Chapter 21, Section 3.2: Core reading says “Acquisition costs may already have been naturally deferred by an appropriate choice of valuation basis, for example the use of a gross premium valuation. Otherwise, within limits, it is required that a DAC asset be set up in the balance sheet.” I understand this to mean that by using a gross premium valuation, the day 1 reserve is reduced by the present value of the initial expense loadings within the gross premiums. This offsets the initial expenses, so profits aren’t understated and a DAC isn’t necessary. Is this understanding correct and if so, is it the case that a DAC is never appropriate in conjunction with gross premium valuations? I ask because I’ve seen FSA Returns which state that a gross premium valuation has been used (and there’s no mention of net premium valuations and no with-profits business), but where a DAC is present.
Yes, by using the gross premium valuation we have reduced the reserves by the present value of all the initial expense loadings in future premiums. So there's no need for a DAC. If we'd used a net premium valuation then we'd have ignored the expense loadings in the office premium, so we set up a DAC instead. I can't see any justification for a DAC if gross premium valuations have been used. It would be interesting to hear if anyone else has seen this used in practice and knows the reason why. Best wishes Mark
Hi Mark, How can we be sure that the reserves decrease under gross premium valuation if, Gross premium prospective reserve = PV(benefits) + PV(initial, renewal, terminal expenses) - PV(Gross premium), and therefore there is both PV(initial exp) and initial expense loading in PV(Gross premium)?
Before the contract is written we can price using the formula (along the lines you suggest and assuming there are no explicit profit loadings): PV(Gross premium) = PV(benefits) + PV(initial, renewal, terminal expenses) However, we do not reserve for contracts before they are written. Immediately after the policy is written (we have now paid the initial expenses and received the first premium): Gross premium prospective reserve = PV(benefits) + PV(renewal, terminal expenses) - PV(Gross premiums except the first premium) so the reserve is reduced by the initial expense loadings in all the premiums except the first premium. Best wishes Mark
My understanding is the need for DAC is really to ensure the emergence of profits happens in a true and fair manner ala accounting style. So whilst GPV naturally defers acquisition cost, the profit pattern can still be negative and then positive later. So wouldn't this still be not true and fair enough and so a DAC is still needed despite some natural DAC-ing?
We get a strain at outset with GPV in the reserving calculations because the FSA requires us to use a prudent basis. Hence we get a loss followed by a stream of surpluses if we look at the FSA accounts. However, for our published report and accounts we shouldn't be using such a strong basis, so I wouldn't expect such a big loss to show up at outset. Best wishes Mark
