Both redundant and deficient claims reserves can adversely affect the profitability of an insurance company. Understanding the impact of proper reserve management on a company’s results and paying close attention to the reserve management process is a core responsibility of all claims professionals.
When a loss is paid and the case reserve is taken down (closed), the incurred loss is equivalent to the paid loss, less any recovery. Therefore, until the loss is paid, the extent of the reserve redundancy may be unknown. It is important to note that although the evaluation process for purpose of settlement and establishing claim reserve values may be the same, it does not mean that the settlement amount must always be equivalent to the claim reserve. If the settlement amounts are consistently equivalent to the reserve amounts, there will be no redundancy. However, a small amount of redundancy is prudent in order to offset any deficient claim reserves.
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Let’s look at an example of a reserve redundancy issue. A claims operation has an overall 25 percent redundancy on all of its claims case reserves. The company is targeting a 10 percent redundancy range. The company writes $300 million in annual premium and has a 50 percent loss ratio, or $150 million in incurred losses. Now let’s see the impact by adding an additional 15 percent to the incurred losses:
$150,000,000 Incurred Losses = 50% Loss Ratio (Current)
$300,000,000 Earned Premium
$172,500,000 Incurred Losses = 57.5% Loss Ratio (Redundant)
$300,000,000 Earned Premium
The loss ratio increased by 7.5 percent, or $22.5 million. A simple example, but it illustrates how case reserves impact loss ratios. In this example, the claim operation was 15 percent over a targeted redundancy rate of 10 percent.
Since the increase in the loss ratio was due only to higher reserves and not increases in paid losses and expenses, why be concerned? The adverse impact of this reserve redundancy could have the following impact:
- If insurance rates were established using the 57.5 percent loss ratio when it should have been 50 percent, the rate (premium) may have been too high, losing a competitive edge in the marketplace, affecting policy retention and premium growth.
- Agents who placed the insurance business for the company may have not received profit sharing, or less than they should have, due to the increased loss ratio. This could prompt the agent to place business with a competitor on renewal.
- The additional 7.5 percent would have dropped to the bottom line as increased profit. For example, if the combined ratio (underwriting expenses; losses and claim expenses; agent commissions; boards; bureaus; and taxes) is 95 percent, then it could have been 87.5 percent, a $22.5 million increase in profit.
Redundant claim reserves can be intentional or unintentional. Intentional high redundancy at an aggregate reserve level that is known can be controlled, if it is consistent and actuarially sound. A small amount of redundancy at the case reserve level is acceptable to offset any potential future deficient case reserves.
However, unintentional high redundancy at the case reserve level may not be immediately known unless the company has reviewed all of its case reserves and the claims staff is monitoring reserves against paid losses routinely.
It’s not too difficult to achieve high redundancy rates at the case reserve level, and the change may be very subtle. Consider an average bodily injury claim of $10,000, moving to $11,500 (15 percent). Although this represents a subtle change at $1,500, multiply it on a daily basis across all liability claims and you may have a serious problem by year end.
There will always be bodily injury liability claims that have not yet reached maturity (no further development) with future expected reserve development. This can occur for a variety of reasons, such as injuries requiring further surgical treatment; an unexpected witness increasing the liability exposure; an unsuccessful summary judgment motion; or an unexpectedly high plaintiff’s jury verdict at trial now on appeal. The key is to avoid adverse reserve development in later policy or underwriting years, which is controllable through proper claims handling and effective management controls.
Reserve Deficiency
Typically, reserve deficiency is more easily recognized than reserve redundancy, especially when payments are being processed against a deficient claim reserve or when an adjuster refers a claim to a manager for settlement authority and/or reserve adjustment approval.
Let’s use the same loss ratio example as above for an illustration of deficient reserves with a reserve deficiency rate of 15 percent.
$150,000,000 Incurred Losses = 50% Loss Ratio (Current)
$300,000,000 Earned Premium
$127,500,000 Incurred Losses = 42.5% Loss Ratio (Deficient)
$300,000,000 Earned Premium
The loss ratio decreased by 7.5 percent, or $22.5 million. In this example, the claims operation was 15 percent below an acceptable 10 percent redundancy rate. The adverse impact of this reserve deficiency could have the following impact:
- If insurance rates were established using the 42.5 percent loss ratio when it should have been 50 percent, the rate (premium) may be inadequate, causing a loss of profit in the future, requiring rate increases to bring the rates to a proper level, as well as the potential loss of business in the future as a result of increased rates that may be higher than normal to “catch-up” with proper rate levels.
- Agents who placed the insurance business for the company may have received profit sharing when they were not eligible, due to the lower loss ratio.
- The additional 7.5 percent may have dropped to the bottom line as increased profit, but may deteriorate in the future due to the inadequate rates.
Deficiencies in case reserves may cause the insurance company to use surplus to pay for claims in the future, which is not what an insurance company would do in the normal course of business. Reductions in surplus may adversely affect the ability to write additional premium due to the insurance company not meeting premium-to-surplus ratios required by regulators, such as a requirement of $1 of surplus for every $3 of written premium.
If reserve deficiency is not recognized over the long term, it could cause an insurance company to experience financial problems or even result in bankruptcy. Sometimes you may read about insurance companies announcing a “reserve strengthening,” which may mean that a reserve deficiency was recognized and is now being corrected either at a bulk reserve level or by adjusting individual case reserves.
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, michael_murdock@renolan.com.