White Paper - Corporate Reserving for Loss & LAE

CORPORATE RESERVING FOR LOSS AND LAE

This paper describes actuarially-set corporate reserving for loss and loss adjustment expense (Loss and LAE) arising from an insurer issuing casualty insurance policies (e.g. general liability, Workers Compensation, etc.). These are the current Loss and LAE reserves for all claims for all years as stated in the Annual Statement or “Yellow Book” developed by the NAIC and adopted by each state. They are more than the case-based estimates or “case reserves” set for individual claims.

Loss includes the indemnity and medical benefits payable as determined by the facts of each claim and the applicable state’s law or statutory benefits scheme. LAE includes the expenses directly related to the Loss, e.g. defense counsel fees, medical exams, etc. and includes both Allocated LAE (outside attorneys, investigators, etc. allocable to specific claims) and Unallocated LAE (employed staff and general claims expenses) described further below.

Corporate reserving is an actuarial and financial calculation applicable to all claims from all years which is performed by the Actuarial Department and Financial Department using information from the Claim Department and other sources. It includes new reserves from the most recent year as well as adjustments made in that year to prior years of corporate reserves.

Corporate reserving starts with the case-based estimates or “case reserves” established by the Claim Department for individual claims – but are much more. This paper describes how an insurer establishes corporate reserves for its entire portfolio of claims. It does not describe in detail how the Claim Department adjusts, manages and estimates the cost of individual claims until they are closed.

Accident Year corporate reserves apply to claims occurring within a specific January to December period. The figures for that one year routinely change each year until all claims are closed. Calendar Year corporate reserves include the current Accident Year and include the net changes occurring in that year to estimates from all prior Accident Years. Once set, Calendar Year reserves do not change for that specific year-end, unless restated for an accounting reason.

Corporate reserving for each Accident Year is a continuous process of re-estimation until every claim from that year is closed. There is no single “right” corporate reserve at any point in time. Corporate reserves are a series of estimates and re-estimates, each being the “best estimate” at the time based on current knowledge. Next year’s estimate will be different but will also be a best estimate. It can change markedly because facts and circumstances change and because payments for Loss and LAE have occurred, which moves amounts from being a “reserve for future payments” to being a “paid amount”, which is no longer part of a corporate reserve.

The Combined Ratio of an insurer consists of: the amount of Losses and LAE for the year divided by earned premiums (the “Loss Ratio”); plus the amount of all other expenses from underwriting and general operations divided by written premiums (the “Expense Ratio”). This latter category of general expense includes those not directly associated with specific losses (which would be LAE) such as the cost of the Underwriting Department and general operational expenses.

A Calendar Year combined ratio under 100% indicates an underwriting profit (i.e. the premium exceeded the associated loss and expense). A combined ratio over 100% indicates there was no underwriting profit, but the insurer may have nonetheless made a profit on an “operating ratio” basis, wherein the investment income is also included along with premium income.

Corporate reserving for Loss and LAE starts with the Claim Department adjusting and paying individual claims and establishing a case-based estimate for each claim, which is the adjuster’s best estimate of the ultimate cost of each claim. Actuarially-set corporate reserving is in part based upon the aggregate of adjusters’ case-based estimates for all open claims and much more

Claim executives open and manage claim files as losses are reported. Initial determinations and estimates of the total future payments for indemnity, medical and LAE are made. Adjusters determine whether there is coverage for the loss under the policy, intending to only reserve for and pay forf covered claims. The claim file is continuously managed until closed so as to: (1) develop facts, judgments and estimates on the Loss and LAE and the insurer’s liability under the policy to pay them; and (2) record payments made, which directly reduce the case-based estimate and may eventually reduce the actuarially-set corporate reserve.

Actuarially-set corporate reserves are a continuously revisited estimation across the Loss and LAE for the entire portfolio of claims. It uses actuarial technique and judgment and analysis of patterns and trends so as to estimate: (a) how the totality of case-based estimates of individual claims will develop over time; (b) what approximate dollar amount of claims likely have happened but have not yet been reported; and (c) how will the previous, actuarially-set estimates of Loss and LAE from both reported and unreported claims develop over time (favorably or adversely). Which estimate becomes the current actuarially-set best estimate of the ultimate cost the insurer will pay for incurred Loss and LAE.

The corporate reserving process involves periodically recording and re-estimating Accident Year Loss and LAE data. The Loss and LAE for a particular claim forever belong to that single Accident Year even as the estimates continuously change during the year or from year to year. Some losses, such as a broken bone, have an obvious, single date of occurrence and Accident Year. Others might be attributed to a number of years and policies, such as a loss from ingesting asbestos particles over many years that may be attributed to a single date when the injury manifests, or to a period of exposure to the cause of the loss, or to a blend of those two loss triggers (i.e. a so-called “triple trigger” occurrence).

The corporate reserving process also involves Calendar Year Loss and LAE data, which is the sum of that year’s Accident Year data and the net of changes to prior Accident Years that occurred during that calendar year. Once established, a Calendar Year result as of a year-end never changes (unless a restatement is required for legal or accounting reasons).

