Why Are Claim Reserves Necessary?

Insurance is characterized as an "intangible" product because the insured does not receive anything material or tangible for his or her premium dollar until a claim is paid. The payment of a claim is what consummates the insurance contract. It is especially important, therefore, that when claims become due, money is available to meet those obligations. Insurance companies are regulated for solvency so that they will be able to pay claims in the future.

With respect to liability claims, and particularly bodily injury liability claims, years may pass before a claim is paid. This might be due to the fact that time is needed for the injury to heal or because the claim is in litigation. Because of the extended time involved before such claims are finally settled and closed, bodily injury liability claims are sometimes referred to as "long tail"" claims.

Since an insurer has an obligation to pay covered claims, it is understandably important that funds be available for this purpose when claims are ultimately settled.

Claim reserves are necessary to properly recognize, at any given time, a company's future obligations.

The importance of proper reserving is further demonstrated by the fact that claim reserves are required by insurance regulatory law. In addition, the reserving practices of companies are periodically audited by state insurance departments in an effort to recognize potential problems and to take corrective action to avoid company insolvencies.

Improper reserving, both under-reserving and over-reserving, adversely affect a company's financial position. Inadequate reserves understate a company's liabilities and overstate its surplus. The following example, although admittedly an oversimplification, should help demonstrate the effect of under-reserving.

A basic accounting principle is that assets minus liabilities equal surplus.

In this hypothetical example, assume that assets are $1,000 and liabilities are $750. For purposes of illustration, assume further that liabilities are comprised totally of claim reserves.

Suppose, however, that this particular company has a serious under-reserving problem, and as claims are ultimately settled, they actually cost $950, instead of the $750 originally estimated.

Under these circumstances, the balance sheet would appear as follows:

It is evident here that as claims are settled, the company must draw from its surplus in order to meet its claim settlement obligations. If such a situation continues unchecked, and surplus is depleted, the company faces insolvency.

In addition to the fact that inadequate reserving understates the company's liabilities and overstates its surplus, it also may have a negative effect on rate making. Since reserves are an integral part of rate making, inadequate reserves can result in rates that are lower than they should be and this may hasten a company's decline.

Over-reserving can create problems as well. Over-reserving understates a company's financial strength and may create the false impression that rate increases are necessary or justified. In addition, since earnings are understated, the company pays less taxes. A company suspected of over-reserving invites audits by the tax authorities that could result in penalties being assessed against it.

In summary, claim reserves are necessary to properly recognize a company's future obligations. Proper reserving is important in order to accurately reflect a company's financial position. The importance of proper reserving is further demonstrated by the attention given to companies' loss reserving practices by the various state insurance departments.

Proper and realistic case reserving is one of the primary responsibilities of the claim department. Who sets the reserve, whether it be the adjuster, supervisor, or manager, is determined by individual company claim policy. Regardless of who sets the reserve, however, the claim adjuster is in an ideal position to furnish the kind of information necessary to set accurate and realistic case reserves. This necessary information includes the adjuster's opinion of legal liability, nature and extent of the injury or damage, medical bills, and so on.

Precisely when in the life of a claim a case reserve is established varies by company and by line of insurance. Some companies require that case reserves be established immediately after the initial investigation is completed or within 30 days from notice of claim. Other companies defer setting case reserves for as long as three or even six months, so that sufficient information can be obtained to set a relatively realistic reserve. Until that time, these claims usually carry an average reserve.

The more specific information the adjuster obtains about the loss or claim, the more accurate the reserve will be. With the necessary information, the person responsible for setting the reserve can make a fairly accurate assessment of the company's exposure and decide upon a monetary figure that represents the ultimate cost of the claim.

In those cases in which little or no payment is contemplated, such as where the insured's liability is doubtful and the case will be defended or settled on a compromise basis, the expense factor must be considered. An expense reserve is usually established to reflect the fact that considerable investigative and legal expenses will be incurred to defend the claim.

