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3 Things All Risk Managers Should Know about Loss Reserves

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This article highlights three items all risk managers and finance professionals should know about their self-insured program’s loss reserves.

An actuarial loss reserve analysis has the potential to affect an organization’s financial position. This potential is formally recognized by an organization when the liabilities on its balance sheet are adjusted to equal the actuarial reserve recommendations. The magnitude of the required balance sheet adjustment will depend, in part, on the type of accrual methodology in use. This article examines the financial implications that result from changes in actuarial loss reserve estimates for the most common accrual methods.

1. Loss Reserves Tend to Increase over Time

Perhaps you have noticed a tendency for your self-insured program’s loss reserves to increase over time. It may be some consolation to know that an upward trend is more the norm than the exception, especially for newer programs. More importantly, the tendency for estimates to increase over time can be modeled in advance. Your actuary can develop a multi-year forecast of loss reserve estimates that can be used to set expectations with your company’s finance leaders as well as inform asset investment strategies.

So why do loss reserves tend to increase over time? There are three main factors that put upward pressure on your program’s loss reserves: inflation, exposure growth, and payment pattern.

Inflation, the tendency for goods and services to increase over time, contributes to steadily higher claim costs for self-insured programs. Inflation drives loss reserve estimates upward since the expected loss experience of each new policy period tends to be higher than that of the preceding one.

As your company grows, so does its self-insured exposure. Higher payrolls contribute to increased workers compensation costs and a larger vehicle fleet contribute to higher commercial automobile costs. Growth is a key goal of most companies, and this tends to result in higher costs for the company’s self-insured program. Exposure growth can also result from other sources, such as an increase in the program’s self-insured retention.

For relatively new, or “immature” programs, loss reserves will tend to increase significantly with each policy period added to the self-insured portfolio. This phenomenon is particularly relevant for casualty coverages due to their “long-tailed” payment characteristics (i.e, it often requires several years for all claims to be completely paid).

In addition to the factors that put upward pressure on loss reserves, variability in actual loss experience is another source of volatility in reserve estimates. However, this type of volatility tends to be unbiased, that is, it is equally likely to result in increases or decreases to loss reserves. Variability in actual loss experience can be in the form of paid loss or case incurred loss (paid plus case reserves). The type of loss is important since either exert a unique influence on loss reserve estimates:

  • Unusually high or low paid loss activity directly influence loss reserve estimates. Since reserve obligations are reduced as losses are paid, unusually high payment activity has a downward influence on loss reserves. The opposite is true of unusually low payments.
  • Actual case incurred loss emergence that is significantly different than expected prompts the actuary to revise his or her previous estimates. Higher than expected case incurred loss emergence has an upward influence loss reserves. The opposite is true of lower than expected emergence.

The good news is that future loss reserve estimates can be modeled. Your actuary can develop a multi-year forecast of loss reserve estimates based on inflation, exposure growth, and payment pattern assumptions (see this article for a more detailed discussion). The analysis can also incorporate ranges to reflect the uncertainty inherent in future loss experience. A forecast such as this will provide a proper context from which to assess future actuarial loss reserve estimates.

2. A Change in Actuarial Loss Reserve Estimates is Not the Same as the Financial Effect

An actuarial loss reserve analysis has the potential to affect an organization’s financial position. This potential is formally recognized by an organization when the liabilities on its balance sheet are adjusted to equal the actuarial reserve recommendations. The magnitude of the required balance sheet adjustment will depend, in part, on the type of accrual methodology in use.

The financial effect of a loss reserve adjustment depends on changes in actuarial loss reserve estimates and changes in accrued loss reserves. The financial effect can be stated as follows:

Financial Impact Formula 3

In this formula, a value greater than zero reflects a favorable financial effect to the organization’s balance sheet (reduction in accrued liabilities), whereas a result less than zero reflects an adverse financial effect (increase in accrued liabilities). This formula demonstrates that the financial effect of a loss reserve adjustment cannot be determined by changes in actuarial loss reserve estimates alone. One exception to this rule applies to organizations that have no interim accrual process in place. These organizations rely exclusively on actuarial reports to determine loss reserve adjustments (the change in accrued loss reserves in the formula above equals zero).

Most organizations have a process in place whereby loss reserve accruals are periodically adjusted to reflect the cost of additional self-insured exposure as well as loss payment activity during the interim period. For these organizations, the change in actuarial loss reserve estimates is dependent on actual loss payment activity whereas the financial effect of a loss reserve adjustment is not. This means that unusually high or low loss payments in the interim period can have a significant effect on actuarial loss reserve estimates but not have a corresponding financial effect.

A common misconception is that an increase in actuarial loss reserves estimates translate to a corresponding adverse financial effect.  As discussed above, the financial effect of a reserve adjustment generally cannot be determined based on actuarial loss reserve estimates alone – the accrued loss reserves are a critical component of the calculation.

A more detailed discussion of this topic can be found in this article.

3. Changes to Case Reserve Practices May Distort Actuarial Estimates

Case reserve levels for self-insured portfolios routinely fluctuate over time as payments are made, new claims are reported, and existing claims are reevaluated. When case reserves are established on a consistent basis, both in magnitude and timing, case reserve adequacy is likewise consistent. However, when changes are made that affect either the magnitude or timing of case reserves for otherwise identical claims, case reserve adequacy is also affected. Such changes often occur as the result of revisions to claim handling practices or changes in claims administrators.

A change in case reserve adequacy can produce dramatic distortions in standard actuarial reserving methods. It is important that intentional changes to case reserving practices are communicated to your actuary, preferably in advance of their implementation. With the benefit of this knowledge, actuaries can adjust their analysis to reflect any changes in case reserving practices.

