1. Reserving for Automobile Warranty and Other Long Duration Contracts
Auto Warranties
and
Auto Extended Service Contracts
Grover Edie GMAC Insurance
The main thrust of my portion of this discussion/presentation is evaluating the Unearned Premium Reserves for Auto Extended Service Contracts.
Loss reserves are usually not a problem for these lines of business. Some times there no case reserves.
Other times, the case reserves are for special classes or sizes of claims.
However, because of the nature of the contracts, we’ll have to take a quick look at the earning patterns and loss payment patterns for this line of insurance.

2. Reserving for Automobile Warranty and Other Long Duration Contracts
Earnings patterns are jealously guarded by ESC writers (also, no “bureau” for data)
Earnings patterns in this paper are purely fictitious - any semblance to actual earnings patterns is accidental
Earnings patterns vary considerably due to variations in coverage, vehicle, deductible, time/mileage limits, etc.
All of the numbers in my paper are purely fictitious
Earning patterns vary considerably due to variations in coverage, vehicle, deductible, time/mileage limits, underlying manufacturer’s warranty, geographic location, road conditions, driver characteristics, and the list goes on and on

3. Reserving for Automobile Warranty and Other Long Duration Contracts
New Car Manufacturer Warranties
ESC Sold when new car placed into service
“Extended Eligibility” new vehicle ESC’s
Used Vehicle ESC’s
Auto warranties, that being the first day coverage that is provided by the manufacturer, can use the concepts described here, with one significant exception. The base auto warranty knows, more or less, when the exposure starts - when the car goes into service. So in a sense, auto warranty coverage is a special case of auto extended service coverage.
We used to only have Extended Service Contracts sold when the vehicle is sold as new, now we have “extended eligibility” contracts, which is a sale of an ESC after the in-service day, or date the vehicle was delivered to its initial owner, so long as the vehicle is still within the manufacturer’s original warranty

4. Auto Warranties and Auto Extended Service Contracts
Problems:
Earnings over several calendar years
Exposure does not earn evenly over the coverage period
Some contracts have more than one earnings path (example: time AND mileage)
Catastrophes CAN happen (“spills”)
This is just a list of some of the unique characteristics of these policies, or what one should keep in mind when working with them.
Catastrophes happen when you have an unusually warn summer, and engines are more likely to overhear, air conditioners go bad, and so on.
A particularly icy winter can cause drive train and transmission problems.

5. Auto Warranties and Auto Extended Service Contracts
Good news / Bad News:
Vehicles are sold with no practical means of revising their warranties, other than to expand the coverage
ESC Sales are essentially “one shot,” there are no renewals (rate changes do not affect current book of business)
Vehicle manufacturers have no practical way to revise their warranties, other than to expand them.
In both the case of the manufacturer warranty and the ESC, courts and legislators can alter the language, just as they can with insurance contracts.

6. Auto Warranties and Auto Extended Service Contracts
Very Important!
For warranty coverage, talk to the engineers, if you can
Talk with the people that price the ESC product
Talk with the people who market the ESC product to understand any shifts in distribution, new programs, etc.
Vehicle Content
(New cars can be “re-skinned” old cars, and old cars can have material internal changes)
Even if you are pricing or reserving for ESC’s, knowledge of the vehicles themselves helps you with your estimates.
Not all vehicles have a 36 month, 36,000 mile manufacturer’s warranty.
Some Manufacturer warranties cover parts such as emission controls, catalytic converters, and other items for longer than 36/36. For those contracts that are all parts unless excluded, changes to the manufacturer’s warranty on these parts may mean that what you used to not cover you might now cover.
There is less content creep for lower coverage levels.
Content is my term for what is in the vehicle - intermittent wipers used to be an extra cost option, now its usually standard, and so is the coverage if not excluded. Most if not all cars have fuel injection, many have four valves per cylinder, and other items that increase the cost and likelihood of a claim. Other examples – cd players, abs brakes and OnStar!

