Earned premiums net of DAC

[studentmb]

Hi I am confused about how you calculate this.
Q2 from 2011 ST7 tutorials part 3 implies this:

EP(net) = GWP - increase in net UPR

whereas Sept 2008 ST3 paper Q5 part (i) implies this:

EP(net) = NWP - increase in net UPR

e.g for 2005 contract A: EP = 8,351 - (4,175-3,975) = 8,150 where the 8,351 is NWP. If you try to put in GWP which is 13,918 the calc doesn't give you the right answer.

Please can someone clarify which is correct?

Thanks!

 

[Coralie Clarke]

Hi studentmb,

Yes, the correct way to calculate earned premium is:

EP = WP - increase in net (of DAC) UPR

In this particular exam question, the examiners also accepted answers where the written premiums were reduced for acquisition costs. This gave earned premiums net of acquisition costs - equivalent to combining the earned premium and the acquisition expense items from the revenue account, ie:

EP (net of AC) = WP (net of AC) - increase in net (of DAC) UPR.

In normal accounting questions, always stick to the first definition above.

I hope that helps,

Coralie

 

[studentmb]

Hi

Sorry but am still confused here. I will work with numbers given in the tutorial question:

Yr 1: WP = 400, AC = 100, UPR(gross of AC) = 200, UPR(net of AC) = 150
Yr 2: WP = 600, AC = 150, UPR(gross of AC) = 300, UPR(net of AC) = 225

I would say
A) EP (gross of DAC) = GWP in yr 2 - increase in UPR (gross of DAC)
= 600 - (300-200) = 500

B) EP (net of DAC) = GWP - increase in UPR (net of DAC)
= 600 - (225-150) = 525


In a normal revenue account for Yr 2 I would out the first one:
Net (of RI) EP = 500
Expenses paid (i.e DAC paid) = 150
Increase in DAC = 50
therefore profit = 500-150+50 = 400


but that 400 profit is not the same as what you suggest they did in the other exam paper where they combined the above revenue account all into one:

EP(net of DAC) = NWP in yr 2 - increase in UPR (net of DAC) = 450 - (225-150) = 375

I'm lost.....




A secondary issues is I don't really follow the logic for calculating B)
Assuming written evenly over time:

A) EP (gross of DAC) = GWP in yr 2 - increase in UPR (gross of DAC)
= 0.5* GWP in yr 1 + 0.5 * GWP in year 2
= 0.5 * 400 + 0.5* 600
= 500
I understand this and it matches the above

but for

B) EP (net of DAC) = GWP - increase in UPR (net of DAC)
applying the same logic I would say:
= 0.5 * NWP in yr 1 + 0.5 * NWP in yr 2
= 0.5 * 300 + 0.5 * 450
= 375
which disagrees with the calc above which gives 525 as the answer! but does agree with the exam paper answer of 375.....

Again I'm lost....

I think in summary what I am asking is how do you calculate Earned premiums in various different ways allowing for and not allowing for DAC?

 

[Katherine Young]

Hi studentmb,

I've written a detailed response to your queries below, just for completeness. However, it strikes me you're getting tied up in knots about this.

Therefore, as a high level recommendation, I strongly suggest that you stick with what Coralie has already said: Always use the formula EP = WP - increase in net (of DAC) UPR. It will always be acceptable to the examiners, and you'll be much less likely to go wrong.

Please find below the nitty gritty, complete answer.


=======================================

I would say
A) EP (gross of DAC) = GWP in yr 2 - increase in UPR (gross of DAC)
= 600 - (300-200) = 500

B) EP (net of DAC) = GWP - increase in UPR (net of DAC)
= 600 - (225-150) = 525

This is correct. Well done.

In a normal revenue account for Yr 2 I would out the first one:
Net (of RI) EP = 500
Expenses paid (ie DAC paid) = 150
Increase in DAC = 50
therefore profit = 500-150+50 = 400

This isn't quite right. We're not talking about profit here, because we have no information regarding claims, investment return, non-commission-related expenses etc. Also, we can't talk about expenses paid, but only acquisition expenses paid. Any other expenses would have to be given in the question.

So you're trying to think about something that doesn't really make sense. Let's draw a line under it and move on.

EP(net of DAC) = NWP in yr 2 - increase in UPR (net of DAC) = 450 - (225-150) = 375

This is EP net of AC, not net of DAC. If you use this method, you'd then have to be careful not to double count your acquisition expenses later on. For this reason, I don’t recommend you use this method in the exam.

B) EP (net of DAC) = GWP - increase in UPR (net of DAC)
applying the same logic I would say:
= 0.5 * NWP in yr 1 + 0.5 * NWP in yr 2
= 0.5 * 300 + 0.5 * 450
= 375
which disagrees with the calc above which gives 525 as the answer! but does agree with the exam paper answer of 375.....