In order to appreciate the potential distortion caused by changes in case reserving practices, consider the following example. Suppose that new claim guidelines are implemented that result in a significant increase in case reserves. Further, assume that this increase is exclusively the result of case reserving practices (i.e., there are no changes in the loss potential of the underlying claims). All else being equal, the total loss reserve estimate (case reserves plus IBNR) should be unchanged. However, if the actuary is unaware of the new case reserving practices, standard actuarial methods will tend to interpret the increases in case reserves as a sign of worsening loss experience. As a result, actuarial estimates of IBNR are likely to increase as well, creating a “double-whammy” effect of increased case reserves and increased IBNR.

This example is illustrated in the chart below using three scenarios:

Scenario 1 represents the total reserves (case reserves and IBNR) before any changes are made to claims practices.

Scenario 2 shows the sample composition of total reserves based on the assumption that total loss reserves are unaffected by the changes in claims practices.

Scenario 3 illustrates the potential distortion in actuarial reserve estimates as a result of uncommunicated changes in claims practices. Note that in this scenario, the case reserve values are equal to those of Scenario 2; however, the relationship between IBNR and case reserves is similar to that in Scenario 1 (in this example, the ratio is 1.5 to 1). If changes to claims practices are contemplated in the actuarial modeling process, the result will more closely resemble Scenario 2 than Scenario 3.

3 Things Chart1

A more technical discussion of the implications of case reserve changes on actuarial methods is found in this article.

Disclaimer: Information presented in this article should not be relied upon as actuarial or accounting advice, which should be provided by a credentialed actuary or accountant familiar with the details of your organization’s risk management program.

The Financial Implications of an Actuarial Reserve Report (for Self-Insureds)

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This article examines the financial implications of changes in actuarial loss reserve estimates for self-insured organizations.

An actuarial loss reserve analysis has the potential to affect an organization’s financial position. This potential is formally recognized by an organization when the liabilities on its balance sheet are adjusted to equal the actuarial reserve recommendations. The magnitude of the required balance sheet adjustment will depend, in part, on the type of accrual methodology in use. This article examines the financial implications that result from changes in actuarial loss reserve estimates for the most common accrual methods.

Calculating the Financial Effect of an Actuarial Report is “Easy”

The potential financial effect of an actuarial loss reserve report can be quickly determined by calculating the difference between the amount the organization has accrued and the actuary’s current loss reserve estimate. If the organization intends to adjust the liabilities on its balance sheet to equal the actuarial recommendations, the realized financial effect to the organization is summarized as follows:

Financial Impact Formula 1

In this formula1, a value greater than zero reflects a favorable financial effect to the organization’s balance sheet (reduction in accrued liabilities), whereas a result less than zero reflects an adverse financial effect (increase in accrued liabilities).

Despite the simplicity of this calculation, the financial effect of a loss reserve adjustment rarely appears in an actuarial report. This is due to the fact that an organization’s accrued loss reserves are usually not known at the time of the reserve analysis.  Instead, most actuarial reports highlight the amount by which loss reserve estimates changed from the prior report. This measure provides continuity between reports and is a key conclusion of a reserve analysis. The change in the actuarial loss reserve estimates is determined by calculating the difference between estimates from the current and prior actuarial reports:

Financial Impact Formula 2

While the change in actuarial loss reserve estimates is a valuable measure, it cannot be used independently to calculate the financial effect of a loss reserve adjustment. The relationship between the measures can be seen in the formula2 below:

Financial Impact Formula 3

A common misconception is that an increase in actuarial loss reserves estimates translate to a corresponding adverse financial effect.  It is obvious from the above formulas that the financial effect of a reserve adjustment cannot be determined based on actuarial loss reserve estimates alone – the accrued loss reserves are a critical component of the calculation.

Before more thoroughly discussing the financial effects of loss reserve adjustments, it will be helpful to review some supporting material. The next section describes the components underlying the change in actuarial loss reserve estimates, followed by a review of the accrual methods commonly employed by self-insured organizations.

A Closer Look at the “Change in Actuarial Loss Reserve Estimates”

The change in actuarial loss reserve estimates can be defined by its three primary components as seen in the formula below:

Financial Impact Formula 4

Change in estimated ultimate loss for the prior policy period

The change in estimated ultimate loss for the prior policy period results from the reevaluation of actuarial estimates of ultimate loss between the current and prior actuarial reports.  The “prior policy period” corresponds to the entire (usually multi-year) policy period subject to review in the previous actuarial analysis.

If it was possible for an actuary to consistently predict loss activity with perfect foresight, this amount would always be zero.  In this hypothetical case, the original estimates of ultimate loss would be precisely accurate, thereby eliminating the need for revised estimates in the future.  Of course, the random nature of claim activity virtually guarantees a difference between actual and expected loss estimates.  In practice, the change in estimated ultimate loss for the prior policy period is often a non-zero value. An amount greater than zero reflects an upward (adverse) adjustment of the actuarial estimates while an amount less than zero reflects a downward (favorable) adjustment.

Estimated ultimate loss for interim policy period

The estimated ultimate loss for the interim policy period reflects the expected ultimate losses associated with any additional self-insured exposure during the interim period. For active programs, this amount will always be greater than zero.  For occurrence-based policies, all accidents that occur during the period are included, whether reported or not.

Actual loss payments in interim period

This amount reflects the actual loss payments made during the interim period, regardless of accident date of the underlying claims.  Typically, in any period, loss payments are made for claims stemming from several different policy periods. This amount is usually greater than zero in aggregate; although, in rare instances, large claim recoveries can result in negative overall amounts.

As can be seen in the formula (by the presence of the minus sign), loss payments serve to decrease loss reserve estimates. This reflects the fact that reserve obligations are reduced as claims are paid.

