Best's Review



Loss Reserve Trends
Approaching the Line

Insurers have relied on reserve releases to bolster earnings, but that time may be coming to an end.
  • Kate Smith
  • November 2018
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When David Flandro began covering the insurance sector for an investment bank in the early 2000s, his first job was to monitor loss reserve trends.

Now the global head of analytics for JLT Re, Flandro is still tracking loss reserves. Flandro is part of a JLT Re team that studied 20 years' worth of loss reserve data from the top global property/casualty insurance companies. JLT Re initially released the findings in 2016, and in September it updated the results with the most recent loss reserve numbers.

While Flandro is quick to agree that loss reserves have been and remain mostly redundant, his research suggests the industry is inching toward the even mark and could be approaching a period of net deficiencies.

Flandro spoke to Best's Review about the findings.

David Flandro, JLT Re

David Flandro, JLT Re

Many in the sector these days have never experienced reserve strengthening. We’ve been in an environment of redundancies for such a long time.

Most in the industry say loss reserves have been a non-issue. How did you come to a different conclusion?

Flandro: When actuaries and equity analysts look at reserves, they normally review accident year trends. One of the problems with this is that if you're looking at longer-tail claims—workers' comp, general liability, commercial auto, umbrella—and you're reviewing a recent accident year, say, 2017, there won't have been much time for losses to develop. You can't really draw meaningful conclusions about what is happening with recent accident years on long-tail business.

To get a broader view, we decided instead to look at calendar year or accounting year reserving. And not only accounting year, but accounting quarter. We looked at every quarter going back to 1998. And we looked at the top 30 global property and casualty companies. The global nature of the study was an important bonus. Detailed accident year data are usually only available in the U.S. and a few other countries. Accounting year data are available virtually everywhere.

We took all of the biggest global P&C companies and averaged their calendar year reserve development. A calendar year is an amalgam of many accident years, and it is the calendar year that comes through in quarterly earnings. So we looked at every single 10-K, 10-Q, IFRS annual statement, RNS statement, conference call transcript, presentation, etc., for every one of these 30 companies going back every quarter for over 20 years. That's 84 quarters.

It's a huge undertaking, but we did it because we wanted to see how reserves developed in aggregate and on average for every quarter of the last two decades.

What did you see?

Flandro: What we see is that in the very late '90s and early 2000s the sector became self-evidently too cavalier with its reserve releases. In fact, we can now see deficient accident years in 1998 through to 2002, and at the same time, we can see most carriers releasing reserves into earnings during this very period. This is what some people call the cheating phase and it is now crystal clear with the benefit of hindsight.

Some call this cash flow underwriting—that is, “get the premiums in the door and we'll price the business accordingly.” It was competitive underwriting and aggressive reserving. And it caused a liability crisis.

The liability crisis was driven by many things—asbestosis for one, but also by aggressive underwriting and under-reserving. The consequence of this under-reserving was that calendar years 2001, 2002, 2003, 2004 and 2005 suffered from growing and eventually devastating reserve strengthening. I believe that most carriers panicked and proceeded to strengthen reserves too aggressively in the wake of this. There was a large, detrimental effect both on earnings and on capital with long-term consequences for the sector.

It wasn't until fourth quarter of 2005 that reserving finally began to have a positive effect on carriers' earnings, on average.

How did that affect the industry?

Flandro: We think that cost the insurance sector well over $300 billion in capital over that period. It was massively expensive—more expensive than Hurricane Katrina or last year's hurricanes, and five times more expensive than most catastrophe years. In fact, one of the results of the liability crisis was psychological. A great deal of trust in what were called “best estimates” was lost.

Starting in about 2003, companies began to over-reserve on an accident year basis, and that over-reserving then flowed through to earnings, as I've said, in 2005. Those redundant reserves got more and more redundant in '05, '06, and '07, on a calendar year basis, all the way through '09.

The first or second quarter of 2009 was the peak of reserve redundancies.

What has the trend been since then?

Flandro: Ever since then, we've stayed redundant, usually comfortably so. But the redundancies are getting less and less. Not every quarter, but if you look at the trend we're getting back up closer to the line.

