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An insight into the process of setting loss reserves in insurance companies. The Vice President of Fireman's Fund Insurance Companies explains the basic principles, the role of uncertainty, and the importance of loss reserves in matching revenue and costs. The document also covers the concept of calendar period losses and the accounting view of underwriting income.
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F a c u l t y
A l a n M. C r o w e W i l l i a m M. Mercer, Inc.
D a r l e n e P. T o m F i r e m a n ' s Fund I n s u r a n c e C o m p a n i e s
MS. TOM: This morning, we have two speakers. I am D a r l e n e Tom. I am a Vice P r e s i d e n t with F i r e m a n ' s Fund I n s u r a n c e C o m p a n i e s , and my major r e s p o n s i b i l i t y is setting loss r e s e r v e s for my company. I have been a s s o c i a t e d with the i n s u r a n c e i n d u s t r y for 15 years.
My c o s p e a k e r is Alan Crowe and he is with W i l l i a m M. Mercer. He is an a s s o c i a t e c o n s u l t a n t and he has been with the i n s u r a n c e i n d u s t r y for six years. The p u r p o s e of this s e s s i o n is to r e v i e w some b a s i c d e f i n i t i o n s and c o n c e p t s that are o f t e n e n c o u n t e r e d in loss r e s e r v i n g practices. First, we'll d e f i n e what a loss r e s e r v e is, touch upon some key important a c c o u n t i n g aspects, and d i s c u s s some key dates that are used when e v a l u a t i n g loss reserves.
W e ' l l a l s o get into some of the major e l e m e n t s of a loss r e s e r v e p r o v i s i o n i n c l u d i n g loss a d j u s t m e n t expense. Next, we'll cover the b a s i c p r i n c i p l e s that are used in e v a l u a t i n g loss reserves; what is an a c t u a r i a l l y sound reserve, and the p r i n c i p l e of u n c e r t a i n t y.
Lastly, we'll c o n c l u d e with a d i s c u s s i o n of some m a j o r c o n s i d e r a t i o n s that are made when setting loss reserves: the data e l e m e n t s o r g a n i z a t i o n ; and, the a p p l i c a t i o n of judgment.
(Exhibit i)
Let us start by d e f i n i n g Loss Reserves. It is the a m o u n t a c o m p a n y sets aside to settle o u t s t a n d i n g claims. W h e n a c o m p a n y c l o s e s out an a c c o u n t i n g p e r i o d (a year, quarter, or month), the c o m p a n y must have a p r o v i s i o n called loss r e s e r v e s w h i c h r e p r e s e n t s all future p a y m e n t s to be made on claims that have o c c u r r e d up to that pint, r e g a r d l e s s of w h e t h e r or not the c o m p a n y has been n o t i f i e d of the loss.
A key c h a r a c t e r i s t i c of a loss reserve is that it is an e s t i m a t e d l i a b i l i t y. The p r e c i s e amount is not known until the c l a i m s are f i n a l l y settled. C o n s e q u e n t l y there is always a c e r t a i n level of u n c e r t a i n t y in the e s t i m a t i o n of loss reserves.
T h e r e are several reasons why loss reserves are important. T h e y r e p r e s e n t the largest financial o b l i g a t i o n of an i n s u r a n c e company. R e s e r v e s are a major c o m p o n e n t in e v a l u a t i n g the f i n a n c i a l c o n d i t i o n of a company - whether or not the c o m p a n y will be a r o u n d to honor its f i n a n c i a l o b l i g a t i o n to the c l a i m a n t s. C o n s e q u e n t l y , the a c c u r a c y of the f i n a n c i a l c o n d i t i o n of an insurer is d e p e n d e n t upon the a c c u r a c y of the loss r e s e r v e e s t i m a t e s.
R e s e r v e s are also important in the v a l u a t i o n of u n d e r w r i t i n g income - w h e t h e r or not a company has made or lost m o n e y d u r i n g the year.
(Exhibit 3)
T h e r e are some i m p o r t a n t dates to keep in mind in e v a l u a t i n g loss reserves. The first is the a c c o u n t i n g date. The a c c o u n t i n g date d e f i n e s the g r o u p of claims for which l i a b i l i t y exists, that is, all c l a i m s i n c u r r e d up to that point in time. The c l a i m s are the f i n a n c i a l o b l i g a t i o n for the i n s u r a n c e company.