Accrual Methods for Loss Reserves

Organizations often update their balance sheets more frequently than actuarial loss reserve analyses are performed.  To support the need for interim loss reserve estimates, and to account for changes in these estimates over time, various accrual methods are typically employed. The three most common methods are described below.

Standard Accrual Method

The “standard” accrual method is the most common approach used to estimate interim loss reserve liabilities. In this method, a loss reserve estimate is calculated based on the amount carried on the prior balance sheet. The prior loss reserve is adjusted to reflect the cost of additional self-insured exposure as well as loss payment activity during the interim period. This calculation is summarized in the following formulas:

Financial Impact Formula 5

Fixed Reserve Accrual Method

The fixed reserve accrual method is less common and is only appropriate for situations that require less accuracy. This method works better for mature, stable self-insured programs.

In the fixed reserve accrual method, estimates of loss reserves are maintained between formal actuarial reserve analyses. The simplicity of this approach is obvious in the formulas below.

Financial Impact Formula 6

Fixed IBNR Accrual Method

The fixed IBNR accrual method is perhaps the least common approach, and, like the fixed accrual reserve method, is only appropriate for situations that require less accuracy. This method may be somewhat more accurate than the fixed reserve accrual method since changes in case reserves are explicitly recognized. The calculation for loss reserves is summarized in the formulas below.

Financial Impact Formula 7

In this method, estimated IBNR is implicitly unchanged between formal actuarial analyses since total loss reserves (case reserves + IBNR) are only adjusted for changes in case reserves during the interim period.

The Financial Effect of a Loss Reserve Adjustment

This section examines the financial effect of loss reserve adjustments for each of the three accrual methods described above.

Standard Accrual Method

If an organization employs the standard accrual method, the change in the loss reserve accrual is summarized as follows:

Financial Impact Formula 8

As described earlier, changes in actuarial loss reserve estimates can be stated using the following formula:

Financial Impact Formula 9

Since the financial effect of a loss reserve adjustment can be calculated as the difference between the change in the loss reserve accrual and the change in the actuarial loss reserve estimate, the following formula can be derived:

Financial Impact Formula 10

This formula contains important insights for organizations that employ the standard accrual method. First, the financial effect of a loss reserve adjustment stems from of two main sources:

  1. The difference between budgeted and actuarial estimates for ultimate loss in the interim policy period, and
  2. The change in actuarial estimates of ultimate loss for prior policy periods.

Second, the budgeted estimate of ultimate loss for the interim policy period directly affects the magnitude of the financial effect. A budget estimate that is greater than the actuarial estimate (as determined with the benefit of hindsight) results in a favorable financial effect when loss reserves are adjusted.

It is also interesting to note that the change in actuarial loss reserve estimates is dependent on actual loss payment activity whereas the financial effect of a loss reserve adjustment is not. This means that unusually high or low loss payments in the interim period can have a significant effect on actuarial loss reserve estimates but not have a corresponding financial effect. This is consistent with the premise that loss payments offset reserve liabilities.

Fixed Reserve Accrual Method

For organizations employing the fixed reserve accrual method, no additional accruals are established between actuarial reserve analyses:

Financial Impact Formula 11

The financial effect for all accrual methods can be calculated as the difference between the change in the loss reserve accrual and the change in the actuarial loss reserve estimate.  For the fixed reserve accrual method, the financial effect of a loss reserve adjustment is stated as follows:

Financial Impact Formula 12

In other words, for this accrual method, the financial effect of a loss reserve adjustment is entirely determined by the change in the actuarial loss reserve estimate. Note that the measures are inversely related – for example, a decrease in the actuarial loss reserve estimate results in favorable financial effect.

Fixed IBNR Accrual Method

For organizations using the fixed IBNR accrual method, the change in the loss reserve accrual is summarized as follows:

Financial Impact Formula 13

As described earlier, the formula for changes in actuarial loss reserve estimates can be stated as follows:

Financial Impact Formula 14

The difference between the above two measures is used to derive the financial effect for this accrual method:

Financial Impact Formula 15

Noting that the change in case reserves plus loss payments equals case incurred loss, this formula can be simplified as follows:

Financial Impact Formula 16

For this method, the financial effect is highly dependent on case incurred loss activity during the interim period. Growing organizations using this method will tend to observe an adverse financial effect when loss reserves are adjusted. This is because case incurred losses (item 1 in the formula above) will tend to be less than the combined effect of the change in ultimate losses during the interim period (items 2 and 3 in the formula above).

Summary

The financial effect of a loss reserve adjustment depends on changes in actuarial loss reserve estimates as well as changes in accrued loss reserves. Except in special cases, the financial effect of a loss reserve adjustment cannot be determined by changes in actuarial loss reserve estimates alone.

For organizations using the standard accrual method, the change in actuarial loss reserve estimates is dependent on actual loss payment activity whereas the financial effect of a loss reserve adjustment is not. This means that unusually high or low loss payments in the interim period can have a significant effect on actuarial loss reserve estimates but not have a corresponding financial effect. (Recall that, in the standard accrual method, liabilities are reduced as payments are made.)

For the standard accrual method, the financial effect of a loss reserve adjustment depends on :

  1. The difference between budgeted and actuarial estimates for ultimate loss in the interim policy period, and
  2. The change in actuarial estimates of ultimate loss for prior policy periods.

For organizations using the fixed reserve accrual method, the financial effect of a loss reserve adjustment is entirely determined by the change in the actuarial loss reserve estimate. (The measures are inversely related – for example, a decrease in the actuarial loss reserve estimate results in favorable financial effect.)

Disclaimer: Information presented in this article should not be relied upon as actuarial or accounting advice, which should be provided by a credentialed actuary or accountant familiar with the details of your organization’s risk management program.

