LC Calc - Appendix

bennybees1

I was going through the LC calcs in the excel exhibits and have the following questions:

1) Could you explain why Direct UEP= Premium received + Premium receivable - Insurance Revenue? Why is it not just Premium receivable?

2) Is the cancellation adjustment always only applicable to variable acquisition costs, and not fixed acquisition costs? I saw they only applied it to the variable acq. costs. Do we not apply it to fixed acq. costs for obvious reasons?

3) They calculated premiums receivable discounted as premium receivable - direct UEP * (1-cancellation adj.) * discount factor. Why is the formula not just premiums receivable * cancellation adj. * discount factor?

4) In their formula for FCF, they added the term DAC(net of cancellations) - DAC(gross of cancellations). Could you please explain the rationale behind this? In the Approach tab of the excel file, the formula they have for FCF did not include the present value for DAC so i'm wondering where this comes from and the thought process behind it.

Thanks in advance!

Staff-T1

1) Because premiums receivable are similar to premiums received. They both reflect an obligation to provide coverage to the insured
2) For fixed costs, they are always the same regardless of how many policies are written. In that sense, it would make sense that they would not change regardless of the amount of cancellations we expect
3) They are discounting the whole amount. Check the formula carefully. The cancellation portion is because you'd only refund the unearned portion of premium
4) They are not taking the PV of DAC here. This is just to reflect that some of the DAC will not be realized due to cancellations, which means you have smaller expenses

AlyMarquis

I still don't get point #3. Why is the formula not just premiums receivable * cancellation adj. * discount factor?

Staff-T1

You have an expected amount of policies that will cancel that are currently in force and have a UEP component. Without accounting for that, you are understating the amount of premiums receivable

bennybees1

Another follow-up question:

LRC excl. LC = Premium Rec'd - Insurance Revenue - Gross DAC. Why is it not Net DAC of cancellations?

bennybees1

In the CAS SampleQuestion #17, I noticed future acquisition costs were not discounted. Do we always assume that future acquisition costs will be realized at contract inception (in this case, it would be Dec 31, 2023) unless told to assume otherwise?

Staff-T1

Mainly because the PAA is a simplification, so no need for all those intricacies.

Staff-T1

No, future acquisition costs should be discounted (refer to the master formula in the LRC sample Excel from the CAS) That said, in this question specifically they probably just assume that it is all incurred in day one since there is no discount factor for said expenses

AndrewL

Can you please indicate where is this master formula?

I cannot seem to find it. Thanks

bennybees1

@AndrewL It's the first page in the excel exhibits for the LRC reading. But note that the 'master formula' does not contain the fact that you would deduct any DAC that are expected from cancellations

Staff-T1

Yup, benny is right - Tbh in actual real IFRS calculations many people do not adjust the DAC for expected cancellations

AndrewL

Thanks @bennybees1 @Staff-T1

Is this what you refer as master formula?

Staff-T1

Correct

hstai91

In the sample q, PV of attributable costs uses discount factor of premium I am curious why can't the same be use for discounting future acquisition cost as it is also derived based on premium?

Staff-T1

The unearned premium that is used to derive the future acquisition cost is already "discounted". The whole point of discounting the premiums is to bring all the future premium inflows to time 0. In the case of the unearned premium, they are all already at time 0. Also, the formula referenced above does mention that we need to discount the future acquisition costs.

user1

For question 4's answer from above : 4) They are not taking the PV of DAC here. This is just to reflect that some of the DAC will not be realized due to cancellations, which means you have smaller expenses <- i don't understand why this step needs to be done. Didn't we already adjust the deferred acq costs to be net of cancellations?

hstai91

Could you clarify a bit more? If the unearned premium is already "discounted" which is what we use to derive attributed cost as well, why do we apply discounting on attributed cost? What I am trying to understand is both the future acquisition cost and other attributed cost should be discounted as per the master formula. But in this q that CAS posted, even though both were derived based on unearned premium but the solution only discounted the other attributed cost and not not future acquisition cost, what is the reason resulting in this difference?

Staff-T1

Part 4: Yes, we have one column for the cancellations adjusted DAC and the other column for the unadjusted DAC. What you are doing is removing the expenses related to policies that are expected to be cancelled (net DAC - gross DAC) sometime during the policy term. If you do not do this step, then your FCF will be too high as you are projecting more expenses than what will actually be incurred. You cant just use net DAC directly as DAC is only used directly in the PAA, not the GMA. Without this step, you are implicitly expecting that not a single policy will cancel throughout the term.

Staff-T1

As I mentioned above in October last year, the implicit assumption here is that future acquisition costs are incurred immediately, which means while they should be discounted, they aren't because they're not spread out over the term of the policy while other attributable costs are