Chapter 5: Reserving Bases Flashcards
The results of operating activities in the Statement of Comprehensive Income consist of 5 main items
- net insurance premium earned
- investment income
- other income
- net insurance claims incurred
- expenses, including acquisition and administrative costs.
Key considerations in SAICA’s circular: “Recognition and Measurement of Short-term Insurance Contracts”
- The annual basis of accounting shall be used, as opposed to the fund basis. Under the annual basis of accounting, the underwriting result in the period reflects the profit or loss from providing insurance cover during the period. Under the fund basis of accounting, premiums, claims and associated expenses are related to the underwriting year in which the policies incept.
- Premium revenue is recognised in the financial period in which it is earned. It is recognised evenly over the period of the policy or in accordance with the pattern of the incidence of risk where the result is materially different.
- Earned reinsurance premiums would similarly be determined according to the period of risk. For proportional reinsurance this usually implies the pattern of risk of the underlying insurance policies, whereas for non-proportional reinsurance, the period of the reinsurance arrangement would normally apply.
- Provision is made at the balance sheet date for the expected ultimate cost of settlement of all claims incurred in respect of events up to that date, whether reported or not, together with related claims handling expenses, less amounts already paid. If a liability exists but there is uncertainty as to its eventual amount, an estimate is made. Where the uncertainty is considerable, a degree of caution will be necessary in the exercise of the judgement, such that liabilities are not understated.
- The level of claims provisions is set such that no adverse run-off experience is envisaged.
- If the expected value of claims and expenses attributable to the unexpired periods of policies in force at the balance sheet date exceed the unearned premiums provision in relation to those policies, after deduction of any deferred commission expenses, the insurer assesses the need for an unexpired risks provision.
- Commissions paid to intermediaries are accounted for over the risk period of the policy to which they relate. The portion of commission which is deferred to subsequent accounting periods is termed a “deferred acquisition cost”.
International Accounting Standards Board (IASB)
Exposure Draft on Phase II of IFRS 4
These new standards include a range of changes in the accounting for insurance contracts.
They are intended to provide a high quality standard that provides a consistent basis for accounting for insurance contracts.
In so doing, they aim to make it easier for users of financial statements to understand how insurance contracts affect an insurer’s financial position, financial performance and cash flows.
The proposals would enhance comparabilities across entities, jurisdictions and capital markets.
The proposals would apply to all insurance contracts whether issued by insurers or by other entities.
International Accounting Standards Board (IASB)
Exposure Draft on Phase II of IFRS 4:
The exposure draft proposes a new measurement model, comprised of 4 building blocks:
- Current estimates of future cash flows:
The amounts the insurer expects to collect from premiums and pay out for claims, benefits and expenses, estimated using up-to-date information. - Time value of money:
An adjustment that uses an interest rate to convert future cash flows into current amounts. - Risk adjustment:
An assessment of the uncertainty about the amount of future cash flows. - Contractual service margin:
risk-adjusted expected contract profit (reported over the life of the contract).
Statutory returns
The statutory returns
(STAR - Short-Term insurance Annual Return)
are made in terms of the Short-term Insurance Act and Regulations.
Their purpose is essentially to enable the regulatory authorities to monitor insurers’ ongoing solvency, and thereby improve the likelihood that policyholders will have their claims paid.
8 Statutory classes of business used in the STAR
- Property
- Engineering
- Motor
- Marine
- Guarantee
- Liability
- Miscellaneous
- Transportation
Provision for cash-back benefits
Insurers are required, where relevant, to make provision for cash-back benefits in their statutory accounts.
The default approach, according to the Board Notice issued by the FSB, is that the percentage cash-back bonus stipulated in the policy document must be reserved for in full in respect of each premium received in respect of which a cash-back bonus will become payable.
This is a conservative approach, as it does not make any allowance for future lapses or claims, which typically reduce an insurer’s cash-back liability.
As with IBNRs, if an insurer wishes to hold a different reserve level, it will need to apply to the FSB with a formal actuarial report.