1. For this formula to be valid, it is important that the actuarial loss reserve estimate and the accrued loss reserves are each evaluated at the same point in time (e.g, as of 12/31/2018).

2. This formula is simply the earlier version of the same measure represented by changes in the corresponding amounts. In order for this formula to be valid, the prior accrued loss reserve must equal the prior actuarial loss reserve estimate (i.e., it is assumed that the organization adjusts its liability accrual to equal the actuarial recommendation.)

How Changes in Case Reserves Affect Loss Reserve Estimates

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Many loss reserves estimates rely heavily on a few traditional actuarial methods. This article explores how four of the most common methods respond to changes in case reserves. This topic is of particular importance in situations involving changes to case reserve adequacy. This article will help the reader understand the potential implications such changes may have on their self-insured organization’s loss reserve estimates.

Case reserve levels for self-insured portfolios routinely fluctuate over time as payments are made, new claims are reported, and existing claims are reevaluated. When case reserves are established on a consistent basis, both in magnitude and timing, case reserve adequacy is likewise consistent. However, when changes are made that affect either the magnitude or timing of case reserves for otherwise identical claims, case reserve adequacy is also affected. Such changes often occur as the result of revisions to claim handling practices or changes in claims administrators. This article focuses on four of the most common loss reserving methods and their response to changes in case reserves, with an emphasis on changes in case reserve adequacy.

In this discussion, total loss reserves are defined as case reserves plus IBNR (Incurred but Not Reported), where case reserves are established by claims administrators and IBNR is estimated using various actuarial methods. More detailed information on reserve components can be found here.

Incurred Development Method

The incurred development method is one of the most commonly favored approaches for estimating loss reserves. This method produces estimates of total loss reserves based on three primary inputs: paid loss (cumulative basis), case reserves, and incurred loss development assumptions. In the following discussion, the development assumptions appear in the form of age-to-ultimate loss development factors (ATUs).

In this method, IBNR and total loss reserves are calculated using the following formulas:

IBNR  =  Paid x (ATUInc – 1)  +  Case Reserves x (ATUInc – 1)

Total Loss Reserves   =  Paid x (ATUInc – 1)  +  Case Reserves x (ATUInc – 1) + Case Reserves

Where ATUInc represents the age-to-ultimate development factor used to develop incurred losses (cumulative paid plus case reserves) to their ultimate value. Except for unusual situations, ATUs are always greater than or equal to one.

The formula for IBNR demonstrates that estimates of IBNR increase as case reserves increase. Specifically, IBNR increases by a factor of (ATUInc – 1) times the increase in case reserves. Consequently, estimates of total loss reserve increase by an amount larger than the increase in case reserves.

Intuitively, the positive linear relationship between IBNR and case reserves makes sense: in most instances, higher case reserves indicate the need for higher IBNR. This is because case reserves, on average, are inadequate to fund future payments. In this sense, case reserves represent a measure of exposure to potential development.

However, a contradiction arises when changes in case reserves are due to changes in case reserve adequacy. When this occurs, case reserves are no longer consistent measures of exposure to potential development. In fact, a change in case reserve adequacy implies that case reserves and IBNR should have an offsetting relationship. For example, if a change in case reserving practices results in a $1 million increase in case reserves for an otherwise unchanged claim portfolio, then IBNR should decrease by $1 million. In this example, there is no change to the underlying characteristics of the claims, only the case reserving practices. Rather than recognizing the reduced need for IBNR when case reserve adequacy is increased, the incurred loss development method indicates the need for more IBNR (equal to $1 million times (ATUInc – 1)).

To make matters worse, an increase in case reserves will result in higher indicated incurred ATUs. To the extent the higher historical development is considered in the incurred ATUs selected for the model, the discrepancy is exacerbated further.

It is clear that the incurred loss development method does not respond appropriately to changes in case reserve adequacy. Adjustment to the results or the use of other methods are important in such instances.

Paid Development Method

The paid development method produces estimates of total loss reserves based on just two inputs: paid loss (cumulative basis) and paid loss development assumptions. This method, unlike the incurred loss development method, responds to changes in case reserves with an equal and opposite change in indicated IBNR. Additionally, estimates of total loss reserves are independent of case reserves. These observations can be seen in the following formulas:

IBNR  =  Paid x (ATUPaid – 1)  –  Case Reserves

Total Loss Reserves  =  Paid x (ATUPaid – 1)

Where ATUPaid represents the age-to-ultimate development factor necessary to develop paid losses to their ultimate value.

The relationship between case reserves and IBNR in this method is appropriate for situations involving changes in case reserve adequacy. However, in general, this method tends to produce less stable and less accurate results than the incurred development method, thereby limiting its usefulness. The paid development method tends to underperform the incurred development method for the following two reasons:

  1. Utilization of Case Reserve Data – the paid development method does not use case reserves in estimates of total loss reserves. Case reserves are estimates of future payments made by claims administrators and are therefore highly correlated with total loss reserve needs. The incurred development method uses case reserves directly in estimates of total loss reserves as well as indirectly in loss development pattern assumptions.
  2. Speed of Development Pattern – paid losses develop more slowly than incurred losses. The “slower” payment pattern has numerically higher ATUs, especially for less mature claims portfolios. These higher ATUs can result in leveraged and unstable indications of total loss reserves that are very sensitive to payment activity.

For the above reasons, actuaries tend to favor the incurred loss development method to the paid development method when assigning weights between the two. In instances of changes in case reserve adequacy, it is rarely reasonable to simply ignore the incurred development method in favor of the paid development method.