The other i m p o r t a n t date is called the v a l u a t i o n date, w h i c h d e f i n e s the time p e r i o d for which i n f o r m a t i o n is i n c l u d e d in e s t i m a t i n g the reserve. This i n f o r m a t i o n t y p i c a l l y i n c l u d e s all the a c t u a l loss t r a n s a c t i o n s that were r e p o r t e d to that c o m p a n y as of the g i v e n v a l u a t i o n date.
An initial e s t i m a t e of the reserves for a g i v e n a c c o u n t i n g date can c h a n g e at s u b s e q u e n t v a l u a t i o n dates, as more and m o r e of the i n f o r m a t i o n is r e p o r t e d to the company. So, for example, an e v a l u a t i o n of y e a r - e n d 1986 reserves v a l u a t e d as of June 1990 w o u l d be an e s t i m a t e of the reserve r e q u i r e d for c l a i m s that o c c u r r e d on or prior to 1986, based on all the r e p o r t e d loss t r a n s a c t i o n s up through June of 1990.
That e s t i m a t e w o u l d p r o b a b l y differ from the initial e s t i m a t e w h i c h was b a s e d on c l a i m t r a n s a c t i o n s r e p o r t e d t h r o u g h y e a r - e n d
(Exhibit 4)
Now I'd like to cover the d i f f e r e n c e b e t w e e n a c a r r i e d loss r e s e r v e and an i n d i c a t e d loss reserve. The c a r r i e d loss r e s e r v e is the a m o u n t of loss reserves shown in a c o m p a n y ' s p u b l i s h e d f i n a n c i a l statement, such as the balance sheet. An i n d i c a t e d loss r e s e r v e is the e s t i m a t e d amount of what the reserve s h o u l d be and is g e n e r a l l y the result of a p a r t i c u l a r loss reserve e v a l u a t i o n p r o c e d u r e.
The i n d i c a t e d loss reserve s u b s e q u e n t v a l u a t i o n points.
amount, again, can c h a n g e at
The a d e q u a c y of the c a r r i e d reserve is the d i f f e r e n c e b e t w e e n the c a r r i e d loss reserve and the i n d i c a t e d loss reserve. W h e n the c a r r i e d loss reserve is s u b s t a n t i a l l y greater than or equal to the i n d i c a t e d loss reserve, the c a r r i e d r e s e r v e s are c o n s i d e r e d a d e q u a t e and the d i f f e r e n c e b e t w e e n the c a r r i e d and i n d i c a t e d r e s e r v e is c a l l e d the reserve margin.
W h e n c a r r i e d reserve are less than the i n d i c a t e d reserve, the c a r r i e d loss r e s e r v e s are said to be deficient, w i t h the a m o u n t of the d e f i c i e n c y equal to the d i f f e r e n c e b e t w e e n the c a r r i e d and the i n d i c a t e d reserve amount. Usually, that number is e x p r e s s e d as a n e g a t i v e number.
We o f t e n hear the term reserve s t r e n g t h e n i n g or r e s e r v e w e a k e n i n g. There is often some c o n f u s i o n about what these terms mean. Some w o u l d d e f i n e s t r e n g t h e n i n g or w e a k e n i n g as s i m p l e the c h a n g e in the c a r r i e d reserve from one a c c o u n t i n g p e r i o d to the other. If reserves have increased, then they m u s t be 'stronger'. This is not n e c e s s a r i l y true.
R e s e r v e s t r e n g t h e n i n g and reserve w e a k e n i n g refers to the c h a n g e in the reserve m a r g i n from one a c c o u n t i n g p e r i o d to the next. So if the d i f f e r e n c e b e t w e e n the c a r r i e d versus i n d i c a t e d r e s e r v e is m i n u s $25 m i l l i o n at the close of one a c c o u n t i n g period, a d e f i c i t of $25 million, and that d i f f e r e n c e n a r r o w s to zero, or no m a r g i n or deficit, then the amount of reserve s t r e n g t h e n i n g is equal to $25 million. Your reserve m a r g i n has i n c r e a s e d f r o m a d e f i c i t p o s i t i o n of $25 m i l l i o n to reserve adequacy.