The fourth quarter of 2016 was the first time since the third quarter of 2005 that the sector recorded net deficiencies. The third and fourth quarters of 2017 were very close to the line, although we've come back down a bit in the early quarters of 2018. But the point is, we're very close to that line now.

So yes, we're still redundant. But that doesn't mean everything is fine. The long-term trend seems to show we are getting less redundant and we could, soon enough, again get into a position of deficiency.

Has the industry—or certain lines of business within the industry—taken action on this?

Flandro: If you look at certain lines of business—U.S. commercial auto, some general liability lines and umbrella lines—you can see that since the second quarter of 2017 there have been clear pockets of price increases. This is an important development. During the long period of reserve redundancies, from 2005-2010, prices did nothing but go down. After 2010, they started to increase a little, but then fell again.

If pricing is a reflection of reserving in any way, market prices are telling us something, and I think it is clear: Reserves aren't as redundant as they used to be. That's what our analysis is saying; reserves in general are still redundant if you take a snapshot, but if you go back 10 years and watch the movie, you can see that reserves are becoming less redundant over time.

Is it hard to course correct once we cross that line?

Flandro: If we start to get over the line, certainly we will again see reserve strengthening —we're seeing incidents of it now. A broader sector shift could prove painful. Reserve strengthening hurts earnings and increases capital costs. Underwriting discipline is therefore particularly important at this point in the cycle.

Many in the sector these days have never experienced reserve strengthening. We've been in an environment of redundancies for such a long time. If you have to strengthen reserves in an environment where your accident year combined ratio is around 100, it means you're no longer making money on underwriting. And in the environment we're in today, with low yields, if we strengthen reserves and lose money on accident year underwriting, we're certainly not going to make it up on investments.

Have insurers become dependent on reserves to bolster earnings? And is there concern around what will happen when they don't have reserves to release?

Flandro:We've had large losses both in the cat market and on the asset side with the financial crisis over the last 10 years. Reserve redundancies have helped. We've had low interest rates and low yields on investments. All of these things depress earnings. We have become somewhat dependent on reserves and we're getting closer to a point where we will not be able to rely on that.

What steps should insurers be taking to preserve their position?

Flandro: Everything starts with underwriting discipline. But if you want to trade through this and you need to underwrite, risk transfer is incredibly important right now.

We're seeing a larger demand for loss portfolio transfers, adverse development covers, stop-loss products—all reserving protection products—structured products, and legacy deals. I am seeing more of this right now than I have seen in my broking career, which began in 2006. There's no frenzy of demand, but there is a solid pipeline of these things and these deals are taking place in a way that they weren't a few years ago.

Do you expect that trend to continue?

Flandro: I see no sign of it abating. Obviously the world can change quickly. We could get into a situation where inflation falls unexpectedly; there could be a massive slowdown in economic growth that's unanticipated. There are always the macroeconomic factors that can intervene. But if we stay on the track we're on now, I anticipate no abatement at all.

Are those macroeconomic factors more likely to affect reserving than, say, the next asbestos-type event?

Flandro: Both things are really important. I would say asbestos is a micro factor, where interest rates, yields, inflation and GDP are macro factors. And both affect reserves. Micro factors can emerge and surprise, as happened with asbestos in the '90s and 2000s. There could be another looming micro factor out there that could emerge and surprise us. Cyber comes to mind.

But for me the macro stuff is really important right now. Since the financial crisis we've been in an environment where it has been assumed, rightly, that inflation wouldn't be very high, that yields would be low, that growth would be subdued, and that there would be plenty of liquidity. We've come to rely on that for the last 10 years. But it's starting to change a little bit right now.

We are now in an environment of very strong economic growth and low employment, which usually means inflation. Inflation usually means higher interest rates and worsening claims experience.

Many people in the sector may be looking at the last 10 years and projecting them into the future, believing that the environment we've just lived through is the new normal for the world we live in. But we may yet be entering a 'new, new normal' macroeconomic cycle. And that's going to have an effect on reserves.

Reserving Judgment

Loss reserves have been benign for a decade. Years of cautious reserving, prompted by the liability and financial crises, have left the industry over-reserved.

An estimate of an insurer's liability for future claims, loss reserves typically are the largest number on a company's balance sheet.

