Reserving process followed by insurance companies

Loss reserving refers to the calculation of the required reserves for a tranche of general insurance business. It includes outstanding claims reserves.

Typically, the claims reserves represent the money which should be held by the insurer so as to be able to meet all future claims arising from policies currently in force and policies written in the past.

Methods of calculating reserves in general insurance are different from those used in life insurance, pensions and health insurance since general insurance contracts are typically of a much shorter duration. Most general insurance contracts are written for a period of one year, and typically there is only one payment of premium at the start of the contract in exchange for coverage over the year. Reserves are calculated differently from contracts of a longer duration with multiple premium payments since there are no future premiums to consider in this case. The reserves are calculated by forecasting future losses from past losses.

The reserving process can refer to different components of the process to internal or external personnel at the insurance company. The claims department is at the frontline when a claim is reported and a case reserve needs to be posted. An internal actuarial department performs work in support of the recorded loss and loss adjustment reserves (reserves) in the insurance company’s statutory financial statements. Either the internal or external appointed actuary relies on reserving methods or models to opine on a company’s Dec. 31 recorded reserves. Company management is responsible for the financial reporting process including the recording of loss and loss adjustment reserves and controls over the entire process.

One of the state insurance regulators’ primary functions is solvency regulation for which the risk-focused examination is a key tool. The primary purpose of a risk-focused examination of an insurer is “Assessing and monitoring its current financial condition and prospective solvency.” Conservatism in the recorded reserves is preferable to understated reserves when viewed in light of solvency regulations. It has been 40 years since the National Association of Insurance Commissioners (NAIC) June 1980 Plenary Session where the first formal statement of a loss reserve opinion requirement was adopted and nearly 30 years since what is now referred to as a Statement of Actuarial Opinion as required by the NAIC Property and Casualty Annual Statement Instructions was required. This Statement of Actuarial Opinion has operated as a regulatory control over the reserving process by helping to mitigate the risk of insurance company loss reserves being “too low” (deficient or inadequate) or “too high” (redundant or excessive).

Chain Ladder Method

The chain-ladder or development method is a prominent actuarial loss reserving technique. The chain-ladder method is used in both the property and casualty and health insurance fields. Its intent is to estimate incurred but not reported claims and project ultimate loss amounts. The primary underlying assumption of the chain-ladder method is that historical loss development patterns are indicative of future loss development patterns.

Methodology

According to Jacqueline Friedland’s “Estimating Unpaid Claims Using Basic Techniques,” there are seven steps to apply the chain-ladder technique:

• Compile claims data in a development triangle
• Calculate age-to-age factors
• Calculate averages of the age-to-age factors
• Select claim development factors
• Select tail factor
• Calculate cumulative claim development factors
• Project ultimate claims

Limitations

The chain-ladder technique is only accurate when patterns of loss development in the past can be assumed to continue in the future. In contrast to other loss reserving methods such as the Bornhuetter–Ferguson method, it relies only on past experience to arrive at an incurred but not reported claims estimate.

When there are changes to an insurer’s operations, such as a change in claims settlement times, changes in claims staffing, or changes to case reserve practices, the chain-ladder method will not produce an accurate estimate without adjustments.

The chain-ladder method is also very responsive to changes in experience, and as a result, it may be unsuitable for very volatile lines of business.

Bornhuetter–Ferguson Method

The Bornhuetter–Ferguson method is a prominent loss reserving technique.

Background

The Bornhuetter–Ferguson method was introduced in the 1972 paper “The Actuary and IBNR,” co-authored by Ron Bornhuetter and Ron Ferguson.

Like other loss reserving techniques, the Bornhuetter–Ferguson method aims to estimate incurred but not reported insurance claim amounts. It is primarily used in the property and casualty and health insurance fields.

Generally considered a blend of the chain-ladder and expected claims loss reserving methods, the Bornhuetter–Ferguson method uses both reported or paid losses as well as an a priori expected loss ratio to arrive at an ultimate loss estimate. Simply, reported (or paid) losses are added to a priori expected losses multiplied by an estimated percent unreported. The estimated percent unreported (or unpaid) is established by observing historical claims experience.

The Bornhuetter–Ferguson method can be used with either reported or paid losses.

Methodology

There are two algebraically equivalent approaches to calculating the Bornhuetter–Ferguson ultimate loss.

In the first approach, undeveloped reported (or paid) losses are added directly to expected losses (based on an a priori loss ratio) multiplied by an estimated percent unreported.

BF = L + ELR * Exposure (1-w)

In the second approach, reported (or paid) losses are first developed to ultimate using a chain-ladder approach and applying a loss development factor (LDF). Next, the chain-ladder ultimate is multiplied by an estimated percent reported. Finally, expected losses multiplied by an estimated percent unreported are added (as in the first approach).

BF = L*LDF*w + ELR * Exposure (1-w)

The estimated percent reported is the reciprocal of the loss development factor.

Incurred but not reported claims can then be determined by subtracting reported losses from the Bornhuetter–Ferguson ultimate loss estimate.