7. Auto Warranties and Auto Extended Service Contracts
Losses
Often, there are no case reserves, only payments
Earned Premium is not proportional to time, so loss ratio methods are misleading, at best
Often, there are no case reserves, or case reserves are only for certain types of losses or losses over a threshold amount.
In such instances, the reported loss ratio is simply a paid loss ratio.

8. Auto Warranties and Auto Extended Service Contracts
Data Elements (Pure Premium, etc.)
The first key in reserving or pricing for this business is in how the data is arranged.
It is very much like human mortality tables - you set out the mortality, in this case the costs or claim counts, indexed to the age of the contract.
It also means that the points will continue to develop over time.
For example, in looking at the first month’s loss cost for the 2000 Cavalier, we would not have complete data until the last 2000 Cavalier was sold.
For practical purposes, since there may be a 2000 Cavalier on some dealer’s lot somewhere, we might use a proportion of the model year production as our “ultimate” count.
In the case of ESC’s, we know when all of the calendar year 2000 policies sold, but to find out the first month’s experience of those ESC’s, we have to wait until a month after the last one was sold, i.e. until January 31, 2001
Time in service or since contract inception

9. Data Element (Pure Prem, Freq, Etc.)
Time since in-service date or contract inception

10. Once the data is sorted, we can view it - this is purely fictitious warranty data
you get an incremental cost that might look something like this.
“Day Zero” is the term used for the day the vehicle is delivered to the customer, or the inservice date.
Note that the initial month is not zero, as the vehicle dealers do find some things to fix during their vehicle preparation and initial inspection.
The early costs are typically high frequency, low cost items such as for squeaks, rattles, trim issues, and so on.
Later on, the frequency might drop but the costs go up, as problems are more likely to be engine, suspension, and more costly items.
And towards the end of the warranty period, some claims are reported after the coverage period due to reporting delays.
The experience changes, as more vehicles are brought into service. Thus the only time the day zero pure premium is fixed is after the last vehicle goes into service. The same applies to the other data points.

11. Some like to look at the cumulative cost per vehicle, it allows them to compare model year losses at the same age.
You could see it in an incremental chart as well, but it tells a different story.

12. Manufacturers like to plot cumulative points as it can tell something about the quality of each model year or production year, compared to each other.
This is a nice way of illustrating to your customer whether or not those product improvements really paid off.
The underlying ASSUMPTIONS are that the YEARS ARE DIRECTLY COMPARABLE IN AN ABSOLUTE SENSE, E.G. NO CONTENT CREEP OR INFLATION

13. Consider this cumulative graph - looks pretty blah

14. But when you look at the incremental components that make it up, and once again this is a fictitious curve, the incremental approach shows more of what's happening.
In this instance, some of the components are likely to fail at given ages, and we can see it in this multi-modal curve.
New, lets look at an ESC,

15. Manufacturer’s Warranty20 40 60 80
100
120
Kilometers (000)
72 month/100 Km ESC Plan
Manufacturer’s Warranty 12 24 36 48 60 72
Months

16. Example of ESC Earning Pattern
This pattern is for a 6 year ESC, with
an underlying mfg warranty of 36/60 assumes all policies are written on January 1 of the year
there are no cancellations, to trade ins,etc
lets assume the vehicles covered by this particular contract group average about 16,000 kilometers per year
There is some exposure in the initial year, due to towing, roadside services, etc.
More exposure in the second year, but in year three, some will kilometer (mile) into the ESC but most are low kilometer (mile) drivers, so do not mile into it
In year four, all of the vehicles are exposed in the ESC.

17. Example of ESC Earning Pattern
Graphing the earning pattern, we see the following
This graphs the calendar period earnings of the policy year writings
If we add up the bars, they total 100%, if we did this right.
Again, simplified as all of the contracts are written at the beginning of the year.

18. Example of ESC Earning Pattern
A second year of the same ESC generates the same earnings pattern,
Here again we see the contribution of each policy year’s writing into the calendar year.
In the second calendar year, we only earned five percent of two years writings.
We’ll earn 13% in the third year, 33% in the forth year, and so on.
AS BEFORE, THIS ASSUMES EACH YEAR IS AT CONSTANT WRITTEN PREMIUM VOLUMES

19. Example of ESC Earning Pattern
Graphically, the earnings of the two years looks like this
Note that, in the first two years of the program, very little premiums are earned.
As we would expect, most of the earnings occur in the latter years of the contract.