Accident Year Loss and LAE “Triangles” are financial statement exhibits which display up to ten years of re-estimates of Loss and LAE for each Accident Year as of the estimation date. They visually illustrate changes to the estimates for that Accident Year over time and whether a company has a pattern of being over-reserved or under-reserved by Accident Year.

Corporate reserves are ever-changing re-estimates regarding reported and unreported losses. They continue to change because reserves are subject to the outcome of events that have not yet occurred. The loss event happened and the claim may have been brought, but the damages arising from the loss and whether there is liability for those damages can continue to change over time. There are also continuous changes at the insurer and in the business and legal environment in which it operates that can affect reserves.

An insurer is obligated to at least annually: (1) calculate its best estimate of its ultimate incurred Loss and LAE; (2) subtract amounts actually paid in that current year from the Claim Department’s case-based estimates; (3) add in IBNR (for both unreported loss and for changes in estimates regarding reported loss); and (4) produce a revised best estimate of unpaid ultimate liabilities as its corporate reserve.

Techniques for establishing corporate reserves include: (1) using the Claim Department’s latest calculations of individual case-based estimates; and (2) using a combination of the Actuaries’ calculations such as: (a) initial figures from formulaic reserves (ie. the insurer’s protocols for initially setting then revisiting and re-estimating Loss and LAE periodically or situationally); (b) re-estimations using reliable actuarial techniques; and (c) ongoing actuarial judgment and analysis of internal and external data and trends.

The actuaries regularly review: (1) actual loss payments in the aggregate, (2) timing of the emergence of previously unreported losses, (3) frequency and severity of the emerging losses, and (4) incurred loss and paid loss development patterns. “Incurred losses” include the total amount of paid claims and case-based estimates, but do not include IBNR losses described below.

Insurers experience a lag between the time when a loss occurs and when it is reported to the Claims Department. That phenomenon requires estimation of “Incurred But Not Reported” (IBNR) Loss and LAE by the actuaries. A property insurer may have a short time lag, whereas an automobile or general liability insurer can have significant lag time. The insurer’s mix of business largely determines the timing of loss reports. The term “IBNR” involves the actuaries giving their best estimate of the development of loss and expense on both reported and unreported claims – even though the term connotes it might only apply to unreported claims.

Corporate reserves are never “exactly right”. There is no single correct figure as you can surmise from a continuous re-estimation process and the effects of normally-occurring claim payments that reduce both the case-based estimates and the corporate reserves by the approximate amount of the paid claims.

When a case-based estimate is established for a newly reported loss – for example, if the estimate of the ultimate incurred loss is 100, nothing might have been paid yet. The case-based estimate is therefore 100. Once 20 is paid on that case and if the adjuster’s best estimate of the case’s ultimate incurred loss is unchanged at 100, the math becomes 100 of case ultimate incurred less 20 of paid Loss and LAE equals 80 of case-based estimate for Loss and LAE for that claim.

At least annually the insurer will re-estimate its corporate reserve liabilities, which amounts change due to payments and other factors such as changes in the schedule of Workers’ Compensation indemnity payment, increased medical costs, claimants are not recovering as anticipated, etc. – that impact both the adjusters’ case-based estimates and the actuarially-set corporate reserves.

A case starting with a case-based estimate with an ultimate incurred of 100 with 20 of paid Loss and LAE and a resulting case-based estimate of 80, over time might produce a re-estimate of an ultimate case-based estimate incurred of 135. If by then 40 was paid, the math is: a new ultimate case-based estimate incurred of 135, a paid amount of 40, and a resulting case-based estimate of 95 (up from the initial estimate of 80 = “adverse development”). This adjuster-set process of subtracting paid amounts and re-estimating case-based estimate amounts continues for each claim until that claim is closed. The actuarially-set corporate reserving process also continues across the entire portfolio of case losses in the aggregate until all claims are closed.

Allocated Loss Adjustment Expense (ALAE) reserves are the best estimate of the future LAE to adjust individual claims, which expenses can be allocated or attributed specifically to a claim (e.g. attorneys’ fees, doctor’s exams, etc.). When referring to “case-based estimates of Loss and LAE” and to “corporate reserves for Loss and LAE”, we’re referring to ALAE.

Unallocated Loss Adjustment Expense (ULAE) reserves are the best estimate of the future not-claim-specific expenses of adjusting all the insurer’s claims, such as the general expense of salaries or the rent paid by the Claim Department. (For example, outside attorneys’ fees for a claim are ALAE; Claim Department salaries are ULAE.)

Together ALAE and ULAE have become known as Defense and Cost Containment and Adjusting and Other in the Yellow Book filed with regulators. There is no direct conversion of what was formerly ALAE and ULAE into DCC/AO, since some re-categorization took place. This comment is merely to note that the old terminology has largely been replaced by the new terminology used in the Yellow Book example below.

Reviewing some key terminology:

Accident Year (AY) Loss and LAE are the total of the corporate reserve assigned to the losses from a specific year. A loss occurring in 2008, and all future re-estimates of that loss by the adjuster and the corporate reserving process, will forever be in the AY 2008 loss data. These Accident Year re-estimates will change routinely. The insurer’s Yellow Book presents Accident Year corporate reserve figures individually by year for the past ten years and lump together in a single row the aggregation of changes arising from all Accident Years prior to ten years ago (where individual year analysis would become less meaningful or just unwieldy).

