Setting Loss Reserves What You Don t Know Can Hurt You

Transcription

1 Setting Loss Reserves What You Don t Know Can Hurt You Robert L. Johnson, Marsh Paul J. Struzzieri, Milliman, Inc. Magali Welch, Johnson Lambert & Co. Monday, March 8 th 3:10 4:30 PM

2 Components of Loss Reserve Estimate of ultimate cost of settling claims Includes paid and future claim costs Future claim costs include: Case Reserves expected payments on insured events that have occurred and have been reported (but not paid) Incurred But Not Reported (IBNR) expected payments on insured events that have occurred but have not been reported (also includes future changes in case reserves) Allocated Loss Adjustment Expense (ALAE) Defense, Cost Containment, other expenses allocable to individual claims Unallocated Loss Adjustment Expense (ULAE) Claims adjusting expenses; not allocable to individual claims

3 Loss Reserving Process - Roles & Responsibilities Captive Management Actuary Auditor

4 Roles and Responsibilities Captive Management Captive owner should annually reappoint an approved actuary in their domicile. Most often, this is at the annual board meeting. Provide actuary with current claims and exposure data in an organized and timely basis. Board should address the reserve/funding study and reserving philosophy, i.e., confidence level, point within the range. Focus on consistency and business trends. Captive Manager will book all reserve types to the captive s financials and communicate movement via monthly/quarterly financial statements and annual audit.

5 Roles and Responsibilities Appointed Actuary Talk to management about changes in captive s exposures, operations, etc. Conduct an actuarial analysis of unpaid claim liabilities using data as of the annual financial statement date At least annually; if not more frequently Based on this analysis, determine whether or not the recorded reserve is reasonable Issue a Statement of Actuarial Opinion (SAO) Help management understand trends, risk factors and variability around the reserve estimates

6 Roles and Responsibilities Auditor Express an opinion on the financial statements which includes the liability for losses and LAE (fairly presented in accordance with GAAP or SAP) Actuary is independent Review appointed actuary s analysis Understanding of the coverage (lines of business, limits, reinsurance ) Methodologies Test the data used (paid, case, payroll, # of beds )

7 Why is the Loss Reserving Process So Important? Loss (including LAE) reserves = largest liability item Typically more than 70% of total liabilities Typically more than 130% of capital and surplus Loss reserves are highly variable; a small deviation from recorded loss reserves could result in: Larger change in surplus Large change in current year net income (e.g., adverse development in loss reserve for prior years could wipe out current year s profits)

8 Reserves: Highly Variable Variability comes from 3 sources: Source 1: Random nature of the insurance claims process, i.e., variation from the expected loss. Source 2: Uncertainty in the measurement of expected loss reserves. Source 3: Unanticipated unusual events

9 Reserves: Highly Variable Variability comes from 3 sources: Source 1: Random nature of the insurance claims process, i.e., variation from the expected loss. Expected means average - Captives will not get the average number of claims each year and not every claim will be of average size. Other measures of loss reserves: Median (=50th percentile) Half the time the results will be higher than the median; half the time the results will be lower. Higher percentiles 60%, 75%, 90%, etc. The Expected loss is typically greater than the 50 th percentile Next few slides assume we are trying to estimate the Expected loss

10 Probability Sample Loss Distribution 50 th Percentile 25 th Percentile 75 th Percentile Mode Expected Value Median Estimated Liability

11 Reserves: Highly Variable Variability comes from 3 sources: Source 2: Uncertainty in the measurement of expected loss reserves o o The true expected losses are not known and therefore must be estimated With a range of estimates of expected losses, there is a better chance it includes the true value

12 Uncertainty in Measurement a. Actuary can provide a range of reasonable estimates b. A range of reasonable reserve estimates is a range that could be produced by appropriate actuarial methods or alternative sets of assumptions that the actuary judges to be reasonable. c. High and low ends of the reasonable range do NOT imply an absolute best and worst case outcome Range of possible outcomes can be much wider d. Management selects a best estimate within the range Unfortunately, you cannot book a range of reserves!

13 Reserves: Highly Variable Variability comes from 3 sources: Source 3: Unanticipated unusual events o o o o Shock losses Catastrophes Unanticipated court decisions Law changes

14 Management s Decision: What Number to Book SSAP 5 - If the likelihood that a claim liability has been incurred is probable; and the amount of the liability can be reasonably estimated, then a loss reserve must be recorded. Two possibilities from which to select the reserve to book to the captive s financials a. Based on confidence levels; or, b. Book to a point within a range of reasonable estimates (of expected losses)

15 Management s Decision: What Number to Book Considerations for reserving at higher or lower confidence levels: 1. Regulators will not allow to book below expected level 2. If higher, better solvency regulation but you could have IRS concerns if you violate risk transfer 3. If lower, assuming that funding = reserving, you may not build surplus fast enough to cover an adverse year Implications of booking outside the range Probable regulatory, audit and actuarial concerns

16 Management Considerations When Selecting From Within a Range When the actuary provides a range, management is presented with the opportunity to select their best estimate within the range The auditor will look for consistency in the selection made by management from year to year Appropriate explanations will need to be provided for a significant move in within the range

17 Example 1 = ABC Ins. Co. Low Central High Actuarial 12/31/08 9,800 13,000 20,000 Company 12/31/08 18,200 $ Difference from Central 5,200 Booked as % between Central and High 74% Actuarial 12/31/09 10,000 15,500 23,000 Company 12/31/09 22,500 $ Difference from Central 7,000 Booked as % between Central and High 93%

18 Management s Reasons for Moving within the Range Company ABC- Increase Reserve Our policyholders (doctors) have been prescribing more antidepressant medications during the past few years, which have been shown to have harmful side effects. We are concerned with an increase in both the severity and frequency of claims due to the effects of these medications. We believe by using historical data to estimate the current loss reserve, the reserve for the past few years are understated and we have increased our recorded reserve to account for this potential increase risk.