20. Example of ESC Earning Pattern
Adding a third year, it looks so
Even in the third year, very little earned premiums, so the calendar year earnings are still quite low

21. Example of ESC Earning Pattern
Adding the forth year
Now we are starting to see some premiums earn on a calendar year basis

22. Example of ESC Earning Pattern - Steady State
We continue to write contracts, and have an earnings parallelogram like this
I have cut off the last few calendar year earnings, but there are earnings that continue for a few more years
The chart just got too small to be seen very well in its entirety

23. Example of ESC Earning Pattern - Steady State
Continuing to add policy years, we have a graph of earnings that looks like this
Note that the earnings do not reach a steady state until the sixth year

24. Example of ESC Earning Pattern - Steady State
Back to the earnings parallelogram, note the contribution each policy year has on the calendar year.
Here the rows each add to 100%
If we were to know the expected loss ratio of each of the policy years, we could calculate the expected calendar year loss ratio for each of the calendar years

25. Example of ESC Earning Pattern - Steady State
Since I stopped writing at policy year 8, the proportions of the policy year earned contributions to each calendar year will not be the same in the final years
Here, the rows do not add to 100%, the columns do
We are examining the proportional contribution each policy year makes to the calendar year’s earned premiums

26. Example of ESC Earning Pattern - Steady State
If the Expected Loss Ratio for each policy year is the same, 75%, the calendar year loss ratios should also be the same.
These examples assume that the earnings pattern is correct, and that losses exactly follow the earnings pattern. That is not what happens with real data.
Again, the earnings add up down the column to 100%.
The Expected Loss Ratio is shown at the bottom of the column

27. Example of ESC Earning Pattern - Steady State
This example is fictitious, but it illustrates how out of hand a program can get before the calendar year results show a problem.
The expected loss ratio is increasing by five percentage points a year, until it reaches 100%
But the program doesn’t even look bad for the first four years. By that time, the Policy Year Expected Loss Ratio has increased to 95%
At Calendar year 4, the program is in deep trouble, and the calendar year results are still less than 3 points above the initial expected loss ratio of 75%
If you estimated the UEP reserve at this point with a 75% ELR, you’d be very inadequate.
Even at 6th year, the CY loss ratio isn’t so bad

28. Example of ESC Earning Pattern - Steady State
A more subtle change in the Expected Loss Ratio would look like this
For the first four years of the program, the calendar year loss ratio is within one point of the initial Expected Loss Ratio of 75%.
It’s these types of situations that make it very difficult to convince senior management that a rate change is needed.
In this case, you need a 20% increase to get back to a 75% loss ratio
And you can forget trying to convince the marketing people you need that much.

29. Example of ESC Earning Pattern - Steady State
Lets consider that we are to estimate the adequacy of the unearned premium reserve at the end of calendar year 5.
If we were to use a loss ratio method, what loss ratio should we select? (76, 78? Do we trend it?)
The calendar year loss ratios will be deceiving. The first two calendar year loss ratios are determined by extremely low earnings.
Calendar year five still has a pretty good loss ratio, but its because most of the earnings is due to the 75% loss ratios of the first two policy years.

30. Example of ESC Earning Pattern - Steady State
Recall our graph of the earnings of policy years by calendar year
The higher loss ratio years have just begun to earn, and there will be higher losses to pay in the future

31. Example of ESC Earning Pattern - Steady State
Averaging the Expected Loss Ratios by earnings, we get an average of 76.2% for the average Calendar Year Loss ratio for Calendar Years 1 through 5
But look at what’s ahead - the loss ratio for the remainder of the period is 82.7%
Remember, these loss ratios are weighted by the premiums earned

32. Example of ESC Earning Pattern - Steady State
Continuing to add policy years, we have a graph of earnings that looks like this
Note that the earnings do not reach a steady state until the sixth year

33. Example of ESC Earning Pattern - Steady State