Incurred Bornhuetter-Ferguson Method

There are two versions of the very popular Bornhuetter-Ferguson (B-F) method: the incurred B-F method and the paid B-F method. Each of these methods rely on the user to provide an a priori estimate of ultimate loss. Conceptually, this is the amount the user would have expected in the absence of actual loss experience.  In the incurred B-F method, IBNR and total loss reserves are calculated using the following formulas:

IBNR = (1 – % Incurred to Date) x a priori Expected Ultimate Loss

Total Loss Reserves = (1 – % Incurred to Date) x a priori Expected Ultimate Loss + Case Reserves

The estimates produced by the incurred B-F method incorporate the actual claims experience and the appropriate portion of the a priori expected ultimate loss, where the “appropriate portion” is determined by the incurred loss development assumptions.

The incurred B-F method tends to be highly favored by actuaries, particularly for less mature claims portfolios. However, the a priori expected ultimate loss is a critical and influential assumption in the method. To the extent that this assumption is based on results of the development methods, the aforementioned weaknesses are introduced into the B-F estimates. In one sense, the incurred B-F method simply transfers the onus of an accurate estimate of IBNR to the a priori expected ultimate loss assumption.

The incurred B-F method responds to changes in case reserves on a dollar-for-dollar basis in estimates of total loss reserves. As discussed earlier, this is not an appropriate response in situations involving changes in case reserve adequacy.

Paid Bornhuetter-Ferguson Method

The paid B-F method is similar to the Incurred B-F version, except that paid losses are used in place of incurred losses. IBNR and total loss reserves are calculated using the following formulas:

IBNR = (1 – % Paid to Date) x a priori Expected Ultimate Loss – Case Reserves

Total Loss Reserves = (1 – % Paid to Date) x a priori Expected Ultimate Loss

The paid B-F method shares the following characteristics with the paid development method:

  • changes in case reserves are exactly offset in estimates of IBNR, and
  • estimates of total loss reserves are independent of case reserves.

Again, these are desirable characteristics in situations involving changes in case reserve adequacy.

The usefulness of the paid B-F method is highly dependent on the accuracy of the a priori expected ultimate loss estimate, particularly for less mature portfolios. This dependency is more significant than that described for the incurred B-F method due to differences between paid and incurred development patterns. This method also shares the disadvantages of the paid development method described above.

Summary

In situations involving changes in case reserve adequacy, it is important to give close attention to the methods used to estimate loss reserves. Absent any adjustments, the incurred development method and the incurred B-F method will respond to case reserve strengthening by overstating total loss reserve needs. The paid development method and the paid B-F method are not directly affected by changes in case reserves, but tend to produce less reliable and less stable estimates.

The table below summarizes how each of the four methods described above respond to a $1 increase in case reserves.

RxChange_Table1

There are actuarial methods specifically designed to contemplate changes in case reserve adequacy; however, these methods are more complicated and less commonly utilized. It is important to advise actuaries and auditors of any changes in claim handling practices that may affect loss reserves so that they may incorporate alternative methods or make the appropriate adjustments to more common methods. It is particularly important to advise auditors of changes in practices before they occur.

Disclaimer: Information presented in this article should not be relied upon as actuarial or accounting advice, which should be provided by a credentialed actuary or accountant familiar with the details of your organization’s risk management program.

Understand Where Your Loss Reserves Are Heading

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The behavior of loss reserves for self-insured organizations may seem mystifying at times. This article is designed to help readers understand the key factors that influence the direction of loss reserve estimates over time. 

There are several factors that contribute to changes in loss reserve estimates over time. The most significant is often random volatility in claims experience. In fact, the influence of randomness is usually so large that no attempt is made to forecast loss reserves beyond a few months into the future. Despite the significant role randomness plays, it is possible to project loss reserves several years into the future based on a few simplifying assumptions. The resulting projection can be used to establish a benchmark around which budgeting, capital management, and program performance can be organized.

In this article, we will explore a simple model for establishing benchmark loss reserve estimates using a newly self-insured program as an example. This model is deterministic in the sense that it does not contemplate randomness. More sophisticated versions of the model will be discussed in future articles that incorporate elements of randomness in the form of confidence intervals.

Our model is based on assumptions in each of the five following areas.

  1. Inflation – In a self-insured context, inflation refers to the change in the cost of claims over time. Hypothetically, this refers to the cost of identical claims and does not contemplate changes in the types or frequency of claims over time (these costs are included in exposure growth, below). For simplicity, we assume that inflation applies on a policy year basis. In other words, with a 10% inflation assumption, the loss pick would increase from $1 million in the first policy year to $1.1 million in the second policy year, and so forth.
  2. Exposure growth – In this context, exposure growth is anything, aside from the claim inflation defined above, that leads to an increase in claim costs. This is our “catch all” category. Exposure growth may be due to an increase in the number of employees (for workers compensation), an increase in the self-insured retention,  or a deterioration of the organization’s risk profile. Exposure growth can be favorable (a negative percent) or adverse (a positive percent).
  3. Payment pattern – A payment pattern refers to the rate at which losses are paid over time. For our purposes, we are interested in the payment pattern corresponding to an individual policy year. Payment patterns are often characterized as “fast” or “slow”, referring to the rate at which claims are paid.
  4. Initial loss pick – In practice, an actuarial estimate of ultimate loss and expense for a policy year is commonly called a loss pick. In each of the following examples, we assume that an organization begins a newly self-insured program with a $1 million loss pick for the first policy year.
  5. Changes in prior policy year ultimates – In each of the following examples, we assume that there are no changes in prior policy year ultimates. This simplifying assumption is equivalent to assuming that the policy year loss picks are selected with perfect foresight. In pratice, random volatility in claims experience results in periodic revaluations of prior policy year ultimates.

