UPR in solvency II

Discussion in 'SA3' started by padasala, Dec 20, 2021.

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  1. padasala

    padasala Ton up Member

    The core reading material says UPR is not allowed for in S2.

    However, there's also a best estimate premium provision that is equal to the best estimate of future cashflows with respect to unearned exposures rather than the unearned portion of the premium

    Aren't cashflows based out of unearned exposure and unearned premiums essentially the same thing?

    Also what is the difference here? One difference I can think of is PV of cashflows (which would involve some discounting) but would insurers want to discount premium cashflows?

    Any help would be much appreciated
     
  2. CapitalActuary

    CapitalActuary Ton up Member

    UPR is the unearned portion of your premium. Under GAAP accounting you hold this on your balance sheet as a liability, because even though you've received (or will receive) the full amount of premium, you haven't earned it all yet so your net assets shouldn't increase straight away. Instead the UPR is written off over time which allows you to profit gradually as your net assets increase. Note that as we 'earn' the UPR we will also probably be paying claims and expenses though. So if we take £100m of premium in, we record a £100m UPR, and as we write this off over time some will go toward claims and expenses (e.g. with a 60% loss ratio £60m will go toward this) and the other £40m will go into profit.

    Under Solvency II there isn't this notion of recording a UPR item to prevent earning all the £40m profit immediately. That's a GAAP / accrual accounting thing. Under Solvency II there are only cashflows! Cashflows are king! There is no need to create this artificial UPR liability and write it off over time under Solvency II. If you receive £100m premiums up front you can whack on the full £100m onto your cash and the only liability you need to record is a liability in respect of the claims and expense cashflows you expect to pay out, i.e. the £60m I mentioned above. Hence we'll profit by £40m straight away.

    Note that we can still split out cashflows relating to 'unearned exposures' and 'earned exposures' under Solvency II - but all this means is cashflows relating to events that haven't happened yet (the unearned ones) and cashflows relating to events that have happened (earned ones).
     
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  3. padasala

    padasala Ton up Member

    So lets assume that we write $10 mil of business on 1st july. Assuming that the exposure of the risk is uniform, we'd expect to have half the exposure for this year and half the risk exposed for next year.

    The expected loss ratio is say 50%...

    In this case, is it correct to assume that we'd book $2.5 mil in profits this year and $2.5 mil next year?

    Also, isnt accrual based accounting more prudent (and therefore more preferred) than cashflow based accounting? Doesnt this method of recognizing profits put more pressure on actuaries to be spot on (when in reality there will be a lot of uncertainty around the estimation of claims)?
     
  4. CapitalActuary

    CapitalActuary Ton up Member

    Under Solvency II you'd profit $5m straight away. You'd record $10m of premiums as either cash if received up front, or as cash inflows as part of your premium provisions if not received up front. And you'd record a liability for $5m claims you expect to pay out on. Hence your own funds increase in $5m from writing the business, which is a profit of $5m. Of course, I'm ignoring the risk margin here. And also ignoring any deferred tax assets or liabilities arising, or for that matter any discounting and so on.

    Under GAAP / accrual accounting you'd record $10m of premiums as either cash if received up front or premium receivables if not received up front. And you'd record $10m of UPR. You wouldn't have any profit at this point. But by the time you reach the end of the year, as at 31 Dec, you'd have written off $5m of the UPR and would only have $5m UPR remaining. You might have paid out some claims as well, and you might also have reserves in respect of claims that have happened but you haven't paid out on yet. If your loss ratio is bang on 50% and you always get things exactly right, then the claim payments plus your reserves would be $2.5m in total. For longer tailed business like liability a lot of that $2.5m would probably be in the reserves, and for shorter tailed business like property comparatively more of that $2.5m would have been in payments. Hence as at 31 December you'd have profited $2.5m. Rinse and repeat over the next 6 months to realise another $2.5m of profit assuming we got the loss ratio right again etc.

    I suppose one could argue that GAAP accounting is more prudent, as 'prudence' is indeed one of the 'principles' of accrual accounting and under Solvency II you are meant to do things on a 'best estimate' basis which is neither optimistic nor pessimistic. Note a company's net assets / own funds could be higher or lower under Solvency II compared to GAAP though, as there are lots of differences between the two.

    Whether this puts more pressure on actuaries to get things spot on is an interesting question... In practice actuaries will tend to come up with a best estimate or 'central estimate' for reserves using triangulation methods and other techniques. Then this gets split into cashflows using a payment pattern and discounted (and a risk margin added) to come up with Solvency II technical provisions. The central estimate also gets adjusted separately for the preparation of GAAP accounts: a margin for prudence might be added by actuaries and/or management (deciding on what reserves they actually want to book), the full amount of UPR (plus maybe AURR) will be held as a liability rather than just the expected losses. There are other minor differences too. I wouldn't say this puts extra pressure on actuaries particularly, apart from time pressure as they might have to be involved in the presentation of their estimates on two (or more) different accounting bases! At some companies accounting or finance might handle most of this though, with the actuaries mainly just being in charge of the central reserve estimate.

    A lot of detail skipped over, but hopefully this was helpful.
     
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  5. padasala

    padasala Ton up Member

    Yes it was very helpful. thanks for the explanation.
     
  6. GIDEON CHACHA

    GIDEON CHACHA Made first post

    Would you give an example of cashflows relating to events that haven’t happened yet?
     
  7. Katherine Young

    Katherine Young ActEd Tutor Staff Member

    Imagine that you calculate SCR as at 31st December. You wrote a policy in November, which will still be in force in the new year. That would have counted as an 'unearned exposure' in the Solvency II accounts. Any claim that occurs (in January, say) would represent a cashflow that hadn't yet happened at the time the SCR was posted.
     
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  8. GIDEON CHACHA

    GIDEON CHACHA Made first post

    Thanks for the clarification.
    Now, in computing Premium Provision, S2 requires a deduction of future premiums receivable(Unearned Element), how do we get it and my understanding is if you have a 12 month contract starting in Nov, if the premiums is paid monthly, then if you computing SCR as at 31st Dec, then the other 11 months of premiums goes to this element.

    What if its a one-off payment premium which was received in Nov in full? What forms the unearned premium for this contract? Is it UPR even though the company having received the premium in full?
     
  9. Katherine Young

    Katherine Young ActEd Tutor Staff Member

    I recommend you go back and revise SP7. The methods for calculating UPR are discussed in depth in Chapter 15, and there are many questions at the end of this chapter and at the end of Chapter 26 to help you practise these techniques.
     

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