Calendar Year (CY) Loss and LAE are the total of the corporate reserve estimates for the current Accident Year plus net changes taking place during that year to the estimates from all prior Accident Years. Once a Calendar Year result is reported, it never changes and remains a permanent statement of financial condition as of that particular year-end. Whereas Accident Year Loss and LAE continuously change.

Reserve Development means that the estimated ultimate amount of Loss and LAE for an Accident Year has changed from the earlier estimates. Such Development (“favorable” if lower and “adverse” if higher) can occur because:

- Claims were closed for more or less than the established case-based estimates

- Case-based estimates for open claims changed up or down

- Actuarially-set corporate reserves for reported claims changed up or down

- Unreported claims emerged for amounts greater or lesser than estimated

- Actuarially-set estimates of emergence patterns on unreported claims changed

- Changes in earned premium happened, which can affect IBNR reserve estimates

Accident Year Loss Triangles are a graphic display of the insurer’s total cost of Loss and LAE at the end of each Accident Year. Individual Accident Years are provided for 10 years and all prior Accident Years since the company started are consolidated into one additional row.

Outside Actuarial Analysis is used by most Insurers. These external advisors estimate a range of adequate reserves for an insurer by line of business. Often, one consulting actuarial resource is retained just for reserve analysis (perhaps every few years) and a second analysis is provided annually by the Independent Auditor’s actuarial staff in the course of their audit of the insurer’s financial statement. These consulting actuaries provide a range of reasonable reserving, which is based on the insurer’s data and some of the actuary’s own or industry data. Their range is compared to the insurer’s range, as well as the point-estimate reserve (ie. the insurer’s single “best estimate” number), at which its corporate reserves were set. Consulting actuaries and auditors provide ranges of reasonableness. The insurer sets its own ranges of reasonableness then independently picks its own point-estimate reserve number. The insurer’s point-estimate is compared to the outside actuaries’ ranges and conclusions can be drawn.

An insurer presents its corporate reserves in its Yellow Book net of the effect of ceded reinsurance (ie. a loss of 100 with 20 of reinsurance recoverable is recorded as a net liability of 80). Publicly held insurers typically have to separately present triangles on a gross and a net-of-reinsurance basis, as a consequence of SEC disclosure rules.

Summary Comments:

An insurer establishes corporate reserves for Loss and LAE for each January-December Accident Year in which those claims occurred. The Calendar Year financial results in the Yellow Book consist of the current Accident Year, the net new changes to prior Accident Years, plus other income and loss from that year’s operations.

Accident Year Loss Triangles illustrate annual changes in corporate reserves over a ten-year period. They demonstrate whether, in retrospect, an insurer was over-reserved or under-reserved for all Accident Years since the company began business.

Case-based estimates are established from the greater knowledge and experience of the adjuster with each claim. The date of loss determines the permanently-assigned Accident Year of that loss. Those individual case-based estimates of claims along with actuarial techniques result in actuarially-set corporate reserves in the aggregate for the Loss and LAE for the entire portfolio of claims. These actuarially-set corporate reserves are a formulaic, analytical and judgmental approach to estimating the totality of Loss and LAE and is performed by the Actuarial and Financial Departments. The ultimate point-estimate reserve is set by management.

IBNR Reserves are actuarially-set estimates that address both: (1) Loss and LAE that typically emerge from claims not yet reported; and (2) re-estimates of Loss and LAE on reported claims, which show favorable or unfavorable development as regards previous estimates. This process of re-estimation for both unreported and reported losses is termed “IBNR”, even though the term connotes it only applies to unreported claims.

Payments made on claims are subtracted from the case-based estimate of the ultimate incurred loss and expense, since case-based estimates are exclusively for unpaid amounts. Incurred loss includes both paid claims and case-based estimates but do not include IBNR.

Some insurers (with long tail liability business, e.g. general liability or professional liability) might also use bulk estimates of incurred Loss and LAE and add that estimated amount (a “fudge factor”) to the corporate IBNR reserves they have established from case-based estimates and actuarially-set corporate reserves as described above.

Accident Year Loss Triangles show the annually re-estimated Loss and LAE changes in the carried corporate reserves for each of the last ten Accident Years as well as the aggregate amount for all prior years. They show the initial, total corporate reserves by Accident Year and how a specific Accident Year’s corporate reserve has been re-estimated to show development up (“adverse”) or down (“favorable”).

These triangles are informative as to the conservatism (or lack thereof) of an insurer’s reserving practices – as well as the effect of any significant changes in claim handling philosophy, external changes in the costs of resolving claims and any emerging legal theories of loss or reserving. Some observers refer to any one year’s corporate reserving as a “self-graded exam” because of the judgment involved. The results over time provide a better picture of reserving expertise and philosophy.

Insurers are obligated to periodically record their best estimate of Loss and LAE. The actual ultimate cost of the loss and associated expense on open cases is simply unknowable. It is a continuous process of re-estimation with no single “right” answer.

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