Equalisation reserves: classes other than credit business: creation of the reserve
In the first financial year (see GIM7210) to which the equalisation regulatory rules apply companies must create an equalisation reserve carried forward at the end of that year and brought forward at the commencement of the next.
The rules governing the movement on the reserve are as follows.
- First, transfers into the equalisation reserve are calculated by reference to that year’s net written premiums.
- Secondly, transfers out of the equalisation reserve are calculated by reference to claims incurred and premiums earned in that year.
- Thirdly, a maximum equalisation reserve limit is calculated by reference to net written premiums. If necessary a further transfer out is made to bring the reserve down to the permitted maximum.
- Finally, transfers out are set against transfers in so as to arrive at a single net figure for the transfer into or out of the reserve for the year.
This description is for accident year basis. For underwriting year basis the reference is to claims paid and premiums written - see GIM2090.
Each year the computations are made in this order - transfers in, transfers out, then a reserve maximum calculation.
For each financial year the amount transferred in is a set percentage of the net written premiums of that financial year. The relevant percentages for each business group are shown in the table at GIM7040.
On an accident year basis transfers out of the reserves are triggered when net claims incurred in a financial year for a particular business group exceed a set percentage of net earned premium for that business group for the same year - called an ‘abnormal loss’.
On an underwriting year basis the ‘abnormal loss’ is the amount by which net claims paid for a particular business group for that year, together with the increase (or less the decrease) in the net technical provisions, exceeds a set percentage of net premiums written for that business group for the same year.
The amount of transfer out of the reserve is the amount of the abnormal loss, subject to applying a cap equal to the maximum reserve level for that business group at the end of the year. The business group maximum reserve is calculated as shown in GIM7040. If both accident and underwriting year accounting is used for the same business group, the maximum reserve cap is applied to the aggregate of the abnormal loss calculations on each basis. Transfer out is also limited to ensure that the reserve does not fall below zero.
GIM7040 shows claims ratio triggers for each business group.
Even though the above transfer out calculations are made for each business group individually, as described above, the whole of the reserve remains available to draw regardless of the origins of transfers into the reserve.
High claims in a year may not be the only trigger for transfers out. As the total equalisation reserve maximum is recalculated each year, based partly on previous years’ results, the recalculated reserve may exceed the new maximum where the pattern of business has changed. So, even if there are no transfers out on account of adverse claims experience, there may be a transfer out of the reserve of the excess over the new total maximum reserve, after calculating transfers in. GIM7090 explains how the maximum reserve level calculation is made.