Proposition 103, passed by California voters in November 1988, requires insurance companies to obtain approval from California’s Insurance Commissioner before implementing property and casualty insurance hikes. It was intended to protect consumers from arbitrary insurance rates, but it can also put insurance companies in a difficult position when setting the price of insurance coverage that covers claims costs and operational expenses while still allowing for a reasonable profit.
Adding to the mix of persistent inflation, the challenging reinsurance market, and the ever-present risk of natural catastrophes, it’s understandable why an increasing number of insurance carriers are leaving the Golden State.
For the accountants of insurance companies that have decided to stay in California and fight, JLK Rosenberger brings an article about the premium deficiency reserve (PDR).
What is PDR?
A premium deficiency reserve is defined as a probable loss on the unexpired portion of insurance policies. Accounting principles generally accepted in the United States (U.S. GAAP) state that a premium deficiency shall be recognized when the sum of expected claim costs and claim adjustment expenses, expected dividends to policyholders, unamortized acquisition costs, and maintenance costs exceeds related unearned premiums.
Why is this requirement in place?
It aligns with the accounting guidance pertaining to loss contingencies, which must be accrued when two conditions are met:
- It is probable that, at a balance sheet date, a liability has been incurred, and
- The amount of the loss can be reasonably estimated.
ASC 944-60 requires insurance contracts to be grouped consistent with the entity’s manner of acquiring, servicing, and measuring the profitability of its insurance contracts to determine if a premium deficiency exists.
Example: Premium deficiency calculation for short-duration contracts
Anticipated investment income can be considered a factor that decreases the calculated PDR. The decision to include the anticipated investment income in the calculation should be disclosed in the entity’s financial statements.
In our example, the calculated PDR or liability is $5, which equals the calculated premium deficiency from Policy Grouping A and cannot be offset by the anticipated profits from Policy B.
Recording in the general ledger
A premium deficiency shall initially be recognized as a reduction to the DPAC asset. If the premium deficiency is greater than the DPAC asset, a liability shall be accrued for the excess deficiency.
In our example above, the calculated PDR of $5 is less than the DPAC asset of $150; hence, it can be fully offset. The journal entry would then be:
Had the calculated PDR been $160 (exceeding DPAC asset by $10), the journal entry would be as follows:
*The accounting standards do not explicitly specify the income statement account in which the calculated PDR should be recorded, other than that it should be charged to operations. JLK Rosenberger believes the “other underwriting expense” account is the appropriate place to record this charge in order to follow the spirit of the available accounting guidance.
Statutory Accounting (STAT)
SSAP No. 53 discusses the PDR. The main difference between U.S. GAAP and STAT is that under SSAP No. 71, commissions and other acquisition costs are expensed as incurred. There is no DPAC asset under STAT. Consequently, commissions and other acquisition costs do not need to be considered in the premium deficiency analysis to the extent they have been previously expensed. Without any offset, the calculated liability will then be recognized by a corresponding charge to other underwriting income.
Similar to U.S. GAAP, any discovered deficiencies in one policy grouping shall not be offset by anticipated profits in other policy groupings.
Note 30 of the Annual Statement requires disclosure about the PDR, even if there is no liability to be accrued. The official NAIC Annual Statement Instructions, Property/Casualty, adopted as of June 2022, prescribe the following exact format to be used:
- Liability carried for premium deficiency reserves $__________
- Date of the most recent evaluation of this liability __________
- Was anticipated investment income utilized in the calculation? Yes □ No □
Unlike our simplified example, the actual calculation of the PDR can become quite complex, and you may need to consult with your actuary and accountant. An indicator that often triggers such consultation is when the combined ratios (U.S. GAAP) or loss & LAE ratios (STAT) are close to or exceed 100%.