenly over a very long period of time, taking account of inflation. It should use past data available at the moment of the theoretical decision by insurers of the level of their premiums. This includes the year under study.

Expectation approach U.S. method: For each type of insurance, normal loss (term used in the US national accounts for “expected claims”) will be calculated as geometric- weighted moving average of past loss ratios multiplied by the premiums earned during the current period. NL t = NLR t * P t NLR t =  LR t +  (1-  ) * LR t-1 +  (1 –  ) 2 * LR t-2 + ….. NL t = Normal loss in period t P t = Premium earned in period t NLR t = Normal Loss in period t LR t = Loss Ratio : that ratio of actual losses to premium earned) parameter  = 0.3 (based on the evidence that it provides best prediction of future values)

Expectation approach - Critique Methodology employed by insurance companies to evaluate expected claims not available to NAs. Consequences of statistical estimation may be too significant – introduce external factors affecting output estimates. Use ex-post accounting data instead. Mechanism that Insurance companies have developed mechanism to face unexpected large claims Equalization Provisions In case equalization provision not sufficient to meet requirement – enterprise use own fund.

Accounting approach Consists of (1) Extending the scope of technical reserves (provisions) (2) Applying an extended formula including, when necessary, changes in own funds Formula for output Premiums earned + premium supplements - (claims incurred + addition to, less withdrawal from equalization provisions + additions to, less withdrawal from own funds)

Sum of costs and “normal” profit approach In the SNA, the measure of the output is O (Output) = p (premium) + i (property income) – c (claims) New recommendation changes this formula to: O = p + ie (expected property income) – ce (expected claims) Premium can also be written as: p = ce + a (cost of handling insurance service) + w (profit margin) – ie Output can therefore be obtained as O = a + w This is cost plus profit It should be therefore possible to estimate the output using costs and adding a measure of profits. Costs are a well mastered statistical variable. How to measure profit? Can’t take industry estimate of profit – affected by volatility of claims Only solution is to build a measure of ‘normal profit’. “Normal” profit can be estimated based on smoothed past actual profits. The approach is in practice similar to the expectation approach.

Consequences of AEG recommendations Whether using the expectation or accounting approach, requires introduction of adjustment item in the sequence of accounts Decoupling of the accounting identity: D71 (net non-life insurance premiums) = D72 (non-life insurance claims) Now, D71 = adjusted claims plus the difference between actual premium supplements and adjusted premium supplements ≠ D72 Difference between D71 and D72 → implicit current transfer between insurance companies and policy holders. This implicit transfer is positive (in favour of policy holders) if D72 (actual claims) is higher than D71 (adjusted claims), negative in the reverse situation. Overall, with this system, the volatility in claims is transferred from the production/consumption accounts to the secondary distribution of income accounts.

Other changes Treating reinsurance gross (same formula as for direct insurance) → insurance service as intermediate consumption (now consolidated) Excluding income from own funds from premium supplements and income to policy holders. Include equalization provisions and other special provisions in SNA’s definition of provisions for unearned premiums and claims outstanding. Commission and rebates as negative premiums. Profit sharing and bonuses as other income transfers Change in terminology: Technical reserves → Technical provisions, Claims due → Claims incurred

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