If there is no change in the m a r g i n or d e f i c i t f r o m one a c c o u n t i n g p e r i o d to the next, then there is no r e s e r v e s t r e n g t h e n i n g or weakening. The change in your c a r r i e d r e s e r v e is s i m p l y the initial carried reserve amount, m i n u s the p a y m e n t s that w e r e made during the year on prior years' claims, plus a new r e s e r v e a m o u n t for new claims incurred in the c u r r e n t year.
So, if there is no c h a n g e in the reserve margin, the c h a n g e in the c a r r i e d reserve is simply the natural p r o g r e s s i o n of r e s e r v e s over time. You take your old reserves, make p a y m e n t s f r o m those old reserves, then add in new reserves for the new c l a i m s that w e r e incurred.
If you have reserve s t r e n g t h e n i n g , the gap b e t w e e n your c a r r i e d r e s e r v e and your i n d i c a t e d reserve i n c r e a s e s over time, so e i t h e r your d e f i c i t is s h r i n k i n g or your m a r g i n is i n c r e a s i n g. If you have reserve weakening, this gap gets smaller. Either your m a r g i n is d e c r e a s i n g from one a c c o u n t i n g p e r i o d to the next or your d e f i c i t is increasing.
W i t h r e s e r v e s weakening, calendar year results are better than your a c c i d e n t year results. The change in reserve is less than the c h a n g e that w o u l d be required to support new l i a b i l i t i e s.
(Exhibit 5)
E x a m i n e the e l e m e n t s of a loss reserve p r o v i s i o n. H e r e is a list of the major elements. Typically, a c o m p a n y will v a l u e r e s e r v e s b a s e d on some s u b g r o u p i n g of this list.
The first c o m p o n e n t is case reserves, and those are the e s t i m a t e s m a d e by the claims a d j u s t e r s for future p a y m e n t s on c l a i m s that h a v e been r e p o r t e d to the company.
The next c a t e g o r y is formula reserves. F o r m u l a r e s e r v e s are an a m o u n t that is set aside for a s p e c i f i c g r o u p of claims. O f t e n t i m e s , they are d e r i v e d by using an a v e r a g e v a l u e a p p l i e d to all the c l a i m s with similar risk c h a r a c t e r i s t i c s. For example, a
l!
It w o u l d also include a p r o v i s i o n for c o m p a n y o v e r h e a d or their share of the c o r p o r a t e expense. For example, there are m a n y s u p p o r t s e r v i c e s w i t h i n a company that are not d i r e c t l y a s s i g n a b l e to either OA&G or loss a d j u s t i n g functions, so the c o m p a n y may c h o o s e somewhat a r b i t r a r i l y to a s s i g n part of their o v e r h e a d to the claims a d j u s t i n g function. Lastly, it may i n c l u d e i n d e p e n d e n t adjuster fees.
The s e t t i n g of reserves for loss a d j u s t m e n t e x p e n s e has p r o v e n to be q u i t e a p r o b l e m for the industry and there are a number of r e a s o n s for this. One is that many c o m p a n i e s do not c a p t u r e case r e s e r v e s on a l l o c a t e d loss expense, so the only i n f o r m a t i o n that you have got is the a l l o c a t e d loss expense payments. So, there is a lot less i n f o r m a t i o n a v a i l a b l e to set loss e x p e n s e r e s e r v e levels than there is for losses where there exist at least the a d j u s t e r s ' case reserve estimates.
The other p r o b l e m is that the increase in loss e x p e n s e o f t e n o u t p a c e s the i n f l a t i o n a r y increase on losses. M a n y c o m p a n i e s do not include a trend for the loss a d j u s t m e n t e x p e n s e in s e t t i n g their r e s e r v e levels, so loss a d j u s t m e n t e x p e n s e has o f t e n p r o v e n to be d e f i c i e n t for many companies.
(Exhibit 8)
Now, I'd like to talk about some of the p r i n c i p l e s that are u s e d in s e t t i n g loss reserves. The first is a f u n d a m e n t a l o b j e c t i v e of the e n t i r e loss r e s e r v i n g process, a c h i e v i n g an a c t u a r i a l l y sound loss reserve.
