Evaluating the Unearned Premium Reserve for Automobile Extended Service Contracts

The balance sheet of a writer of automobile extended service contracts will often list a liability for unearned premiums that is several times larger than the liability for unpaid loss and loss adjustment expense. For the writer of extended service contracts, there is often more risk associated with the adequacy of the unearned premium than with the adequacy of the loss and loss expense reserve. This paper discusses one method of estimating the adequacy of the unearned premium reserve for extended service contracts for automobiles. Essential to the method described is the manner in which the data is segmented and compiled. Data is segmented by contract duration and miles covered, by the coverage level afforded, and separated by whether the contract was sold on vehicles within the manufacturer's warranty and those on vehicles whose original manufacturer's warranty has expired. There are three NAIC prescribed tests for the adequacy of the unearned premiums for contracts greater than or equal to thirteen months. 1. The estimate of the amounts refundable to the contract-holders at the reporting date. 2. The gross premium multiplied by the ratio of the projected future gross losses and expenses for the unexpired term of the contract to the projected total gross losses and expenses under the contracts, and 3. The amount of the projected future gross losses and expenses to be incurred during the unexpired term of the contracts, with specific adjustments for investment income. This method can provide a basis for estimating the third test in the NAIC required tests for unearned premiums for such contracts.