19 Example 2 = XYZ Ins. Co. Low Central High Actuarial 12/31/08 1,800 2,200 3,000 Company 12/31/08 2,200 $ Difference from Central 0 Booked as % within the Range 0% Actuarial 12/31/09 2,000 2,500 3,300 Company 12/31/09 2,200 $ Difference from Central (300) Booked as % between Central and Low -60%

20 Management s Reasons for Moving within the Range Company XYZ- Decrease Reserve - Early in 2008, we implemented new loss controls to prevent falls in the workplace. This year and the later part of 2008, we have seen a decrease in reported claim count. We believe our total reserve for policy years 2008 and 2009 are overstated since our actuary is using historical data to estimate the reserve. Additionally, our actuary has been reluctant to decrease reserves to take into account the newly implemented loss controls, until there is more data to evidence the positive effect of our loss controls.

21 Real Example of Reserve Variability Hindsight review of loss reserves for RRGs RRGs were selected because financial data is publicly available (i.e., yellow books ) Data for 128 RRGs used * 2004 annual statement reserves Accident years 2004 and prior reserves (as of 12/31/04) Using the recorded reserves as of 12/31/08: what are the restated reserves for these RRGs? * Excludes insolvent RRGs and other companies in run-off and no longer reporting

22 RRG Reserve Variability - Results Percentage Increase or Decrease in Reserves % of RRGs Favorable Development of 80% - 100% 18.8% Favorable Development of 60% - 80% 7.8% Favorable Development of 40% - 60% 9.4% Favorable Development of 20% - 40% 18.0% Favorable Development of 0% - 20% 18.0% Adverse Development of 0% - 20% 11.7% Adverse Development of 20% - 40% 4.7% Adverse Development of 40% - 60% 4.7% Adverse Development of 60% - 80% 3.9% Adverse Development of 80% - 100% 0.8% Adverse Development of > 100% 2.3%

23 RRG Reserve Variability - Conclusions The variation of actual results from the recorded reserves was very significant Some companies reserves almost completely went away (i.e., close to 100% favorable development) Some companies reserves increased tremendously (> 100%) Over two-thirds of the RRGs experienced deviations of more than 20% (+ or ) from carried reserves More companies had favorable development than unfavorable development Good luck (random insurance process) or higher confidence levels? Our sample excluded insolvent RRGs and other companies in runoff who are no longer reporting results should have been worse

24 GAAP Accounting Guidance GAAP ASC 944 Financial Services-Insurance- Insurance activities (FAS 60) Liabilities are accrued when insured events occur Estimate of ultimate cost of settling claim Changes in estimates over time as more data emerges Recoveries Salvage and subrogation Loss adjustment expenses (ALAE, ULAE), Defense and Cost Containment (DCC), and Adjusting and Other (AO) Must be accrued when the related liability for unpaid claims is accrued

25 Statutory Accounting Guidance SSAP 55 Unpaid Claims, Losses & LAE Best Estimate (Similar to GAAP) In rare occasions, where a best estimate cannot be identified within a range, midpoint should be recorded ULAE cradle to grave, NAIC INT 02-21

26 Internal Controls over Losses Management needs to establish controls to ensure errors and fraud are prevented or detected and corrected associated with the following risks: Paid loss and LAE transactions do not reflect valid authorized transactions, or are improperly recorded Loss and LAE payments may have occurred but are not be recorded in the GL Case reserves are not appropriately established and recorded Losses may be reported but not be are not recorded in the GL

27 Internal Controls (continued) Management needs to establish controls to ensure errors and fraud are prevented or detected and corrected associated with the following risks: The total recorded liability for losses and LAE (case and IBNR) is not fairly stated in accordance with STAT or GAAP Bias in estimating amount Failure to use appropriate actuarial techniques Data used by actuary in valuing reserves is inaccurate Assumptions used by actuary are not appropriate Actuary had an inaccurate understanding of the some aspect of the insurance program

28 Audit Testing To support significant estimate, the auditor will Read the Statement of Actuarial Opinion & report Review and test actuarial methodologies Test significant data (exposure data, i.e.. payroll, sales, bed equivalents, etc.) Agree incurred losses to loss register Paid and case reserves Gross and net of reinsurance, by line of business, by policy year)

29 Considerations for the Captive s Board of Directors and Audit Committee Captive owners, actuaries, auditors should communicate Gain an understanding of the loss reserving process so that you can articulate the natural uncertainty of the science. Consider the pros and cons of booking to a confidence level vs. a range for your captive. Maintain historical reserving analysis for past accuracy. Graphs and charts do a great job here and can foster wonderful conversations during board meetings and more. Key management statistics loss ratios, etc. Stay current on industry trends via your service providers, periodicals, domicile associations and industry conferences.

30 Considerations for the Captive s Board of Directors and Audit Committee Benchmarking Against your own prior results Against captive industry Select geography, peers, industry type, etc. Any CAT (or other unusual) events. Test the impact with and without. Use of company data vs. industry/benchmark data Have changes in claims managers, philosophy or process been reflected in actuarial analysis? Changes in exposures of the captive Changes in laws, landmark court decisions Better communication can lead to a better appreciation of the financial risks and uncertainties facing your captive

31 Questions and Answers