Establishing proper case reserves in P&C insurance is a fundamental responsibility of the claims department. The adequacy, redundancy, and deficiency of these reserves directly affect an insurance company’s rates, surplus adequacy, and profitability.
Because many insurance companies are operating at a 50 percent loss ratio or above, they need to pay very close attention to the reserve management process. The loss ratio is calculated as the incurred losses and expenses divided by the earned premium. Incurred losses include paid losses and expense, plus outstanding reserves, less recovery (e.g., subrogation and salvage). Redundant claims reserves can inflate a loss ratio, and deficient claims reserves can deflate a loss ratio, meaning that the loss ratio is understated. Both can be detrimental to an insurance company.
Science of Reserve Management
Typically in an insurance company, reserve management is the responsibility of both the claims technical and management staff. All claims staff involved in the reserve management process should have documented reserve authority to establish and/or enter new claims reserves and reserve adjustments.
Case reserves are usually established based on judgment or some other agreed-upon methodology. For this discussion, we will only focus on liability bodily injury and property damage reserves. Property damage reserves are typically based on a fixed amount, such as a repair estimate, appraisal, or some other documentation supporting the amount being claimed. However, bodily injury liability reserves are very different in that there are both subjective and objective reserve components.
When managing liability claims, there two primary components other than coverage: liability and damages. Liability is evaluated based on the law (statutes and case law) and the claims investigation, which may include statements, official reports, ISO ClaimSearch, photos, diagrams, expert opinions, and other relevant information.
Damages are separated into two components: general damages (subjective) and special damages (objective). General damages include pain and suffering, loss of companionship or consortium, disfigurement, and mental or physical impairment. Special damages are specific expenses brought by the claimant, such as medical and hospital bills, wage loss, and property damage that is supported by medical and diagnostic reports, hospital records, wage or income documentation, and repair estimates. Special damages are easier to project than general damages because they are fixed and quantifiable.
A bodily injury liability reserve calculation will include components for both general and special damages, which are considered compensatory damages. Both liability and damages are primary to the claims investigation and should directly support the claims reserve being established. Therefore, the more comprehensive you are in the claims investigation, the better probability that your reserve and ultimate payout will be accurate.
A bodily injury reserve calculation will also include an analysis of liability expressed as a percentage. The percentage will typically be based on comparative or contributory negligence doctrines in the jurisdiction where the claim occurred. These doctrines allocate liability percentages to the plaintiffs and defendants in accordance with their percentage of liability.
Contributory negligence (the strictest) precludes the plaintiff from recovery if the plaintiff is even one percent negligent. There are five states that follow the pure contributory negligence rule: Alabama, Washington, D.C., Maryland, North Carolina, and Virginia. Most other states either follow a pure comparative negligence rule or modified comparative negligence rule.
Pure comparative negligence can allocate liability on each party from one to 100 percent, meaning that the plaintiff can recover even if they were one percent negligent.
Modified comparative negligence will typically preclude the plaintiff from recovery if they are over 49 to 51 percent negligent, depending on the jurisdiction.
Understanding and applying the correct negligence doctrine in your claims evaluation is critical in establishing a proper liability case reserve. This information should be included in the documented reserve calculation.
Most companies have an established reserve philosophy for the claims staff to apply a consistent reserve methodology. Some philosophies may base their reserve methodology on the expected payout, settlement value, or even jury verdict exposure. The expected payout or settlement value is probably the most effective method in establishing a liability case reserve, as jury verdicts are difficult to predict and tend to vary widely. Only a limited number of claims are actually tried to a conclusion, particularly the lower-value claims. Therefore, claims reserves based on jury verdict exposure may not be an accurate assessment of settlement value or the expected claims payout.
Reserve analysis includes liability and damages. The reserve evaluation may include a calculation such as gross claim value multiplied by the percentage of liability on the insured to arrive at a net case reserve (e.g., $10,000 gross claim value X 75 percent liability = $7,500 net reserve). The gross value has several components that include both general and special damages, and each reserve component should be itemized in the reserve calculation with an assigned monetary value. For example, general damages will include pain and suffering, loss of companionship or consortium, disfigurement, mental impairment, and physical impairment. Special damages will include medical, hospital, diagnostic, and wage or income loss.
It looks pretty easy! However, there are two critical and often disputed issues that involve assessment of the damages and liability.
First, the gross claim value includes both general damages and special damages. Special damages are objective and easily quantifiable; however, general damages are subjective until actually received as a jury verdict in a court of law.
Second, the percentage of liability is often a disputed issue among adjusters and attorneys. Can someone really know whether a plaintiff is 55 percent negligent versus 68 percent negligent? Of course not. But if I have a $20,000 reserve, the difference can mean $2,600. Multiply the $2,600 for each injury claim reserve by 5,000 claims and you have a difference of $13 million of either redundancy or deficiency. These issues are the foundation for disputes that are either compromised or may reach the litigation stages for a resolution. Since most claims are settled on a compromised basis, projecting general damages using a settlement value or expected payout would be more appropriate.
