Understanding the Nuances of Unexpired Risk Reserves of Non-life Insurers

A. Introduction

Non-life Insurance service is contingent in nature, depending on the occurence / non-occurence of an unfortunate event, in which the customer might suffer. An alternate description for this service is “risk transfer” – Insurer takesover the customers’ risk for a consideration called premium, In view of its’s dependence on a contingency, non-life insurers unlike other commercial entities do not enjoy the privilege or luxury of knowing the precise cost of their products / service, in advance of pricing them. Therefore pricing is one of the toughest challenges of non-life insurers. This operational limitation calls for extra precautions on their part in their financial plans. They depend heavily on their past experience and support of actuarial techniques to price their products.  Yet, all said and done it is only an estimate based on so many variables. And such estimate may turn to be far from actual results. Hence additional and extra precautions are the second nature of insurance operations. Creation of adequate and liberal reserves of various types is integral to their working. History has repeatedly evidenced, inadequacy of reserves to be the most dominant cause for failure of several non-life insurers. A study of 640 US insurance insolvencies during 1969 to 1998  insufficient reserves were responsible for failure of 145 insurers (Based on AM Best Report of 1999). Several subsequent studies in different markets  have again and again reiterated this fact. It was alsoobserved that beneficial tax regime for holding extra reserves was the cause for very low insolvencies     in Germany.

Reserves of insurers can be classified as technical reserves and general reserves. Technical reserves can again be classified as claims reserves and premium reserves.  Though claim reserves are much more important, premium reserves are no less important. Hence premium reserves are the focus and subject of this write-up.

B. Risk Period and Financial Reporting Period

Idea and concept of unexpired risk reserves is closely associated with the two periods mentioned above. Hence, proper understanding of these terms ‘risk period’ and ‘financial reporting period’.  should help in getting clarity on the concept of unexpired risk reserves.

Risk Period

Non-life insurances, with few exceptions, are annual contracts. In some categories of policies the period co-incides with transit period or completion of certain activity. Technically policy period and risk period are different, but in most of the cases they do converge. The insured gets protection against events during this risk period, defined either by dates or by commencement and termination of transit or similar other method   of determining the period. Insurers go on issuing the policies every day all through out the year. Not only the risk period in all these policies may be different, risk commencement and expiry dates will also be different. For example an annual policy issued on 1^st of April will expire on 31^st March of next year and the one issued on 15th of April will expire on 14^th April of next year.

As stated above in certain policies the risk period and the period of contract are different. Some examples are given below.

• Transit Policies – Risk begins from the movement of subject matter of insurance with an intention to begin transit and ends either on delivery or certain days after reaching the destination. Contract commencing period is policy issue period. No definite contract ending period is recorded.
• Marine Declaration Policies and Annual Policies – The contract period is clearly defined. Risk period is again based on the pattern mentioned in 1 above.
• Group health insurance policies. Contract period is normally the annual period. Risk period in case of additions and deletions of members may be different for such persons.
• With the appearance of usage based new motor policy, risk period might be defined as certain kilometers, contract period and risk period may vary.
• In case of liability Insurance, ‘Claims Made basis’ and ‘Occurrence basis’ can create an issue of risk period and contract period.

Where as policy or the contract period is certain in all policies, risk period has an element   of uncertainty in case of some policies. In such cases of uncertainty insurers use contract period as risk period for some of their activities like creation of reserves.

Financial Reporting Period

For a sustained and viable commercial operation, regular periodic review and stock taking of the operations / performance and the state of affairs, is a necessity. This period is very often called Financial Reporting Period (also called Accounting Period).

Where as the reporting period is definite the risk period is not so. By the nature of insurer’s operations the risk period and the financial reporting period will differ in case of most of their policies, though in some cases there is a possibility, of the two being same. It is this attribute of differing risk periods of policies and reporting period gives rise to unique concepts of ‘unexpired risks’ and ‘unexpired risk reserves’.

C. What are Unexpired Risks

From the discussions in the previous paras it is obvious that, in cases of many policies, the risk period overlaps over two financial reporting periods. Part of the ‘risk period’ falls in one financial reporting period and part of it falls in the next financial reporting period/s. That portion of the risk which overlaps into the next financial reporting period is called “unexpired risk’. The portion of the risk relevant to the expiring reporting period is called ‘expired risk’. Thus, policies where risk overlaps over more than one reporting period will have a part of the risk period known as ‘expired risk’ and a part (balance period of risk) which has not expired called ‘unexpired risk’.

