Setting Loss Reserves in Insurance: Principles and Factors, Lecture notes of Accounting

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1990 C A S U A L T Y LOSS R E S E R V E S E M I N A R

IA: C O N S I D E R A T I O N S IN S E T T I N G L O S S R E S E R V E S

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

1986. The reserve e s t i m a t e can change at s u b s e q u e n t v a l u a t i o n points. E s s e n t i a l l y , the e s t i m a t e of r e s e r v e s is r e v i s e d as a d d i t i o n a l i n f o r m a t i o n is obtained.

(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!

estimates, and doesn't come up with a case reserve estimate until

four to five weeks later.

Three months have transpired and now we are into August. The

claims adjuster has obtained additional information about the

injury and the accident, and revises the case reserve amount.

Six months later, a settlement is reached; a payment is made four

days later. It is not until the claim draft clears that the

claim is closed and the case reserve is taken down. So, there is

quite some time that can transpire between the settlement

agreement and when the claim is finally closed.

Different companies may use different procedures as to when to

close a claim. Some companies may not close it until the claim

draft clears. Other companies may not close it until the release

is signed by the claimant.

Even after the claim closes, there is a slight p o s s i b i l i t y that

the claim may reopen. So, the company has to have included some

amount for the slight possibility that the claim may reopen, and

that amount is usually encompassed in a bulk reserve amount.

(Exhibit 7)

In addition to loss reserves, a company must have a p r o v i s i o n for

loss adjustment expenses, the expenses that are incurred in

adjusting a claim. There are primarily two distinctions in loss

adjustment expense.

The first category is allocated loss adjustment expense, those

are costs that can be assigned to a specific claim. A major

expense is attorney fees, the costs that are incurred in securing

legal representation for defending the insured against claims in

suit. This, by far and away, is the largest component of

allocated loss expense and, furthermore, of loss a d j u s t m e n t

expense, in general.

A l l o c a t e d expense also includes the court costs a s s o c i a t e d with

defending the claim in suit, and for some companies, the use

independent adjusters. When the independent adjuster fees can be

identified on a specific claim-by-claim basis, companies may

choose to include these costs as allocated loss expense. Or the

company may choose to include it as unallocated loss expense

because the function performed is very similar to their own in-

house adjusters.

The other type of loss adjustment expense is u n a l l o c a t e d loss

adjustment expense or costs which cannot be assigned to a

specific claim, generally the cost that is a s s o c i a t e d with

running the claims department. It would include salaries and

benefits, over head costs, the cost of rent, the space the claim

adjusters occupy, cars, supplies.

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.

You can increase the consistency through using credible,

homogeneous data. It's one of the tougher things, to see how to

divide the data depending on the size of the company. Large

companies can break their claim data down into a lot finer detail

than a small company that just writes homeowners and auto. If it

can't be broken into, say, uninsured motorist, medical payments

and so forth, you may need to do various groupings with those

sized companies.

(Exhibit 16)

Emergence in settlement patterns. Emergence is basically the

delay between the occurrence of a claim and when it's recorded on

the company books. A good analogy to the difference in emergence

patterns might be between automobile bodily injury and

homeowners.

If you have a claimant who gets hurt, say, he hurts his back and

he has a claim. He doesn't know that he's hurt his back for a

year or two. The date between the occurrence and when it's

recorded can be two years, if you just started feeling bad after

two years.

Whereas, a homeowner's claim, if a guy's house catches on fire,

he pretty much knows that his house has caught on fire, so the

reported date for that would be much faster.

The average BI claim may not be reported for a year and a half,

and your homeowner's claim is reported shortly after it

happens. This helps to gain an appreciation of why we don't

group auto BI and property claims together. We would get a

masking effect of what our losses look like and how they'll

develop.

Settlement is the delay between the reporting of the claim and

when it's settled. Let's use that BI and homeowner's claim

again. With BI, even though it's reported, the insured may be

incurring hospital expenses, medical expenses and so forth, so

they may not be willing to settle until he is sure of what the

claim is going to cost.

With homeowners, they notify you of the damage and replacement

cost. They can monitor that very quickly. Settlement on the

homeowners would come fairly quickly. There is still a time lag

between what they estimate, perhaps, and what the final

settlement is. It's a lot shorter for property than it is for

liability lines.

(Exhibit 17)

Here's a chart of actual emergence and settlement patterns.

C o l l i s i o n would fall into what we refer to as the short tail

line, where the "A" stands for the accident date; the "E" is when

the loss is reported or recorded; and, "S" is the settlement.

Another component is structured settlements. Structured

settlements are to account or to recognize the time value of

money in the claims. That is, if you have a claim that is going

to make dollars of benefit payments for a long time, they may

discount those to account for the time value of money. You need

to know if the data you are looking at already has a discount

factor built into it.

Contract changes, also affects the reserve estimation process.

You need to know what the contract for the reinsurance might

be. You also have a variety within the policyholder contracts.

For example the company may now be selling larger d e d u c t i b l e

sizes.

There might be a shift in policy limits. Perhaps, the historical

policy limits were $50,000 and now they've shifted up to $i00,

or maybe $250,000. The losses basically had a built-in capping

effect because the company usually wouldn't pay more than the

policy limits. Now, those historical dollars are not at the same

level as today's claims because you've taken out the limitation

from the contract.

Perhaps, they've changed exclusions in the contract. Pollution

liability usually comes to mind when thinking of an exclusion.

You can try to exclude it. Whether the courts allow you to

exclude it or not is maybe another issue, but you need to know if

there are new exclusions in the contract for certain types of

claims. Perhaps the contract covers less than they were

historically.

There's also a variety of endorsements that go along with all of

the different coverages. Perhaps now they write new

endorsements. Basically, you need to find out what is it that's

going into the loss data you're looking at and try to adjust for

changes.

There's also organizational changes within the company that may

affect the data. One type of an organizational change may be a

new manager in the claim department. These people are the ones

that are setting up the data that you're going to analyze, so you

need to understand how their philosophy differs from that of the

people who previously set the reserves.

They may include more people in the claims department. If files

were sitting open on the claims department desk and you add more

people, you'll see an influx of claims. You'll think, "Oh,

things are just surely getting worse because look at the number

of claims compared to what we used to have." The difference is,

they're just getting them put into your statistical base

faster. They're moving them from the desk into the record files.

We also need to consider the mix of business. In mix of

business, I tend to think of the coverages you're writing. If

you're a large insured and have a lot of data, you can look at BI

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?