An a c t u a r i a l l y sound e s t i m a t e is a p r o v i s i o n for the u n p a i d a m o u n t r e q u i r e d to settle all claims, whether r e p o r t e d or not, for w h i c h a l i a b i l i t y exists on a p a r t i c u l a r a c c o u n t i n g date. G e n e r a l l y , this e s t i m a t e is for a d e f i n e d g r o u p of claims. It c o n s i s t i n g of all claims that were incurred on or prior to the a c c o u n t i n g date. The reserve estimate is m e a s u r e d as of a g i v e n v a l u a t i o n date, that date e n c o m p a s s i n g the r e p o r t e d loss t r a n s a c t i o n s that have been reported to the c o m p a n y.
Most i m p o r t a n t l y , the e s t i m a t e s are d e r i v e d from a r e a s o n a b l e set of a s s u m p t i o n s and a p p r o p r i a t e methods. It's p o s s i b l e that, say, five years ago, a reserve e s t i m a t e was d e v e l o p e d and based on the i n f o r m a t i o n that was a v a i l a b l e at that point. F r o m that i n f o r m a t i o n , r e a s o n a b l e a s s u m p t i o n s were formulated, and a set of m e t h o d s w h i c h a p p e a r e d a p p r o p r i a t e at that time was selected.
U n f o r t u n a t e l y , five years later, the reserve e s t i m a t e is u p d a t e d and the e s t i m a t e is now twenty percent higher. Was the initial e s t i m a t e a c t u a r i a l l y sound? It depends on the c o n d i t i o n s w h i c h c a u s e d the e s t i m a t e to be off. Was there i n f o r m a t i o n that was a v a i l a b l e five years ago which could have led one to a m o r e a p p r o p r i a t e set of a s s u m p t i o n s?
It d e p i c t s two r e s e r v i n g specialists, o b v i o u s l y d i s c u s s i n g their r e s e r v e estimates. They are both w o r k i n g with the same set of facts, but their c o n c l u s i o n s differ here. N o n e t h e l e s s , in b o t h cases, their c o n c l u s i o n s are wrong. With that, Alan.
MR. C R O W E : The p r o b l e m with this slide is that if you ask two a c t u a r i e s what a reserve e s t i m a t e is, you'll get three answers, none of w h i c h is 100% correct.
What I'd like to talk to you today about is u n c e r t a i n t y in the loss reserve and, equally as important, the c o n s i d e r a t i o n that once you have an estimate, what are the p a r a m e t e r s you can check it against. Also what are some ways you can say how c o n f i d e n t you are in your estimate, given the a s s u m p t i o n s y o u ' v e made.
Today, y o u ' r e going to talk about various m e t h o d s of coming up w i t h reserve estimates. I want to stress that these m e t h o d s are v e r y good, but they will p r o b a b l y all give you d i f f e r e n t e s t i m a t e s. You have to know what your u n d e r l y i n g a s s u m p t i o n s are, what impact they will have on your estimates, then kind of t h r o w it all together and pick a number that you can stand b e h i n d and support.
T h e r e is a l w a y s u n c e r t a i n t y in a reserve e s t i m a t e and the reason for that is b e c a u s e you're trying to p r e d i c t a future c o n t i n g e n t event. The loss has occurred, but the c l a i m may not have been r e p o r t e d yet. Since some claims are not r e p o r t e d yet, we are trying to e s t i m a t e what is going to happen in the future.
(Exhibit ii)
The true value of l i a b i l i t y for loss or loss a d j u s t i n g e x p e n s e s is only known when all claims have been settled. Even then, some c l a i m s reopen. There is a lot of v a r i a b i l i t y in what you may pay for one c l a i m versus another, who sets the reserves on it, and so forth.
I'll talk a little later about some internal factors that can a f f e c t your reserve e s t i m a t e as well as some e x t e r n a l e c o n o m i c f a c t o r s that can affect your answers. The e s t i m a t i o n of l i a b i l i t y implies a range of reserves can be a c t u a r i a l l y sound.
The range of e s t i m a t e s may widen based upon the line of b u s i n e s s you are reserving. There are s t a t i s t i c a l m e t h o d s to d e t e r m i n e c o n f i d e n c e intervals, which is b a s i c a l l y a c o n f i d e n c e range a r o u n d that point estimate.
T h e r e are also r e a s o n a b i l i t y checks, which I'll talk m o r e about later. When you get your reserve estimate, what are the ways to check it a g a i n s t last year's and the year before to see what is c a u s i n g c h a n g e s?