Again, you've calculated EP net of AC, not net of DAC. The difference is 150, the acquisition expenses paid. So, as above, you'd have to be careful not to double count your acquisition expenses later on in your revenue account.

Kind regards,

Katherine.

 

[studentmb]

Thanks Katherine, I'm pretty much understanding now.
One final question:

I would normally put EP (gross of DAC) = 500 into my P&L
then have a separate line for increase in DAC = 25.
Therefore total = 525 =EP(net of DAC)

would examiners expect to see the 2 lines split out?


---------------------------------------------------------------------
Just to note on the layout of the P&L, I was being lax with my naming (note to self, don't do in exam!), I did mean:

Net (of RI) EP = 500
Expenses paid (=AC paid assuming no other expenses) = 150
Increase in DAC = 25 (I incorrectly typed 50 before)
therefore underwriting result = 500-150+25 = 375
.....rest of P&L continues.......

which matches the calc of EP (net of AC & DAC) which I was trying to get to grips with.

 

[Katherine Young]

Hello again,

would examiners expect to see the 2 lines split out?

The examiners would award marks whether you show the two items explicitly or not. Personally however, I prefer to split them out. Plus, it makes it easier to mark!

Kind regards,

Katherine.

 

[Werner]

EP (gross of DAC) used in exams

I've been struggling with the same concept as studentmb.

I'm happy for EP (net of DAC) to be calculated as WP - incr in UPR (net of DAC). However, it seems that this is not the amount for EP used in the exams.

October 2011 Q5 (ii) uses EP (gross of DAC) as the Earned Premium referred to and does not include incr in DAC for this. In the question 40% of earned premiums are used to calculate the Claims Paid amount but the Gross of DAC EP is used. In other exams I've seen the EP (net of DAC) used. There doesn't seem to be consistency.

For calculating LRs, would I use EP (Gross of DAC) as the denominator? This was done in the Oct 2011 paper too but is at odds with this thread mentioning that we should always use EP (net of DAC) = WP - incr in UPR (net of DAC).

Leaving this a bit late but I've been finding different treatments of this regularly.

 

[freebird]

I agree...I see the same done to question Q&A 6.15.
UPR is taken gross of DAC.

I have one more concern..why the revenue account includes reserve amounts in this question?

 

[freebird]

Is it like that if we do WP less UPR net of DAC then we don't add increase in DAC component later?
So we have to do any one of the two?

 

[Katherine Young]

Responding to Werner's query first:

October 2011 Q5 (ii) uses EP (gross of DAC) as the Earned Premium referred to and does not include incr in DAC for this.

The October 2011 exam has a separate line for DAC lower down. To repeat what I said in my prevoius post, the examiners would award you marks whether or not you include DAC implicitly within your EP, or have an explicit DAC item instead.

In the question 40% of earned premiums are used to calculate the Claims Paid amount but the Gross of DAC EP is used.

This makes sense. I wouldn't expect to use a figure that includes DAC when calculating claims. DAC is just an accounting concept, so it shouldn't affect the insurer's actual claims experience.

In other exams I've seen the EP (net of DAC) used. There doesn't seem to be consistency.

To calculate claims? Really? Please give an example.

For calculating LRs, would I use EP (Gross of DAC) as the denominator?

When calculating claims, that's correct, I wouldn't include DAC. This is one reason why I prefer to show DAC in my accounts explicitly, instead of having DAC implicit in my (net) EP. That way, it's much easier to calculate claims.

This was done in the Oct 2011 paper too but is at odds with this thread mentioning that we should always use EP (net of DAC) = WP - incr in UPR (net of DAC).

Studentmb made an error in the EP calculation. Therefore I gave this formula with the intention of stressing that EP = WP - increase in UPR (which is a much more fail-safe method than using EP = WP/2). In other words, I gave this formula to help explain how to calculate EP, not to help explain the concept of DAC.

Now to answer Freebird's questions:

I have one more concern..why the revenue account includes reserve amounts in this question?

The revenue account is showing the items for WP and increase in UPR separately. It could have written EP = 325 instead (ie 600-275). The company has only just finished its first year of trading, so the UPR last year was 0.

Similarly, instead of having an item for claims incurred, this question shows claims paid and (increase in) outstandings / IBNR separately.

Similarly, since an AURR has been set up, this will decrease the company's profit.

Is it like that if we do WP less UPR net of DAC then we don't add increase in DAC component later?

Correct.

So we have to do any one of the two?

As per my previous posts, and my response above, the examiners will award marks either way.

Kind regards,

Katherine.

 

[freebird]

I understand it now. Thanks a lot!