Premium Deficiency and DAC Recoverability in Personal Auto
A personal auto segment has unearned premium of $85M at year-end. Deferred acquisition costs (DAC) are $12M. The segment's most recent four-quarter combined ratio is 108%, including a 22% expense ratio; the loss ratio has risen because of severity inflation. Investment income on the unearned premium reserve is expected to be $2.1M over the remaining coverage period. Management plans to increase rates 9% effective mid-next year, but the filing is not yet approved. The company's policy is to test premium deficiency at the segment level, grouping personal auto liability and physical damage because they are managed together. The CFO argues that investment income and the planned rate increase should be considered, so no deficiency exists. The auditor asks for a documented conclusion.
1. Determine whether a premium deficiency exists under the given facts, showing the calculation and stating the treatment of DAC.
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The premium deficiency test compares expected losses and expenses on the unearned premium with unearned premium plus anticipated investment income. Expected losses and expenses are 108% x $85M = $91.8M. Adding expected investment income of $2.1M gives available funds of $87.1M. The deficiency is $91.8M - $87.1M = $4.7M. Because DAC is $12M, the deficiency is first recognized by writing down DAC by $4.7M, leaving $7.3M of DAC. No separate deficiency liability is needed because the deficiency does not exceed DAC. The planned 9% rate increase should not be credited because it is not approved and is not yet legally effective; including it would anticipate management action that may not occur.
2. Explain why the planned rate increase should not be fully credited and how the grouping decision affects the result.
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A rate increase can be considered only to the extent it is probable and legally permitted during the remaining coverage period. A mid-next-year filing that is not approved is uncertain in timing, amount, and approval, so crediting it would understate the deficiency. Grouping personal auto liability and physical damage may be acceptable if the products have similar risk characteristics and are genuinely managed together, but grouping can mask a deficiency in one line if the other is profitable. The auditor should see whether the segment-level test is consistent with how profitability is managed and whether separate tests would produce a materially different conclusion. If the liability line is driving the deterioration, I would disclose the sensitivity to separate testing rather than rely only on the grouped result.
3. Recommend the documentation and monitoring you would provide to the auditor.
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I would document the unearned premium, DAC, expected loss and expense ratios, investment income assumption, and the rate-filing status. I would show the deficiency calculation and the DAC write-down, plus a sensitivity showing the result without investment income and with a partial rate increase. I would explain why the rate increase was excluded and what evidence would cause it to be included later. Monitoring should include loss trend by coverage, approval status of the rate filing, and whether the remaining DAC is recoverable from future profits. The conclusion should state that the deficiency is recognized through DAC and that no separate liability is recorded because the deficiency is less than DAC.