Automobile Warranty Unearned Premiums and Deferred Policy Acquisition Expenses

This paper describes one approach to calculate the unearned premium reserves of an automobile extended warranty insurance program, test the adequacy of the calculated reserves, and determine the allowable deferred policy acquisition expenses. A prorata formula is commonly used to calculate unearned premium reserves in property-casualty insurance, but we believe that an exposure adjusted formula is more appropriate in automobile extended warranties. We organize data by the effective month on the manufacturer warranty and employ an expected pure premium methodology to calculate the unearned premium reserves for an automobile extended warranty contract. Unearned premium reserves plus future investment income derived thereof are compared against future claims and expenses to determine if premium deficiency exists. Investment income is estimated form interest bearing assets, taking into account credit risk, interest rate risk and payment pattern risk. Automobile warranties have terms rankings from 1 year to 7 years and acquisition expenses are large relative to the first year earned premiums. In (US and Canadian) GAAP financial statements, insurance companies are allowed to defer policy acquisition expenses to the extent they meet the test of recoverability. Finally, we discuss the impact of reinsurance on a mono line warranty insurance company's balance sheet.