Note that the assumptions for items 4 and 5 are fixed throughout this article. In this simplified environment, we will examine the influence of inflation, exposure growth, and payment pattern on loss reserve estimates.

First Scenario: Company A

In our first example, we begin with the following assumptions for Company A:

  1. Inflation – 0% per year
  2. Exposure growth – 0% per year
  3. Payment pattern – the selected payment pattern for each policy year is such that 100% of claims are paid ten years after the beginning of each policy year. This represents our “medium” speed pattern. For convenience, we present the pattern as the amounts unpaid1 at the end of each respective year. The complete pattern is illustrated in Figure 1.pp_fig1

Later, we will use the above assumptions to forecast Company A’s loss reserve estimates at the end of each of the next ten years. First, let’s focus on the estimates associated with just the first policy year.

The loss pick for Company A’s first policy year is $1 million. Based on our payment pattern assumption, 75% of the losses will be unpaid one year after the inception of the policy year. Therefore, at the end of year one, Company A’s loss reserve estimate is $750 thousand (75% of $1 million). Using similar logic, Company A’s loss reserve estimate at the end of year two (two years after the beginning of the first policy year) is $520 thousand. These amounts, as well as those for the next several years are illustrated in Figure 2.

pp_fig2

Notice the similarity between the results in Figure 1 and Figure 2. In this simplified example, the loss reserves for Company A’s single policy period mirror the shape of the payment pattern.

Next, let’s look at Company A’s loss reserve estimates for multiple policy years. Here things start to get more interesting. As illustrated in Figure 3, the loss reserve balance increases rapidly at first and then stablizes at $2.520 million after nine years.

pp_fig3

Let’s look more closely at the composition of the loss reserve estimates over time. At the end of one year, loss reserves are $750 thousand. This is the same result we observed in Figure 2, above: $750 thousand equals 75% of the $1 million loss pick for the first policy year.

At the end of two years, there are two policy years that require a total of $1.27 million of loss reserves:

  • 1st Policy Year: $520 thousand = $1 million x 52% unpaid loss
  • 2nd Policy Year: $750 thousand = $1 million x 75% unpaid loss

In each subsequent year of the program, an additional policy year is added to the portfolio. After three years, there are three policy years that require a total of $1.660 million of loss reserves, and so forth.

The stabilization of the loss reserves occurs nine years after the inception of the program due to the characteristics of our selected payment pattern. It is interesting to note the similarities between the rightmost two columns in Figure 3. After nine full years, the addition of reserves from a new policy year (the tenth policy year) is exactly offset by the collective run-off of the prior nine policy years.

This stabilization of the portfolio is what many risk managers and finance professionals expect of a “mature” portfolio. However, as we will see below, a more realistic scenario that includes inflation and exposure growth does not result in a similar plateau effect.

Second Scenario: Company B

In our second scenario, we begin with the same initial assumptions as for Company A, except for inflation. Here, we assume that inflation will increase claims costs by 4% a year.

  1. Inflation – 4% per year
  2. Exposure growth – same as Company A (0%)
  3. Payment pattern – same as Company A (medium payment pattern)

As you can see in Figure 4, this seemingly modest change in assumptions has a significant effect on the loss reserves for the portfolio. Whereas our inflation assumption for Company A was 0%, we assumed 4% per year inflation for Company B. Over the ten year period, Company A’s loss reserves are forecasted to grow to $2.520 million; however, Company B’s grew to $3.324 million.pp_fig4

In addition to Company B’s much larger loss reserve estimate, observe that there is a much less pronounced plateau effect. In fact, between the respective ends of years nine and ten, the reserves increased by – you guessed it: 4%. In this scenario, a mature portfolio will continue to grow at the rate of inflation.

In the next scenario, we will look at the effect of exposure growth on the loss reserve estimates.

Third Scenario: Company C

In our third scenario, we begin with the same initial assumptions as for Company B, except for exposure growth. In this scenario, we assume that, in addition to inflation, exposure growth will increase claims costs by 4% a year. On a combined basis, inflation and exposure growth will result in an increase in the annual policy year loss pick of just over 8%2

  1. Inflation – same as Company B (4%)
  2. Exposure growth – 4% per year
  3. Payment pattern – same as Companies A and B (medium payment pattern)

In Figure 5, the combined influence of inflation and exposure growth on reserve balances is obvious. Over the ten year period, Company C’s loss reserves are forecasted to grow to $4.409 million compared to Company B’s at $3.324 million and Company A’s at $2.520 million.

pp_fig5

In this model, inflation and exposure growth have identical effects on the behavior of the loss reserves. For example, a scenario with 4% inflation and 0% exposure growth would be identical to one with 0% inflation and 4% exposure growth. If we desired, we could further simplify our model by combining inflation and exposure growth into one category, “loss pick growth.”

In the next two scenarios, we return to the 0% inflation and 0% exposure growth assumptions and explore how the speed of the payment pattern affects loss reserves.

Fourth Scenario: Company D

In our fourth scenario, we begin with the same initial assumptions as for Company A, except for our choice of payment pattern:

  • Inflation – 0% per year (same as Company A)
  • Exposure growth – 0% per year (same as Company A)
  • Payment pattern – the selected payment pattern for each policy year is such that 100% of claims are paid five years after the beginning of each policy year. This represents our “fast” payment pattern. The complete unpaid version of the pattern is illustrated in Figure 6.pp_fig6

The loss reserve estimates resulting from these assumptions are illustrated in Figure 7. The faster payment pattern results in a quicker “plateau” and a significantly decreased loss reserve forecasts compared to Company A.

pp_fig7

As a rule, faster payment patterns imply less payments in future years, and therefore lower required reserves. In the last scenario, we will look at the effect of a slower payment pattern.

