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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.