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7.2 Loss recognition (premium deficiency) – short-duration contracts
Publication date: 30 Nov 2021
us Insurance guide
If a premium deficiency exists for short-duration contracts, deferred acquisition costs (DAC) should be written off to the extent of the deficiency. If the premium deficiency exceeds the DAC, a liability is established for the amount of the excess remaining after the DAC amount is written off.
The premium deficiency test computation for short-duration contracts is described in ASC 944-60-25-4.
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.
Companies can consider anticipated investment income in determining whether a premium deficiency exists. A company's choice to consider anticipated investment income in premium deficiency calculations is considered an accounting policy election and must be disclosed in the footnotes to the financial statements. Because the method of including anticipated investment income in the calculation of short-duration premium deficiencies is not clearly defined in GAAP, approaches other than the investment income approach illustrated in Figure IG 7-1 may exist.
The test computation is illustrated in Figure IG 7-1 and assumes the company has elected to include anticipated investment income.
Figure IG 7-1
Premium deficiency computation for short-duration contracts
Premium deficiency computation for short-duration contracts
Unearned premiums
|
$1,000
|
|
Anticipated future investment income from funds made available by unearned premiums |
50
|
|
Less:
|
Expected claim costs
|
(550)
|
Expected claim adjustment expenses
|
(75)
|
|
Unamortized acquisition costs
|
(200)
|
|
Expected policy maintenance costs
|
(50)
|
|
Expected policyholder dividends
|
(25)
|
|
Premium sufficiency/(deficiency)
|
$150
|
|
General overhead of an insurance company is a period cost and is similar to unabsorbed overhead of a manufacturing company. It does not enter into the test computation of a premium sufficiency/deficiency. However, expected losses, considering all costs of the business, may be an indication of a going concern or liquidity problem, which should be evaluated in the context of the related accounting guidance for these situations.
In practice, there are two basic methods of calculating the premium deficiency for short duration contracts:
- The discounting approach
- The expected investment income approach
These approaches are subject to many variables and assumptions, including projections of claims and claim adjustment expenses, payment patterns, and investment yields. Both methods incorporate the time value of money.
7.2.1 Loss recognition (premium deficiency) — discounting approach
The discounting approach uses the present value of expected future payments for claim costs, claim adjustment expenses, and maintenance costs. The costs in the premium deficiency test consist of (a) the present value of future payments for claims, claim adjustment expenses, and maintenance expenses expected to be incurred related to the unexpired portion of the contracts, plus (b) unamortized acquisition costs. A premium deficiency is recognized when these costs exceed the related unearned premiums. The unexpired portion of the in-force contracts or policies is viewed as separate and distinct, and no recognition is given to the time value of money associated with the expired portion of the policy. A variation of the approach considers the present value of future costs incurred and expected to be incurred on in-force policies less liabilities recorded at the measurement date (the unearned premium and any existing claim liability) plus the related unamortized acquisition costs. This variation gives accounting recognition to the time value of money associated with both the expired and unexpired portions of the policies.
7.2.1.1 Loss recognition (premium deficiency) — expected investment income
Under the expected investment income approach, the ultimate profitability of an insurance contract is evaluated using all cash flows from the in-force policies, such as premiums, commissions, premium taxes, claims and claim adjustment expenses, investment income and expenses, as well as anticipating the effects of installment premiums and retrospectively rated policies. Investment income is developed using all cash flows relating to the in-force policies. Typically, the entire premium is not available for investment. Some portion of in-force premiums is not collected in advance, and a portion is used to pay acquisition costs, primarily commissions and taxes. Thus, only the net cash is invested and earns income. Also, the receipt of cash may be delayed in some types of policies, such as retrospectively rated policies.
Under one variation of this approach, cash flows associated with only the unexpired portion of the in-force premium (that is, unearned premium less unamortized DAC) are used. We believe this is the most appropriate variation. Under another variation, cash flows from both the expired and unexpired portion are used in the calculation.
7.2.1.2 Loss recognition (premium deficiency) – interest rate
The interest rate used in either the discounting or expected investment income approach should be a rate equal to the expected yield to be earned on total invested assets (expected portfolio rate) over the period that the claim liabilities are expected to be paid. The yield is the ratio of expected interest income, dividends, and rents, net of investment expenses, to the total invested assets. The premium deficiency computation is a profitability test based on an insurance company's actual and expected investment performance. Use of a market rate is not appropriate, since it may not be representative of the actual earnings to be realized by the company.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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