Fifth Scenario: Company E

In our fifth scenario, we begin with the same initial assumptions as for Company A, again, except for our choice of payment pattern.

  • Inflation – 0% per year (same as Company A)
  • Exposure growth – 0% per year (same as Company A)
  • Payment pattern – the selected payment pattern for each policy year is such that 100% of claims are paid 20 years after the beginning of each policy year. This represents our “slow” payment pattern. The unpaid version of the pattern is illustrated in Figure 8 (with only the first ten years visible).pp_fig8

The loss reserve estimates resulting from these assumptions are illustrated in Figure 9. Here, a steady increase in the loss reserve balances can be observed. The plateau observed in earlier scenarios does not occur in the first ten years of the program (it would occur between years 19 and 20).pp_fig9

Summary

The above scenarios help illustrate the long-term sensitivity of loss reserves to inflation, exposure growth, and payment patterns under non-random conditions. These results are provided for side-by-side comparison in Figure 10, below.

pp_fig10

You can explore many other combinations of these variables using the Excel version of our Reserve Balance Forecast Tool. A screenshot of this tool appears below.

pp_fig11

This free tool can be downloaded using the following link.

Reserve Balance Forecast Tool – For Educational Purposes Only.xlsx

Are you interested in a loss reserving forecast model tailored specifically to your organization’s self-insured program? Call or email us to discuss! 

 

Disclaimer: Information presented in this article should not be relied upon as actuarial or accounting advice, which should be provided by a credentialed actuary or accountant familiar with the details of your organization’s risk management program.

Footnotes

1. Unpaid loss equals 100% minus the percent of loss paid-to-date.
2. The combined increase is 8.16% per year (= 1.04 x 1.04 – 1).

What is IBNR?

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This article examines the various components of IBNR for self-insured organizations.

A self-insured’s individual claim reserves typically compose a significant, but not complete portion of its overall loss reserve liability. Rarely are case reserves sufficient to fund all expected future payments. Therefore, an additional reserve component is necessary to recognize expected future payments not considered in the case reserves. This additional component, called IBNR, is calculated for a portfolio of claims. In other words, it is not calculated on an individual claim basis, but rather, in aggregate.

IBNR is short for “Incurred but Not Reported” and is sometimes referred to as “unreported loss”. It is inherently composed of the following key elements, though they are usually not individually quantified:

  • Case reserve development
  • Late reported claims
  • Reopened claims
  • Pipeline claims

Depending on the context, the term IBNR may be used to include claim related expenses such as ALAE and ULAE. This article will focus on the general characteristics of IBNR. More information on expense-specific versions of IBNR (ALAE IBNR and ULAE IBNR) can be found here.

The components of IBNR are examined in more detail below.

Case Reserve Development

Adverse case reserve development is usually the largest component of IBNR. Despite claims administrators’ best efforts to estimate future claim payments, on average, case reserves tend to be inadequate. Below are several common causes of adverse (upward) development of case reserves.

  • Insufficient or inaccurate claim information – Determination of insured liability is rarely straightforward. The amount and quality of available information will affect the claims administrator’s ability to accurately determine future expected payments.
  • Newly reported claims – Generally, little information is known about claims that have been recently reported. It may take several months for claims administrators to gather and process enough information in order to establish and record a case reserve. Most claims administrators will establish a relatively small case reserve as a “placeholder” on newly reported claims before the initial claims review is complete.
  • Claims inflation – Case reserves rarely consider future claims inflation. This is particularly relevant in workers compensation wherein medical inflation can be significant and sustained for many years over the course of a claimant’s treatment.
  • Changes in medical condition – for workers compensation, a significant source of adverse case reserve development stems from adverse changes in the injured worker’s medical condition. A claims adjuster cannot reasonably be expected to anticipate such changes.
  • Optimism – case reserves may be set too low due to the intentional or unintentional influence of optimistic expectations set by legal counsel or company management.

Late Reported Claims

Late reported claims describe accidents that 1) occurred on or prior to the accounting date1 and 2) have not been reported on or prior to the accounting date. These claims are sometimes called “pure IBNR” since they allow for a more literal interpretation of expression “incurred but not reported”.

Reopened Claims

The status of a claim as either “open” or “closed” is subject to the judgment of claims administrators and the influence of claims management policies. A claim with a “closed” status will generally have no case reserves as no future payments are expected. A reopened claim is a previously “closed” claim that is once again opened (and case reserved) to provide for the possibility of future payments. This component generally represents a small portion of IBNR.

Pipeline Claims

Pipeline claims are also called “reported but not recorded” claims. As the latter name suggests, these claims relate to accidents have been reported to the organization, but have not yet been formally recorded as claims. This class of claims exists simply due to processing or timing lag and generally represent a small portion of IBNR.

Disclaimer: Information presented in this article should not be relied upon as actuarial or accounting advice, which should be provided by a credentialed actuary or accountant familiar with the details of your organization’s risk management program.

Footnotes

1. “Accounting date” refers to the evaluation date of the reserve analysis. For example, the accounting date would be December 31, 2018 for a year-end 2018 financial statement.

Loss Reserve Components

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This article examines the various components of loss reserves for self-insured organizations.

It is often convenient to use the term “loss reserves” in a general way to describe loss and expense reserves. This shorthand makes communication easier, but it is important to identify the precise elements included in the reserve being considered.  This article will identify and define the reserve components commonly encountered by self-insured organizations.

Background Terminology: Losses and Expenses

Before discussing reserve components, it may be useful to review the claim payment types that give rise to the need for loss reserves. Claim payments can be classified into two major groups: losses and expenses. Losses are those amounts paid directly to a claimant or to a third-party on behalf of the claimant. Expenses are the remaining costs incurred in the administration of a claims program.