As far as the c o n f i d e n c e range; by using s t a t i s t i c a l m e a s u r e s you can o b t a i n c o n f i d e n c e intervals by looking at loss d i s t r i b u t i o n s
and f i n d i n g some p a r a m e t e r s , such as the a v e r a g e c l a i m size, the a v e r a g e number of claims, the l i k e l i h o o d of new claims, and r u n n i n g s i m u l a t i o n models, which g e n e r a t e random claims, b a s e d on your a s s u m p t i o n s. Then you can pick 95 percent, 90 p e r c e n t c o n f i d e n c e levels and so forth.
I think I'd rather spend time on once you get a r e s e r v e e s t i m a t e , what are some p a r a m e t e r s you can check it a g a i n s t and what m i g h t i n f l u e n c e it to change later. G e n e r a l l y , you will use s e v e r a l v a r y i n g m e t h o d s to e s t i m a t e a reserve.
T h e s e m e t h o d s will give you d i f f e r e n t answers, so you need to sort t h r o u g h your a s s u m p t i o n s again and find w h i c h m e t h o d s you think are c a p t u r i n g the right changes in your h i s t o r i c a l data. I'll also speak about those in a moment.
An a p p r o p r i a t e reserve within a range d e p e n d s upon the l i k e l i h o o d of the e s t i m a t e s and the financial r e p o r t i n g c o n t e x t in w h i c h it is used. I think the c o n f i d e n c e that you need to put on your r e s e r v e s may d e p e n d on who it's going to be p r o v i d e d to.
If it's for internal management, they may not w o r r y as m u c h if it's 96 p e r c e n t c o n f i d e n c e or 95 percent c o n f i d e n c e if they want a range for p l a n n i n g purposes. T h e r e ' s also e x t e r n a l v i e w s of r e s e r v e s w h e r e the s h a r e h o l d e r s or the insureds view things a bit d i f f e r e n t l y than the m a n a g e m e n t , a bit d i f f e r e n t l y than the r e g u l a t o r s who may be w o r r i e d about solvency.
You a l s o need to e s t i m a t e l i a b i l i t i e s if there's an a c q u i s i t i o n. You want to make sure you know what the true l i a b i l i t i e s have b e e n for the company, how they are o p e r a t i n g , and so forth. Also, you p r o b a b l y need to e s t i m a t e l i a b i l i t i e s if y o u ' r e p e r f o r m i n g a c o m m u t a t i o n.
If y o u ' r e p u r c h a s i n g someone else's l i a b i l i t i e s , it's s i m i l a r to b u y i n g a car. You want to make sure you're g e t t i n g a g o o d deal, so you need a c o n f i d e n c e range about that, but it m i g h t be a l i t t l e tighter or a little looser than others. T h e r e ' s a l s o l i a b i l i t i e s that need to be a n a l y z e d for reserve c e r t i f i c a t i o n s. W h e n you c e r t i f y reserves, you want to be fairly c o n f i d e n t that the e s t i m a t e s are reasonable.
You a l s o need t o do p r o j e c t l i a b i l i t i e s for p r i c i n g to find out what your past losses have been c o m p a r e d to the p r e m i u m s y o u ' v e c o l l e c t e d , to a r r i v e at a m e a s u r e of rate adequacy.
(Exhibit 12)
A key date I'd like to d i s c u s s is the a c c i d e n t date, the d a t e on w h i c h the loss occurred. The report date is w h e n it's r e p o r t e d to the insurer. The recorded date is when it's r e c o r d e d on the b o o k s of the company.
N o w that we know what kind of data we need, how do we go a b o u t f i n d i n g o r g a n i z i n g data into some useful manner. G e n e r a l l y , you try to get claims that behave alike. I just have to s u b d i v i d e the data that have the same c h a r a c t e r i s t i c s.
(Exhibit 14)
For example, h o m e o w n e r s s e p a r a t e d by c o v e r a g e for h o m e o w n e r ' s p r o p e r t y versus h o m e o w n e r ' s liability. For a u t o m o b i l e , m a y b e a u t o b o d i l y injury versus auto p r o p e r t y d a m a g e v e r s u s c o m p r e h e n s i v e , versus collision.