D. What are unexpired risk reserves

Fortitous events occuring during the entire risk period are the subject matter of financial protection offerred by Insurers in their policies. The events giving rise to claims, viewed from the angle of reporting period might have occured in the expired period, with a further potential of occuring in the unexpired period too. The premium collected by insurers is for the full period.  Logically the insurers earn their premium over the entire risk period which overlaps more than one financial reporting period. Hence full premium can not be included in a single financial reporting period. This is necessary to avoid / eliminate distortion which might be caused by taking all premium in the first reporting period. In Financial Accounting terminology this is known by the name ‘matching concept’- match the income with corresponding expenses/ outgos. The premium corresponding to the unexpired period (also called unearned premium) will have to be taken to the next financial reporting period. The premium corresponding to the expired period is called earned premium. The process of taking the premium collected in one financial reporting period to the next financial reporting period is done by way of creating reserves. Such reserves are called reserves for unexpired risks. These reserves are expected to take care of expected outgos / expenses on such risks which have not expired and will expire in the future period.

E. Two Components of Unexpired Risk Reserves

Unexpired risks attract creation of reserves. These reserves are actually of two types. Very often the term unexpired risk reserve is used interchangeably with the term unearned premium. However unearned premium is only a part of unexpired risk reserves, the other part being reserve for premium deficiency. Unearned premium is the premium apportioned and allocated to subsequent accounting period. As stated above this reserve is meant to meet the expenses / outgos expected in the future accounting period. But it might happen that the reserve might prove insufficient to meet such expenses or outogs. For such contengency of deficiency there is a need for an additional reserve. It is called premium deficiency reserve. If the future period in which events giving rise to claims are expected to produces a situation where the outgos/expenses are more than the corresponding premium apportioned for meeting those contingencies, a reserve is required to be created for meeting the resulting deficit.

F. Basis for creation of Unexpired Risk Reserves

Fundamental principles of financial accounting and Statutory / Regulatory provisions are porimarily the  two basis for the concept of Unexpired Risk Reserves.

As discussed above “Financial Accounting Principles” of ‘Accrual method of accounting’, ‘Matching  income against expenses/outgos’ and ‘Conservatism and Financial Prudence’ (Recognise the expected losses immediately and expected gains only on relisation) are at the roots of these reserves.  The purpose of these principles is to present just and fair financial statements.

Apart from the Financial Accounting Principles mentioned in the previous para, the statutory / regulatory  provisions – Insurance Regulatory and Development Authority of India (Preparations of Financial Statements and Auditors Reports of  Insurance Companies) Regulations and The Insurance Act 1938, also form the basis for creation of these reserves. These provisions are reproduced below.

“Premium shall be recognised as income over the contract period or the period of risk”.

“A reserve for unexpired risks shall be created  as the amount representing that part of the premium written which is attributable to and to be allocated to the succeeding accounting periods and shall not be less than as required under section  64 V(1)(ii)(b) of the Act”.

Section 64 V(1)(ii)(b) of the Insurance Act 1938.

Reserves for unexpired risks in respect of

• Fire and Miscellaneous Business – 50 percent
• (a)Marine Cargo Business – 50 percent
• (b)Marine Hull Business – 100 percent

of the premium, net of reinsurances, during the preceeding 12 months. (Ideally this wording should be ‘Premium, net of reinsurances pertaining to unexpired policies”)

Schedule B Part I of the Insurance Regulatory and Development Authority of India regulations on Preparation of financial statements and Audit Reports of Insurance companies) Regulations 2002 provide “ Premim deficiency shall be recognised, if sum of expected claims costs related expenses and maintenance costs exceeds related reserve for unexpired risk reserves”.

Special dispensation : “In accordance with IRDAI circular                                                        IRDAI/F&A/CIR/FA/126/07/2013, dated 3^rd July, 2013 insurers are not required to recognise premium deficiency arising out of Motor Third Party Portfolio including esrtwhile Motor Pool, Declined Risk Poool and Other Pools”.

F. Methods of calculating unearned premium (dominant part of unexpired risks reserves)

There are three methods of calcuklating unearned premium.