One of the problems with setting case reserves for a bodily injury claim is that it is difficult to estimate the ultimate cost of a claim with only limited information about the injury and no specific indication of how and to what extent the injured person will recover. In addition, important information about the claim or injury may not be known at the time the reserve is established. A turn for the worse in the claimant's injury, for example, may render the initial reserve inadequate. Or a witness adverse to the insured's position may be discovered later in the life of a claim.

The following hypothetical example or analogy might help newer claim people understand the case reserving process more clearly:

Assume that a family of four is planning a 10-day vacation that will include driving to a resort area several hundred miles from home. The family estimates that the entire vacation will cost $5,000. This includes meals, hotel, gasoline, tolls, and some fun money. Will the family simply budget for $5,000? Maybe, maybe not. It is evident that there is an element of uncertainty in making a trip of this nature, and unforeseen events could arise that increase the cost of the vacation. What if the car breaks down on the way? What if a family member gets sick and must be taken to a hospital emergency room? What if the driver gets ticketed for speeding?

For these reasons, it usually is necessary to carry additional funds (or add in a cushion for safety) to meet these potential contingencies. In all likelihood, the family will budget some extra amount for unforeseen contingencies, perhaps $5,500 or $6,000.

Although the family will try to keep within its $5,000 budget, chances are that the cost of the vacation could exceed the $5,000 estimate. Likening this to a claim reserving situation, some claim people may use the $5,000 as a reserve while others take a more cautious or conservative view and add in an allowance for uncertainty, and might reserve the claim at $5,500 or $6,000.

Case reserves should be checked periodically. Although most companies prefer that the initial reserve accurately reflect the ultimate probable cost of the claim, reality suggests rather strongly that reserves need to be adjusted periodically. As new developments occur in a claim, whether favorable or adverse, reserves should be revised to reflect those developments.

Claims reserving should also include Incurred But Not Reported Claims (IBNR) -

Frequently, losses or accidents that have already happened are not reported for weeks, months, or even years after the incident. This is quite common after a catastrophe such as a hurricane or tornado, when early on the company does not know with any accuracy the number or amount of claims that will be generated as a result of the catastrophe. It knows losses have been incurred, but realizes that many of those losses will not be reported immediately. In such cases, it estimates the losses it believes to have been incurred but not yet reported. Despite the fact that these claims have not been reported, they are incurred from the company's standpoint when they happen. Hence, the phrase "incurred but not reported" is used to describe this type of reserve.

With regard to liability claims, accident reports may be delayed for a variety of reasons. Aside from the normal time lag in reporting claims, the insured may be initially unaware that insurance coverage is available for the claim or the claimant may not immediately recognize that the policyholder may have been responsible for the accident. Products liability, medical malpractice, and latent disease claims (i.e., asbestos or lead-related claims) where injuries may not be evident for years after the occurrence or exposure, have magnified reserving problems associated with properly estimating IBNR reserves.

Whatever the reason for the delayed report, it is reasonably safe to assume that a company always has outstanding claims that have not yet been reported.

Estimates for IBNR reserves ordinarily are based on past experience, to the extent possible. They may be further modified by what actuaries believe are relatively certain projections regarding claim frequency and severity. With respect to catastrophe losses, the claim practitioner can estimate the areas (states, counties, etc.) and number of insured's who may have sustained damage to arrive at an IBNR reserve, which may change from month to month.

Conclusion

Although claim case reserving philosophy may vary by company, regardless of the methods used, accurate claim reserving is a major component of the overall claims process. Not only does it serve as a measure of a company's financial health, but it provides a picture of claim trends and assists underwriters in determining whether pricing is realistic or whether action is needed to improve results. It may be the primary responsibility of the claim department, but claim reserving affects the entire company. An awareness and understanding of reserves by the various functional departments contributes to more informed and effective collaboration in gauging potential outcomes and taking the proper steps to improve overall results.