We try to break out the data that's going to b e h a v e the same t h r o u g h time, b e c a u s e as we'll find in these next few s e s s i o n s , using h i s t o r i c a l data to project what's going to h a p p e n in the future, we want data that's going to behave the same in the f u t u r e that it did in the past.
T h a t ' s all well and good, but I find that it d o e s n ' t a l w a y s h a p p e n that way. There are other things that I'll talk about, the i n t e r n a l and e x t e r n a l c o n s i d e r a t i o n s that a f f e c t the way the past losses have behaved.
(Exhibit 15)
T h e r e is a n o t h e r factor to s u b d i v i d i n g data that we try to use w h i c h is the c r e d i b i l i t y of data. C r e d i b i l i t y is a m e a s u r e m e n t of the p r e d i c t i v e value that is a t t a c h e d to data. C r e d i b i l i t y is how c r e d i b l e is the data you're using, how c o n f i d e n t do you b e l i e v e that the data will behave the same, and so forth.
The g r o u p of claims should be large enough to be s t a t i s t i c a l l y reliable. Again, there are ways of s t a t i s t i c a l l y m e a s u r i n g the c r e d i b i l i t y. I look at it from a more j u d g m e n t a l p e r s p e c t i v e. We try to break the claims down as far as p o s s i b l e into g r o u p s that b e h a v e the same, but if you take a piece of pie and you cut it up into too many pieces, all we get are crumbs.
T h e r e comes a point where you have to m e a s u r e the c r e d i b i l i t y v e r s u s the h o m o g e n e i t y and try to get the two to m e s h t o g e t h e r , so that y o u ' r e w o r k i n g with good data that you think is g o i n g to b e h a v e the same, but it's still c r e d i b l e e n o u g h to use.
T h e r e are c r e d i b i l i t y m e a s u r e s that in the next few s e s s i o n s m a y be d i s c u s s e d. T h e r e ' s a point of p a r t i t i o n i n g , w h e r e to d i v i d e the data into groups too small to p r o v i d e c r e d i b l e d e v e l o p m e n t p a t t e r n s is possible.
D e v e l o p m e n t p a t t e r n s refer to tracking a c l a i m t h r o u g h time. At the end of one year, you may think that the loss is g o i n g to be "X" dollars. A year later, it's "Y" dollars. A year later, it's "Z" dollars. So, we try to make sure that that d e v e l o p m e n t stays c o n s i s t e n t t h r o u g h time.
s e p a r a t e l y from p r o p e r t y damage and so forth. A lot of c o m p a n i e s are not large enough to look at it by coverage, so we m i g h t h a v e to c o m b i n e a few of the l i a b i l i t y lines.
You can tell from the e m e r g e n c e p a t t e r n we had up b e f o r e that, d e p e n d i n g on the line of business, you're going to get a d i f f e r e n t e m e r g e n c e to s e t t l e m e n t rate, the number of claims, how fast they're r e p o r t e d and so forth.
We s h o u l d see if the d i s t r i b u t i o n by c o v e r a g e w i t h i n our d a t a set has shifted.
C a s e reserve adequacy. We talked about p e n d i n g c l a i m d o l l a r s , w h i c h is open case reserves. Case reserve a d e q u a c y d e s c r i b e s the a c c u r a c y of the reserves. When a c l a i m is r e p o r t e d and you think the c l a i m is going to cost $i,000, does it settle for $I,000 or does it settle for 500 or does it settle for 3,000?
As long as case reserve a d e q u a c y is fairly c o n s i s t e n t , y o u ' r e okay, b e c a u s e most of the m e t h o d s will throw in any d e v e l o p m e n t on case reserves as a c o m p o n e n t in IBNR. However, if the case r e s e r v e a d e q u a c y changes, we must adjust our m e t h o d s and a s s u m p t i o n s.
We need to see if the reserves are being set up, one, like they used to be; and, two, are they as a d e q u a t e or i n a d e q u a t e as they used to be? We need to know how the case r e s e r v e s are d e v e l o p i n g.