1. Time based appoprtionment – “Daily Prorata Basis”
2. Varying Risk Pattern
3. Statutory Minimum Requirements.

1. Time based appoprtionment – “Daily Prorata Basis” over the risk period/contract period (where risk period is not practicable) which ever is appropriate is the primary     method of calculating unearned premium. In most of the policies the possibility of for tutious events giving rise to claims is same on all days of the risk period. In other words the risk  (in terms of the subject matter of risk and in terms of its vunerability to perils)  is uniformally distributed over the entire risk period. Therefore the best method of accruing income of insurers is to apportion the premium based on time. Apportionment  based on time is done by following either 1/365, 1/24, or 1/12 methods, the latter two being simplified versions 1/365 method. Prior to the advancements in Information  Technology, it was not easy to calculate these reserves on daily basis. Hence Insurers  invented simplified methods of 1/24, and 1/12 methods of calculations. Now the computers have made it easy to use 1/365 method. All indian insurers follow only this method is a proof enough of to the relevance and simplicity of 1/365 method. 1/24 and 1/12 methods have become outdated.

2. Varying Risk Pattern Basis

However the basic assumption of uniform spread of risk over the entire risk period is not   true in certain categories of business / risks. One such example relates to project    insurances. The exposure in these insurances increases as the project progresses. Hence uniform accruing of premium over the risk period is logical for such risks and premium       on such policies may have to be recognised in slightly different way and the method is known as “basis of pattern of risk”.  This method is also recgonised by the regulator in its regulations on preparation of financial statements and audit report of insurance  companies. Another example of varying pattern of risk could be the flood risks. The risk is higher in the rainy season compared to other seasons of the year. The practice of adjusting the yearly own damage premium to the insured declared values of the vehicle in case of long term motor policies is nothing but one form of recognition based on pattern of risk.  Similarly the chances of fires in summer (if empirically supported) seem to be greater than in other seasons and the varying risk pattern method might be more suitable for such risks. Crop insurance is another class of business where the varying pattern basis   is appropriate as the risk goes on increasing and is at its highest, close to and at the time    of harvesting. High level of reserving seen historically in the marine hull segment might be based on the concept of skewed risk distribution (or need for greater degree of precaution in the hull business)

3. Minimum Statutory Requirements. Apart from the above two methods, as a prudent regulatory provision, Regulators / Laws do prescribe creation of minimum level of reserves. In addition some special dispensations may be considered by the regulators. The said provisions applicable for Indian Non-life Insurers are reproduced in “E” above.

G. Observations on status of Un-expired Risks Reserves and related Practices of Indian Non-life Insurers

Keeping in mind the importance of these reserves and based on the the current Un-expired Risks Reserving Practices of Indian Non-life Insurers as reflected in their Annual Reports of 2019-20, few issues have been listed below for further examination by the Regulatory Authorities as well as Insurance Company Authorities, so that the reserving quality improves. Extract of relevant portion of accounting policies relating to un-expired risk reserves is annexed (Annexure B) along with the summarised tabulated status of reserves  (Annexure A).  The information pertains to Twenty Six (26) Indian Non-life Insurers. It does not cover ECGC, Agricultural Insurance Corporation, and some non-life insurers whose reports could not be accessed.