The process may be a science, but still has subjective components that allow for a wide range of reserve values with the same set of facts. Can it get so precise that all claims staff and the legal community will agree on both general damage values and liability percentages 100 percent of the time? I doubt it, but if it could be done, it would substantially reduce the volume of cases in the civil court systems.
Art of Reserve Management
So how it is done, and who has the book? The book probably doesn’t exist and the methodology is a combination of experience, custom, and practice.
Since only a small percentage of claims are actually tried to a conclusion and decided by a jury, jury verdict reporting doesn’t really provide the necessary information. Therefore, reserving based on jury verdict exposure may be considered a “worst case” scenario reserve philosophy. Since more than 95 percent of all claims are usually settled prior to trial, case reserves are generally reserved based on the expected payout or settlement value.
There are only a couple of alternatives. You can use a computerized evaluation tool to arrive at a claim reserve, which generally requires the adjuster to input medical and special damage documentation (including disability treatment details) to arrive at a gross claim value. These programs are fee-based and becoming more sophisticated, but they have not yet completely replaced human interaction.
Or you can base your reserve evaluation on experience, custom, and practice. What does that mean? It’s a combination of the following:
A claims handler or manager’s opinion based on handling similar claims in the past.
A consensus among the claims handler and manager, which may include an average value based on two opinions.
A claims committee discussion that may yield an average value based on the group discussion. Sometimes, a strong committee member personality may drive the value, which could defeat the purpose of this format.
Defense counsel’s opinion of settlement value and jury verdict value, which should only be used as one element of the claims evaluation process and not exclusively.
A multiple of the special damages, such as three or five times the special damage amount. Although this approach is not recommended, it is commonly used by plaintiff attorneys and some adjusters.
There are many factors that affect the value of claims, including the venue or jurisdiction of the claim; the applicable negligence doctrine (e.g., contributory or comparative negligence); the plaintiff’s demeanor as a witness; the plaintiff attorney’s ability and verdict results; and the type of claim and whether society considers it to be an egregious act, resulting in a higher jury verdict. Not to mention punitive damages that serve to punish the defendant for alleged wrongdoing.
Sometimes it is just a “gut” opinion based on the volume of claims handled in the past. It’s comparable to an underwriter having a gut opinion about not writing a risk even though it may fit in the required underwriting “box.” This opinion comes with years of claims experience and is not usually present in less-experienced adjusters.
Remember that if a claim is not settled, it will go into suit and ultimately be tried to a conclusion with the jury making the decision. The jury makeup (typically six jurors) does not consist of adjusters, claims managers, or attorneys. The jury includes lay people who come from a variety of occupations and socio-economic backgrounds. Their value of the claim may be completely different than the insurance company’s claim value, which makes the reserve management task even more difficult.
So when one adjuster values a claim at $15,000 and the another at $25,000, who has the correct evaluation? Both may be correct. First look at the components of the reserve evaluation. Are components of the general damages projected higher or lower? Are the negligence percentages different? How can I know how much pain is worth if I’ve never experienced the injury? The answer is that there is no incorrect evaluation, only a difference of opinion.
Technology and the Future
What will the future bring in terms of reserve management and automation? Will technology and science take over, leaving the “art” of reserve management behind? Computer-based intelligence and automated decision-making tools continue to develop at a rapid pace, and we have already seen several companies that have developed and refined existing bodily injury evaluation tools to automate the reserve process. However, technology has not yet taken the place of human interaction, and it seems unlikely to do so in the immediate future.
Michael Murdock, CPCU, ARM, is a senior management consultant in the property and casualty insurance practice at Robert E. Nolan Company. A CLM Fellow since 2012, he can be reached at (860) 817-3080, firstname.lastname@example.org.
A periodic claims audit by an independent consultant, focusing on case reserve management, will not only validate your reserve philosophy and current case reserve adequacy, but also provide the claims staff with insight, including recommendations for change or improvement in current operating procedures or philosophies. Here are some other recommendations to keep in mind.
Have clear and concise reserve process and procedures.
Maintain a comprehensive, written reserve management philosophy.
Conduct routine adjuster training and development on reserve management.
Establish reserve authority levels.
Ensure supervisory and management oversight. This means having front-end new reserve and reserve adjustment approval at key monetary levels; mandatory six-month reserve reviews by an adjuster and supervisor; and an 18-month ultimate reserve review with a formal report that addresses key issues, such as liability, damages, and status of litigation, approved by management.
Review management reports on a summary and detail level to monitor monthly reserve adjustments, average paid losses, reserve redundancy, and reserve deficiency.
Review of loss triangle reports to monitor reserve development and claim volume development. These reports are very helpful in understanding how case reserves and claim volumes are developing at 24, 48, 36, and 48 month intervals.
Conduct monthly and annual claims audits internally and externally.