Valuation and Reporting

of Future Warranty Claims

K Sriram
Consulting Actuary
 AGENDA
• Warranty Claims: Concept and Characteristics
• Alternative Approaches for Estimating Technical Provisions
• Estimating Technical Provisions: GI Actuary’s Standpoint
• Estimating Technical Provisions: Accounting Profession’s Standpoint
• Current Actuarial Involvement in Estimating Technical Provisions
• Concluding Thoughts: Where Actuaries Can Add Value
• References
 Warranty Claims: Concept and Characteristics
Warranty Claims – An Example
A company manufactures and sells washing machines. Under the terms of the sale contract, the company
undertakes to make good, by repair or replacement ,the manufacturing defects that become apparent within
two years from the date of sale. Based on past experience it is probable that there will be some claims under
the warranties.
Issue: What is the amount of provision to be recognised for the warranty claims as on a given reporting date?

It is common for an entity to provide (in accordance with the contract, the law or the entity‘s customary
business practices) a warranty in connection with the sale of a product

Some warranties provide a customer with assurance that the related product will function as per the agreed
upon specifications. Such warranties are referred to as “manufacturers’ warranties”.

Other warranties provide the customer with a service in addition to the assurance that the product complies
with the agreed upon specifications. Typically the customer has the option to purchase this warranty
separately. Such warranties are called as “Extended Warranties” or “Extended Service Contracts”.
Manufacturer Warranties and Extended Warranties are widely used as marketing tools in the automotive sector
and in the “white goods” industries.

Warranties can be either short term [e.g.., one year] or long term [e.g.., two to five years]
Alternative Approaches for Estimating
Technical Provisions
• Methods for reserving for warranty claims can range from the simplest to the more
complex

• Typically the simpler methods are used for estimating short term warranty claim
provisions. These methods include

 Prior year payments: Under this approach, a company reviews payments from the prior year and
assumes equal warranty expenses to current year products. This method may be satisfactory for
short term warranties, but is inadequate if the product mix changes over time or if a company
experiences extensive product growth/decline.

 Payments per unit sold: This method is an improvement on the “prior year payments” that
recognizes not only volume changes but also cost differences between products.

• For longer term warranties, such as those that cover automobiles and other durable
goods, the above methods generally are inadequate because they reflect only recent
payment activity and ignore the fact that most warranty claims take place near the end of
the warranty period. Therefore reserving approaches similar to what general insurance
actuaries use will be more appropriate.
 Estimating Technical Provisions: GI
Actuary’s Standpoint
• From a GI Actuary’s standpoint, the reserve or technical provision for
warranty claims will be equal to the sum of the following three
constituents:
Technical Provision for Warranty Claims
=
Reserve for Claims Incurred But Not Reported
Plus
Reserve for Claims Reported But Not Paid
Plus
Reserve for Claims not yet incurred
 Estimating Technical Provisions: GI
Actuary’s Standpoint
In symbols, the technical provision for warranty claims can be
expressed as
IBNR + RBNP +URR
which in turn can be further expanded and rewritten as
IBNR+RBNB+UPR+AURR(or PDR)
where IBNR represents Incurred But Not Reported Claims
RBNP represents Reported But Not Paid Claims
URR represents the Unexpected Risk Reserve
UPR represents the Unexpected Premium Reserve
AURR represents the Additional Unexpired Premium Reserve
(AURR is also referred to as PDR or Premium Deficiency Reserve)
 Estimating Technical Provisions: GI
Actuary’s Standpoint
The RBNP reserve can be directly pulled from the reported loss data

The IBNR can be estimated using conventional triangle based actuarial techniques
The reporting and settlement lags are likely to be short in the case of warranty
claims.
Estimating URR is more difficult particularly for the long duration contracts.
In the US context, the Statement of Statutory Accounting Principles 65 (SSAP65)
-applicable to Warranty Insurers - provides the following guidance for calculating
the URR.
According to this statement URR as on an accounting date must be the maximum
of
•The amount payable if all policyholders surrendered their contracts for refund,
•The sum over all in-force policies of the gross premium times the expected
fraction of ultimate losses not yet incurred, and
•The expected present value of future losses, from in-force policies, not yet
incurred.
Estimating Technical Provisions: Accounting
Profession’s Standpoint
• The Ind AS applicable to warranty claims provisions is Ind AS 37:
Provisions, Contingent Liabilities and Contingent Assets.

• What is a “Provision” under Ind AS 37?

The Standard defines a provision as a liability of uncertain timing and
amount A provision shall be recognised when

an entity has a present obligation (legal or constructive) that is a result of a

past event
It is probable that an outflow of resources embodying economic benefits will
be required to settle the obligation and
A reliable estimate can be made of the amount of the obligation
Estimating Technical Provisions: Accounting
Profession’s Standpoint
• Is a provision for “Warranty Claims” required under Ind AS 37
(Recognition Aspect)?
Appendix F which accompanies Ind AS37 clearly states that a
provision is required for warranty claims.
The rationale is as follows:

Present obligation as a result of a past obligating event – The obligating event

is the sale of the product with a warranty, which gives rise to a legal
obligation.
An outflow of resources embodying economic benefits in settlement –
Probable for the warranties as a whole.
A reliable estimate of the obligation can be made on past experience
Estimating Technical Provisions: Accounting
Profession’s Standpoint
• How is the amount of provisions determined (Measurement Aspects)?
Paragraph 36 to 83 of Ind AS 37 deal with the measurement aspect
The amount recognised as a provision shall be the best estimate of the
expenditure required to settle the present obligation at the end of the
accounting period.
An entity can use the following techniques to determine the best
estimate of the amount of provision

Weighted Average of all possible outcomes by their associated probabilities

or

The single most likely outcome.