B u s i n e s s growth. B u s i n e s s growth would also d e p e n d on w h e r e y o u ' r e g r o w i n g at. Claims will vary for several reasons. For example, w h e t h e r you're w r i t i n g in O h i o or w h e t h e r y o u ' r e w r i t i n g in F l o r i d a or M a s s a c h u s e t t s , your claims b e h a v e c e r t a i n w a y s d e p e n d i n g on the way they're o c c u r r i n g at. We need to m o n i t o r w h e r e the g r o w t h in b u s i n e s s is and what types of r e g u l a t i o n s and laws are in effect.
A d d i t i o n a l l y , if y o u ' r e g r o w i n g "away from home", you may h a v e to get m o r e e x t e r n a l claims a d j u s t e r s as you may not have the c a p a c i t y to set up a shop to handle the claims p r o c e s s i n g.
This w o u l d be a case where you'd have to look at your a l l o c a t e d loss a d j u s t m e n t e x p e n s e s in the cost of d e c e n t r a l i z a t i o n.
C l a i m h a n d l i n g p r a c t i c e s might also fall under the o r g a n i z a t i o n a l c h a n g e s in the claims department. D i f f e r e n t c l a i m s d e p a r t m e n t s have d i f f e r e n t p h i l o s o p h i e s. Some claim p h i l o s o p h i e s are such that they say, "We're going to try to p r e d i c t it to the d o l l a r the first day we know about the claims."
O t h e r p h i l o s o p h i e s are, "Well, we're going to set up an a v e r a g e r e s e r v e b a s e d on the type of claim. Then, we'll come back and r e v i s i t it in a m o n t h or two m o n t h s or w h e n e v e r we can get back to it." So, we need to know whether they are trying to set a
T h e r e ' s s e a s o n a l i t y e f f e c t s when you set reserves. For e x a m p l e , some lines of b u s i n e s s seem to incur claims closer to h u r r i c a n e season. C o n s e q u e n t l y , we may need to a c c o u n t for the s e a s o n a l i t y in claims.
The r e s i d u a l m a r k e t also affects the reserve e s t i m a t i o n s. L o s s e s are p o o l e d so we need to u n d e r s t a n d the r e l a t i o n s h i p as it a f f e c t s the r e s i d u a l market.
I n f l a t i o n is a key c o m p o n e n t to p r e d i c t i n g reserves. It will p r o b a b l y cost more to settle a c l a i m t o m o r r o w than it did y e s t e r d a y. We need to u n d e r s t a n d how a c l a i m that o c c u r r e d last year or two years ago or three years ago relates to the same c l a i m o c c u r r i n g today. One thing we do with our data is to a d j u s t the data for i n f l a t i o n if were e s t i m a t i n g what the IBNR or r e s e r v e s w o u l d be from past h i s t o r i c a l data.
Also, e c o n o m i c c o n d i t i o n s will affect your losses and your l i a b i l i t i e s and, c o n s e q u e n t l y , the reserves. For instance, the i n c r e a s e d fuel p r i c e s w o u l d p r o b a b l y cut down on the n u m b e r of m i l e s d r i v e n for v a c a t i o n and so forth, w h i c h m i g h t cut d o w n on the f r e q u e n c y of claims. When the e c o n o m y is not g o i n g good, you s o m e t i m e s have a p e r i o d of i n c r e a s e d c l a i m c o n s c i o u s n e s s. We s h o u l d m o n i t o r the f r e q u e n c y and a v e r a g e c l a i m cost to a c c o u n t for what the e c o n o m i c c o n d i t i o n s of the p e r i o d we are r e s e r v i n g for s h o u l d reflect.
(Exhibit 20)
The last c o m p o n e n t is the a p p l i c a t i o n of p r o f e s s i o n a l j u d g m e n t. W e ' v e t a l k e d about a lot of this, but the loss r e s e r v e is a p o i n t in time e s t i m a t e of a c o m p a n y ' s o u t s t a n d i n g l i a b i l i t y. It's a p o i n t in time e s t i m a t e b e c a u s e when you go back to do it at a later point, you are not e s t i m a t i n g as much of the unknown.
If you look at all a c c i d e n t s that o c c u r r e d in 1986, at the end of 1986, you had just a little bit of e x p e r i e n c e to work with. Now, if you go back and look at those r e s e r v e s today, y o u ' v e got an a d d i t i o n a l four years of d e v e l o p m e n t , so y o u ' r e better a b l e to p r o j e c t those reserves. The more e x p e r i e n c e you have, g e n e r a l l y the better the reserve estimate.