7 Items covered by APN401
- The member is required to take all reasonable measures to ensure that the data used for a valuation of technical provisions are appropriate and sufficient for the specified purpose of the valuation.
- The data are to be subdivided into groups of claims exhibiting similar characteristics, finding a balance between homogeneity and statistical reliability.
- The experience should normally be analysed first on a gross of recoveries basis. Explicit allowance for reinsurance and other recoveries, such as third party recoveries, salvage and subrogation needs to be made. Only approved reinsurance may be used to reduce the gross technical provisions for statutory purposes.
- Selection of the most appropriate valuation model to estimate the liabilities is the responsibility of the members. The member may investigate more than one model before arriving at an estimate.
- Depending on the insurer’s adopted reserving policy, the member may or may not be able to recommend the addition of a margin to be added to the central estimate. The member should apply judgement in recommending the size of the margin by choosing an appropriate level of sufficiency. Historically, a level of 75% was often used.
When determining the margin, the member needs to consider:
a. Diversification benefit and correlations between classes
b. Independent variation
c. Systemic uncertainty. - Technical provisions should include an allowance for the impact on future claim payments of wage inflation, price inflation, court decisions or other economic or environmental causes. If inflation is allowed for explicitly, then it is usual to convert past historical payments into values as at the date of calculations. Allowance must then be made for future claim inflation. In doing this, it may be useful to separate claim escalation into standard inflation and superimposed inflation.
- Discounting should be applied if it will have a material impact on the central estimate result. As a general guideline, when the discounted mean term of liabilities is expected to exceed four years, then reserves should be discounted.
The format of the statutory returns differs from that for the Companies Act accounts in 6 ways
- The statutory returns reflect the insurance company’s own position (subsidiaries are not consolidated).
- The statutory returns are divided by STAR classes of business.
- The statutory returns are dividend by origin year (accident year for insurers and underwriting year for reinsurers).
- The statutory returns show claims development by origin and development (financial) quarter. Paid and reported development triangles are shown.
- The statutory returns are divided by territory and currency.
- Details are given of various forms of reinsurance cover.
The value of technical provisions under the SAM proposed method
Under the SAM proposed method, the value of technical provisions is equal to the sum of a best estimate and a risk margin:
- The best estimate must correspond to the probability-weighted average of future cash flows, taking into account the time value of money.
- The risk margin should increase the value of the best estimate to an amount equal to a theoretical level required to transfer the obligations to another insurance undertaking.
Contract boundary
The measurement of insurance contracts should include all cash flows relating to the contract should they fall within the contract boundary.
The boundary of an insurance contract can be summarised as a future point in time where the insurer or reinsurer has:
- a unilateral right to terminate the contract
- a unilateral right to reject the premiums payable under the contract, or
- a unilateral right to amend the premiums or the benefits payable under the contract at a future date in such a way that the premiums fully reflect the risks.
Purposes of internal management accounts
To determine profitability for each class, determine the need for rating revisions and assist in carrying them out, and project the company’s financial position, including profit testing.
Discounting principles in reserving
Discounting should be considered only if there are adequate data available to construct a reliable model of the rate of claims settlement.
A cautious approach should be taken to the assessment of the amount and timing of future cash flows to ensure a sufficient level of reliability in the construction of the model.
The discount rate should not be greater than the rate expected to be earned by the assets held, that are appropriate in size and nature to cover the provision for claims being discounted, during the period necessary for the payment of such claims.
It should not exceed either:
- a rate justified by the performance of such assets over the preceding five years, or
- a rate justified by the performance of such assets over the year preceding the balance sheet date.
7 disclosures that should be made in the notes to the accounts when discounting is applied
- the total amount of the provisions before discounting
- the categories of claims in relation to which discounting has been applied,
- the methods used,
- the assumed average period to claims settlement,
- the rate of investment return used to determine
- the discounted value of claims provisions, and
- the criteria adopted for estimating the period that will elapse before the claims are settled.
General insurers produce 4 accounts
- financial statements
- statutory returns
- taxation accounts
- management accounts