“The goal of reserve estimation, the academic exercise we undertake, is to come up with the best guess,” Aaron Koch, a principal and consulting actuary at Milliman, said. “Sometimes we'll guess too high and there will be reserves that can eventually be released.”

When losses aren't as large as anticipated, insurers will release reserves back into their earnings. Doing so has bolstered profits in recent years, as carriers have used reserve releases to compensate for low investments, soft market prices and elevated catastrophe losses.

Greg Fears, Pinnacle

Greg Fears, Pinnacle

The trend over the last 10 years is that reserves have been releasing year after year.

“The trend over the last 10 years is that reserves have been releasing year after year,” said Greg Fears, a consulting actuary with Pinnacle.

Since 2010, roughly $60 billion of loss reserves have been released into earnings, according to Stephan Hochburger, senior vice president at Munich Reinsurance America. That equates to 20% of all earnings in that time period.

“When you look at the past five, six, seven years and you look at the returns that we were able to achieve on a calendar year basis, a lot of that had to do with the release of loss reserves,” Hochburger said. “Now, I would argue that the time of major loss reserve releases is probably coming to an end.”

When you start digging into individual lines of business, evidence of a shift is emerging. The picture isn't rosy for all business segments.

“You see certain lines of business where the reserves have been released year after year. But then you have lines of business where they're having adverse development, so reserves are increasing,” Fears said. “In our analysis this past year, we have seen the majority of the lines of business have been releasing reserves. But there are a few lines of business that have been experiencing adverse development.”

Commercial auto, in particular, has been problematic.

Jennifer Marshall, director of P/C reinsurance and large commercial at A.M. Best, sees several issues at play in commercial auto lines.

“Distracted driving is certainly a cause of a lot of accidents,” she said. “There are also changes in the technology and construction of vehicles that have impacted accident frequency and severity. Technology can help in collision avoidance but increase the cost to repair a vehicle. Using lighter construction materials to improve gas mileage may be increasing damageability and severity.”

Fears cited an increase in miles driven and higher repair costs as key factors in commercial auto's performance.

“Two-day shipping. That's a big thing,” Fears said. “What that means is that there is no longer one warehouse that ships all of the packages. There has been a move to having more distribution centers around the country. So you have more short-haul deliveries, and you have more miles traveled.

“You can see that in the industry. There are more trucks on the road. They're driving more miles, but they're going shorter distances.”

With the evolution of technology, vehicles are also getting more expensive to repair.

“If you have damage to a vehicle, you have to repair not only the bumper, but the 10 or 15 sensors that are in it.” Fears said. “So it's not an inexpensive repair anymore.”

Marshall said rate increases have slowed, but not stopped, adverse development trends.

“Companies have gotten some substantial rate increases that have slowed the increase, but we do continue to see the adverse development,” Marshall said. “Despite rate increases, companies are having a difficult time getting ahead of what's happening. They just can't get enough rate to improve results meaningfully.”

Commercial liability is another area of concern, Hochburger said.

“We've seen loss trends going up steadily,” Hochburger said. “We see an increase in litigation. The median awards have doubled since 2010, the jury awards. More cases than ever are going to trial. It's an area that we're watching very carefully and has us concerned not just for us, but for the entire industry.”

It's not just Munich Re that is eyeing commercial lines with caution. “If you look at VJ Dowling, if you look at Conning and other estimates, they have commercial liability results in the 105 level, commercial auto in the 110,” Hochburger said. “That would indicate to me that reserve releases will not be easy to come by.”

Fears said one of the often-overlooked risk factors for adverse development lies within a company's walls. It's change. Changes in claims departments—whether it's how they handle claims, settle claims or even the philosophy of how they settle claims—can have a significant impact on reserves.

“When you're looking at historic information to predict the future, and the process they've been using in the past is changing, how accurate is that past information going to be in predicting the future?” Fears said.

Though loss reserves have not been a problem for most lines, accurate reserving is becoming increasingly important, according to Kevin Ahlgrim, an associate professor in Illinois State University's Department of Finance, Insurance and Law.

“This has been a fairly stable time in terms of reserves,” Ahlgrim said. “But things have been less favorable than they have been. While we still have favorable development, the last few years it's getting less favorable. It's getting closer to zero. There's less room for reserve errors in the future because of that.”

Kate Smith is a senior associate editor. She can be reached at

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