1. As discussed above there are two methods of calculating the unearned premium. All Insurers, except a few (who have folllowed the minimum statutory requirements), follow “ Daily Prorata Basis” (1/365 method)  of calculating the unearned premiums. “Varying Risk Pattern” method of calculating unexpired risk reserves is followed by none (except in case of Kharif Business (crop insurance) of Oriental Insurance)  may be due to difficulties involved in evaluating the risk pattern. But methods have to be developed so that at some point in time insurers will adopt this method in cases where “Daily Prorata Basis” is not appropriate.
2. From the table it may be noted that, the ratio of unexpired risk reserves to net premium range from 33% (GIC re) of net premium to 87%(HDFC Ergo). Even if we exclude GIC Re being a re insurer, the range of 35% to 87%. appears unreasonable, though theoretically such a vide range is perfectly possible. A closer examination is required. The Insurers with very low percentage seems to have not complied with the minimum requirements of 100% for Marine Hull and 50% for other classes of business.
3. Time based apportionment of premium over the risk period in a portfolio which is evenly spread during the financial reporting period, must normally yield a  reserves ratio (to net   premium) of 45 % to 55%. Skewed distribution of business, share of long term policies, share of marine hull policies and (method of risk pattern based calculation of reserves, certain special dispensations like the treatment of crop insurance, Rashtriya Swasth Bima Yojana and pool business  might be some of the reasons for the ratio being beyond this normal range. Yet the status of six insurers who fall in the range of 61 to 87 %  appear unusual. When the regulatory provisions mandate a minimum of 100% for Marine Hull business and 50% for Other business (of net premium) the case of 7 insurers falling in the range of 33% to 49% appears to be an issue of compliance, if not an issue of adequacy of reserves.
4. Certain categories of Insurance, like Crop Insurance, Terrorism Pool Rashtriya Swasth Bima Yojana etc appears to have received special treatment. But uniformity is missing. Amongst the insurers (or some insurers have not disclosed the policy though in practice they have followed it). And also the varying practice between  the acceptor and ceding / retroceeding company (like GIC Re reserving at 50% and the acceptor of retro-cession providing 100%) might result in some anomaly.
5. In case of some health policies by one of the Insurer a variation of time based apportionment is followed.
6. With respect to long term policies the practice observed from reports of some insurers the unearned premium (premium pertaining to future period where the risk has begun) is taken to Advance premium or Allocated premium. Is it right to do so ? What is the need for this deviation in treatment of unearned premium ?
7. The accounting policies reflected in Annual Reports of 2019-20 of Indian Non-life Insurers on Premium Income Recognition indicate some differences. The practices do have a bearing on the working of unexpired risk reserves. Efforts should be made to rationalise the practices to ensure reasonable uniformity, so that the quality of unexpired risk reserves is improved. Ensuring uniform practices from the participants is a good regulatory practice. It is also observed that the language which leaves a scope for different interpretations and the silence which leaves scope for imagined interpretations should be avoided in the accounting policies and disclosures. Rationalisation even if minor, will considerably enhance the quality of disclosure.
8. The term unexpired risk reserve and unearned premium some times used interchangeably. It will be better if unexpired risk reserves should stand only for Unearned premium and premium deficiency. Though in practice in most of the cases premium deficiency being nil, the amount of unexpired risk reserves and unearned premium will be same.
9. Premium deficiency reserve has been created by 3 out of 26 insurers. Few Insurers have explicitly stated their reserve for premium deficiency to be Nil. Some have disclosed the accounting policy even though there is no such reserve. Others are silent. For the sake of good disclosure practice, silence should be avoided.
10. Many insurer explicitly state that pattern of risk based method has not been followed for creation of unexpired risk reserves. Many others are silent on this. Positive disclosure instead of being silent is a good practice.
11. In their policies some insurers have stated that unearned premium is calculated on net premium, others have stated that it is calculated on gross basis. Amongst those who have calculated on gross basis, some have stated that the unearned premium of ceded business is adjusted against unearned premium of gross business. And many insurers are silent about such adjustment. Most of the insurers are silent on unearned premium of accepted business.  Normal meaning of net premium is gross minus ceded plus accepted. Are the insurers who are silent about unearned premium of they complying with the minimum requirements.
12. As far as the certification of premium deficiency reserves, the policies reflect differing practices of the insurers. While some insurers get only ‘expected claims cost’ component of deficiency to be certified by the Appointed Actuary, others get all components of deficiency reserves (Like expected claims costs Expenses, maintenance costs corresponding unearned premium)  so certified.
13. Reinsurance treaties do have clauses called ‘Portfolio premium withdrawal” and “Portfolio premium entry”. Such clauses in fact with unexpired risk reserves relating to re-insurance transactions. The impact of such clauses and transactions flowing there from have to be synchronized with the premium reserving in general, so that duplication or gaps if any are taken care of.
14. In case of long term policies the reserving process has to incorporate discounting into its calculations.

Conclusion

There has always been a trade off between perfection and avoiding complexity. The 21^st century developments in information technology and data management have made perfection possible without the trade off. Pragmatism endowed with flexibility is essential for good governance, but always in an orderly framework and under watchful eyes. Unexpred risk reserves of Nonlife insurers is one of the areas of high stakes for all stakeholders.