Estimating Technical Provisions- An Example from
Ind AS37
An entity sells goods with a warranty under which customers are
covered for the cost of repairs of any manufacturing defects that
become apparent within the first six months after purchase.
If minor defects were detected in all products sold, repair costs of Rs.1
million would result .
if major defects were detected in all products sold, repair costs of Rs. 4
million would result.
The entity’s past experience and future expectations indicate that for
the coming year, 75% of the goods sold will have no defects, 20% of the
goods sold will have minor defects and 5% of the goods sold will have
major defects.
Therefore the expected value of the cost of repairs is:
(75% of nil) + (20% of 1m) +(5% of 4m) = Rs 400,000
Estimating Technical Provisions: Accounting
Profession’s Standpoint
• How is the amount of provisions determined (Measurement Aspects)?
(continued)

The risks and uncertainties that inevitably surround many events and
circumstances shall be taken into account in determining the best estimate
of the provision
Where the effect of the time value of money is material, the amount of a
provision shall be the present value of the expenditures expected to be
required to settle the obligation.
The discount rate (or rates) shall be a pre tax rate (or rates) that reflect(s)
current market assessments of the time value of money and the risks
specific to the liability. The discount rate(s) shall not reflect risks for which
future cash flow estimates have been adjusted
Future events that may affect the amount required to settle an obligation
shall be reflected in the amount of a provision where there is sufficient
objective evidence that they will occur.
Estimating Technical Provisions: Accounting
Profession’s Standpoint
• What are the disclosures required under Ind AS37?
Paragraph 84 and 85 of the Standard deals with the relevant
disclosures
For each class of provision, an entity shall disclose:

The carrying amount at the beginning and end of the period;

Additional provisions made in the period, including increases to existing
provisions;
Amounts used (i.e. incurred and charged against the provision) during the
period;
Unused amounts reversed during the period; and
The increase during the period in the discounted amount arising from the
passage of time and the effect of any change in the discount rate.
Estimating Technical Provisions: Accounting
Profession’s Standpoint
• What are the disclosures required under Ind AS37? (Continued)

An entity shall disclose the following for each class of provision:

A brief description of the nature of the obligation and the
expected timing of any resulting outflows of economic benefits;
An indication of the uncertainties about the amount or timing of
those outflows. Where necessary, an entity shall disclose the
major assumptions made concerning future events ; and
The amount of any expected reimbursement, stating the amount
of any asset that has been recognised for that expected
reimbursement.
Example Under IND AS 37 for Qualitative
Disclosures
• A manufacturer gives warranties at the time of sale to purchasers of
its three product lines. Under the terms of the warranty, the
manufacturer undertakes to repair or replace items that fail to
perform satisfactorily fro two years from the date of sale. At the end
of the reporting period, a provision of Rs. 60, 000 has been
recognised. The provision has not been discounted as the effect of
discounting is not material. The following information is disclosed:
• A provision of Rs. 60,000 has been recognised for expected warranty
claims on products sold during the last three financial years. It is
expected that the majority of this expenditure will be incurred in the
next financial year, and the balance amount will be incurred within
two years after the reporting period.
 Current Actuarial Involvement in Estimating
Technical Provisions

• Actuaries are involved in estimating the provision for warranty claims

associated with automobiles, white goods (like TV, washing machine,
etc.) consumer electronic appliances and medical equipment.

• The frequency -severity approach is used to determine the expected

aggregate claim cost associated with the inforce
contracts/transactions on the valuation date. The frequency rates and
the severity amounts tend to vary [usually increase] over the warranty
term. The severity amounts are adjusted for inflation if the warranty
term extends beyond one year from the date of valuation.
 Current Actuarial Involvement in Estimating
Technical Provisions

• Practice of discounting is not widely prevalent

• Inputs made available by the client are often in the form of the raw
data like number of claims reported, exposure data In terms of sales
volume, past data on failures over the warranty term; the unit costs
(like raw material, direct labour and direct expenses) of repairing the
products. The actuary needs to convert these inputs into frequency
rates and severity amounts over the warranty term.
 Concluding Thoughts: Where Actuaries Can
Add Value
• Estimating IBNR Reserves for Warranty Claims
• Data Management: Capturing correct data including transactional
level data is important not only to estimate warranty costs, but also to
support quality control reviews and monitor the performance of the
key business partners like the service providers. Homogenising the
data will be an important consideration.
• Generating information on how often products break (frequency) and
how much each breakage costs(severity). For large warranty
programs such as those run by auto manufacturers, such analyses can
help in identifying trends in frequency and severity over the life of the
warranty. For example, the frequency of auto warranty claims
generally increases as the warranty ages and the resulting claim
severity also may increase
 Concluding Thoughts: Where Actuaries Can
Add Value

• Refining the methodologies used for calculating the best estimate

provisions. Where credible past data on warranty claims is available it
may be possible to fit appropriate statistical distributions for claim
cost distributions can be used to estimate the expected aggregate
claim cost and the volatility of such claims costs.

• Addressing sources of volatility in claims costs and their impact on the

provision for claims -the introduction of new products modifications
of existing products, regulatory changes and coverage modifications
are some of the key drivers which increase the variability and
uncertainty of warranty costs.
 References

• Richard l. Vaughan, The Unearned Premium Reserve for Warranty

Insurance, Casualty Actuarial Society E – Forum, Fall 2014 – Volume 1
• Indian Accounting Standard (Ind AS) 37: Provisions Contingent
Liabilities and Contingent Assets
• Education Material on Indian Accounting Standards (Ind AS) 37, The
Institute of Chartered Accountants of India
• Indian Accounting Standard (Ind AS) 115 :Revenue from Contracts
with Customers
Thank you