The r e a s o n a b l e n e s s of loss r e s e r v e s should be m e a s u r e d a g a i n s t r e l e v a n t p a r a m e t e r s. I like to think of using these neat m e t h o d s that w e ' l l all learn about in the next day and a half or so, and g e t t i n g a range of reserves from those m e t h o d s. T h e n I have to pick an e s t i m a t e that gives me c o n f i d e n c e to say, "I think this is what your l i a b i l i t y is going to be."
B e f o r e we can do that, we have to see if that e s t i m a t e m a k e s sense. We use the term " p r o f e s s i o n a l j u d g m e n t. " It's judgment. It's an e d u c a t e d judgment, e x p e r i e n c e j u d g m e n t and so forth. What I like to do once I get my answer is to see what kind of i n f e r e n c e s I can draw from it. For instance, we can take the
u l t i m a t e l i a b i l i t i e s and divide it by e a r n e d p r e m i u m and look at loss ratios. If you start to see loss ratios that c h a n g e t h r o u g h time, then you need to be able to a c c o u n t for that. This is one w a y of s e e i n g if your loss reserves c a u s e d s o m e t h i n g to change, or if the p r e m i u m s cased the ratios to change.
We have a loss ratio p a r a m e t e r you can look at to see if the loss r e s e r v e s are telling you what other i n d i c a t i o n s are t e l l i n g you. I like to know what sort or rate i n d i c a t i o n s they need, and see if the loss reserves are similar to what the rate i n d i c a t i o n s w o u l d imply. If they are similar, I feel better about my r e s e r v e e s t i m a t e s telling me what the rates are also telling me.
I a l s o like to m e a s u r e the loss reserve results on a pure p r e m i u m basis. Pure p r e m i u m is the a v e r a g e loss per exposure, w h e t h e r it's a p o l i c y or car or sales. We can see if the r e s u l t i n g p u r e p r e m i u m is e x p l a i n a b l e.
W e ' l l talk the next few sessions more about other methods, but it g i v e s you a good feeling if you can e x p l a i n why the a v e r a g e loss is going up and so forth, instead of running t h r o u g h a m e t h o d and saying, "Well, here's the answer". You need to e x p l a i n your a s s u m p t i o n s to e v e r y o n e involved to make sure the r e s e r v e s m a k e sense.
I a l s o like to look at s e v e r i t y of claims, w h i c h is the a v e r a g e c l a i m size. If e v e r y t h i n g stayed the same and i n f l a t i o n was g o i n g up, you s h o u l d see your a v e r a g e c l a i m p a y m e n t go up.
But, even in c h e c k i n g your s e v e r i t y and pure p r e m i u m and so forth, you have to go back and adjust things for r e i n s u r a n c e l i m i t a t i o n s , p o l i c y limitations, etc., b e c a u s e these will d r i v e your a v e r a g e c l a i m size or your a v e r a g e loss per e x p o s u r e. I a l s o like to look at frequency, w h i c h is the e x p e c t e d number of c l a i m s per exposure. This d i f f e r e n t i a t i o n helps to see if it's the a v e r a g e value of the claims coming in higher, or if we have m o r e c l a i m s coming in.
If I see that the f r e q u e n c y is way up, I talk to the c l a i m s d e p a r t m e n t and ask, "Do we have more claims coming in?" Is it truly m o r e c l a i m s or did we change s o m e t h i n g in our c l a i m s p r o c e s s i n g w h i c h w o u l d cause this."
So, we get our estimate, then we work b a c k w a r d s to see if it m a k e s sense w i t h all the p a r a m e t e r s and a s s u m p t i o n s w e ' v e used. We can a l s o e s t i m a t e the a v e r a g e s e v e r i t y and the a v e r a g e f r e q u e n c y and if we think if follows some m a t h e m a t i c a l curve, we run s i m u l a t i o n s on it. This is a common a p p r o a c h to c a l c u l a t e our c o n f i d e n c e intervals. We can ten say we are 95% c o n f i d e n t that the e s t i m a t e will fall in this range or 75% w i t h i n a n o t h e r range.
I'd like to open the floor up for d i s c u s s i o n s now if a n y o n e has any q u e s t i o n s for me or Darlene. How many p e o p l e here are from an a c c o u n t i n g b a c k g r o u n d?