Further, claim expenses can be summarized into two main categories: allocated and unallocated. Allocated loss adjustment expenses (ALAE) are those costs that are directly attributable to a specific claim. Examples of ALAE include legal costs, fees paid to investigators and outside experts, and costs related to medical bill reviews. Unallocated loss adjustment expenses (ULAE) are those costs not directly attributable to specific claims. ULAE can be thought of as overhead expense. Loss adjustment expense (LAE) refers to all expenses related to the administration of a claims program. LAE equals ALAE plus ULAE.

Loss Reserve Components

Loss reserve components can be classified by payment type (loss, ALAE or ULAE) and by the source of the reserve estimate (individual claim or actuarial). Table 1, below, presents loss reserve components organized by payment type and source of estimate.

Loss Reserve Components

Case Reserves

When a potentially insurable accident is reported to an organization or its third-party claims administrator, a claims handler will review the details of the incident to help determine insurability. If an accident is determined to be covered under the insurance policy and thus compensable, the claims administrator will establish a case reserve. A case reserve is an estimate of future loss payments related to an individual claim. Although case reserves are established on an individual claim basis, the term is used in a similar way to describe the aggregate liability of a portfolio of claims as determined by the claims administrator.

ALAE Case Reserves

Claims handlers may or may not estimate future ALAE payments related to individual claims. When they do, an ALAE case reserve is established. In common usage, the term “case reserves” may refer to case reserves for losses or case reserves for both losses and ALAE.

IBNR

A self-insured’s individual claim reserves typically compose a significant, but not complete portion of its overall loss reserve liability. Rarely are case reserves sufficient to fund all expected future payments. Therefore, an additional reserve component is necessary to recognize expected future payments not considered in the case reserves. This additional component, called IBNR, is calculated for a portfolio of claims. In other words, it is not calculated on an individual claim basis, but rather, in aggregate.

IBNR is short for “Incurred but Not Reported” and is sometimes referred to as “unreported loss”. It is inherently composed of the following key elements, though they are usually not individually quantified:

  • Case reserve development
  • Late reported claims
  • Reopened claims
  • Pipeline claims

These components are discussed in more detail in this article.

ALAE IBNR

ALAE IBNR is similar to IBNR, discussed above, except that it relates specifically to the ALAE payment type. IBNR is yet another term that is often generalized to encompass a broader definition. Depending on the context, IBNR may refer to loss-only IBNR, or some combination of IBNR, ALAE IBNR, and ULAE IBNR.

ULAE IBNR

ULAE IBNR relates specifically to the ULAE payment type. Since ULAE reserves are never established on an individual claim basis1, ULAE IBNR represents total ULAE reserves. . IBNR is yet another term that is often generalized to encompass a broader definition. Depending on the context, IBNR may refer to loss-only IBNR, or some combination of loss-only IBNR, ALAE IBNR, and ULAE IBNR.

Common Usage

In self-insured reserving applications, “loss reserves” most often refer to “Loss and ALAE Reserves” as illustrated in Table 2.

Loss Reserve Components -table2

Somewhat less frequently, “loss reserves” refer to “Loss and LAE reserves” as illustrated in Table 3. An example of this definition is the one specified by the California’s Office of Self-Insurance Plans (OSIP) for qualified self-insurers of workers compensation.

Loss Reserve Components -table3

 

Disclaimer: Information presented in this article should not be relied upon as actuarial or accounting advice, which should be provided by a credentialed actuary or accountant familiar with the details of your organization’s risk management program.

Footnotes

1. By definition, ULAE refers to claim costs that cannot be allocated to an individual claim.

An Introduction to Loss Reserves

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This article provides a brief introduction to loss reserves for self-insured organizations.  

Many organizations self-insure liability exposures such as workers compensation, general liability, automobile liability, or medical malpractice. Self-insurance can assume various forms, such as liability retained through a high deductible policy or an excess policy. Regardless of the self-insurance mechanism it employs, the organization must recognize the resulting obligation for future loss1 payments as a liability on its balance sheet. This liability is commonly referred to as a loss reserve or “loss accrual”. In short, the purpose of a loss reserve is to help ensure that an organization has sufficient assets available to make any necessary payments related to it self-insured exposure.

It is important to recognize that a loss reserve is an estimate of future uncertain events. In order to better understand the nature of loss reserve liabilities, it helps to examine the characteristics of the underlying insurance obligations. For a self-insured, potential liabilities arise from insurable accidents. A significant period of time often elapses between the date of the accident and the date of any loss payments. This lag gives rise to the need for loss reserves. Typically, a loss reserve established at a specified date is required to provide for all future expected loss payments related to accidents that have occurred through that point in time. Since the magnitude of future loss payments are rarely known with certainty, it is necessary to estimate these amounts.

Organizations that purchase guaranteed cost insurance transfer the liability for insurable accidents to the insurance carrier. These organizations generally have no need to establish loss reserves. Also, some organizations may choose not to carry loss reserves if the magnitude of the liability is considered immaterial or cannot be reasonably estimated. In such cases, the organization should be careful to comply with all applicable accounting and state-specific regulatory requirements. Organizations that do carry loss reserves often rely on the services of an actuary to determine the appropriate amount. In addition to accurately quantifying loss reserves, a good actuary can help an organization better understand and manage its risks.

Learn more about the components of loss reserves in this article.

Disclaimer: Information presented in this article should not be relied upon as actuarial or accounting advice, which should be provided by a credentialed actuary or accountant familiar with the details of your organization’s risk management program.

Footnotes

1. In this article, the term “loss” is used in a general sense to refer to loss and expense payments. This article provides more information on the types of claim payments and claim expenses commonly considered in the reserving process.

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