What Does Premium Deficiency Reserve Mean?
A premium deficiency reserve (PDR) is the amount needed by an insurer if the unearned premiums collected may not be sufficient to meet future claims and expenses. A premium deficiency occurs when expected losses, claims costs, administrative costs, selling costs, shareholder dividends, and other expenses exceed related unearned premiums.
This is expressed as a liability in the financial statement. The reserve is a statutory requirement to make sure that a company will be able to pay their insureds. It is also standard practice required by Generally Accepted Accounting Principles (GAAP) and by actuarial standards of practice.
The amount of premium deficiency reserves an insurance company must hold depends on several factors such as the volume of unearned premiums written by the insurer, expected claims costs and expenses, and projected investment returns. Investment income may be used to supplement amounts held in the PDR which means fewer funds need to be held in reserve during times when investment returns are strong.
Premium deficiency reserves held for a particular group or class of business must remain segregated and therefore can not be used to offset shortfalls in other classes of business.
Insuranceopedia Explains Premium Deficiency Reserve
When an insurance company creates a premium deficiency reserve, it does not necessarily mean that the company is operating at a loss. It generally means that it is charging a premium that is lower than what is expected and there is a risk that it may not have enough cash coming in from unearned premiums (not counting potential new business) to cover current and projected expenses.
Expenses factored into this calculation include:
- Claims expenses.
- Administrative expenses.
- Shareholder returns in the form of dividends.
This low premium can be strategic as a way to win more business in a competitive soft market or build out a new line of business. It might mean that through experience, the company knows how much money it needs to set aside and that it is no longer following an actuarial model it used to subscribe to.
Owing to the potential risk of the inability to cover risks in the future, premium deficiency is listed as a liability in a company’s accounting books. In other words, the deficiency is a probable loss on premiums written but yet to be earned by the date the company’s financial statements are compiled.
Similarly, if an insurance company does not carry any unearned premiums on the date the financial statement is compiled, they do not need to meet any statutory premium deficiency reserve requirements. That is of course unless they are obligated to provide coverage that extends past the stated policy period (ie. a sunset clause applied to a professional liability policy held by a firm that has ceased trading).