Property/casualty reserving is one of the top considerations for boards and audit committees, but often technical complexity prevents enough depth of understanding and inhibits effective oversight. Senior and seasoned reserving professionals offer a “how-to guide” for directors.
- Brian Z. Brown, Michael D. Price, Patricia A. Teufel and Steve Wilson
- November 2020
- Status Report: Beginning in 2000 many P/C insurers experienced deficits in their reserves. As a result, regulations were tightened and individual companies improved internal governance of reserving and underwriting functions.
- A Change Is Going to Come: Warning signs indicate that problems are re-emerging—or may already be embedded in reserves.
- Action Items: Audit committee members must learn how to challenge actuaries and management to ensure that risks are being identified, clearly reported and addressed to avoid reserve deficits.
Around the turn of the century, many property/casualty insurance companies (known as general or nonlife insurers in some countries) experienced major reserve deficits. Some of these P/C companies failed due to reserve deficiencies, a significant percentage narrowly escaped insolvency, and many others suffered damaging impacts to earnings. As a consequence, governments tightened regulatory standards and individual companies improved internal governance of reserving and underwriting functions. As a result of these changes and improvements, and because of favorable external factors such as lower inflation, tort reform and no newly emerging mass torts, the industry has been largely free of major reserve problems since 2010.
More recently, however, warning signs indicate that problems are re-emerging—or may already be embedded in reserves.
Companies, regulators, rating agencies, and equity analysts have begun highlighting specific coverages that are generating significant losses, such as directors and officers and commercial auto insurance. While improvements in governance and regulatory oversight over the last two decades have equipped audit committees with a greater understanding of what the risks are to reserves, there is little information available regarding how audit committee members should challenge actuaries and management to ensure that risks are being identified, clearly reported and addressed.
Currently, while issues relating to COVID-19 dominate many agendas, there are potential reserve challenges in the market not related to the virus.
The pandemic makes it even more important for boards to be well-versed in reserving issues. Many insurance coverages will likely be affected by the impacts of the virus: surety, trade credit, event cancellation, business interruption (in some jurisdictions), mortgage guarantee, D&O, medical professional liability, and workers' compensation, among others. Also, for many coverages, premium is determined based on sales or payroll. Affected industries, such as the hospitality industry, will generate significantly lower premium and the impact on auto premium is already seen to be significant.
Given this backdrop, it is essential that boards are confident that their practices and processes for their oversight responsibilities of P/C reserves are fully effective, and, if not, address any issues now. Although there have been many recent legislative changes worldwide aimed at strengthening financial institutions, specifically including the insurance industry, these existing regulations cannot take the place of effective board oversight.
Since estimating reserves is somewhat of an art, management may pressure the actuary to arrive at a lower reserve amount as a higher amount may negatively affect management's compensation, stock price and the company's financial rating. Many actuaries are not sufficiently trained in dealing with confrontation and therefore the audit committee needs to be aware of this situation.
In our combined experience, it is rare that a major deficiency results mainly from a technical failing, or from a failure to follow existing regulations. Invariably, the main drivers are behavioral, reflecting general human instincts as well as the organization's own incentives and culture.
The pandemic makes it even more important for boards to be well-versed in reserving issues. Many insurance coverages likely will be affected by the impacts of the virus, including surety, trade credit, event cancellation, business interruption and directors and officers.
How Reserve Deficiencies Develop
The single most important feature of reserve deficiencies is that they usually originate years before anyone recognizes them and, in some cases, issues may not be reported through to senior management in a timely fashion. The resulting deficiency crystallizes as a financial impact only when the actuary recognizes that the held reserves fall short of the latest estimate of the claim liabilities, and management accordingly books a reserve increase. Deficiencies are sometimes recognized slowly as claims data emerges and small adjustments to the financial statements are made along the way. Other times a deficiency is recognized abruptly in recognition of a sudden change in external conditions, or from a newfound understanding of internal operational shortcomings or even a breakdown in the actuarial estimation process itself. It is these latter scenarios that will tend to be a greater problem as the deficiency can be both a surprise and have a large financial impact.
It is also important to note that the actuary's revised view of needed reserves relates to past liabilities (i.e., liabilities on insurance contracts' exposure prior to the balance sheet date). However, any change in the expected profitability of business written in the past will raise questions on the pricing of contracts currently being issued, as the assumptions used in the pricing of the current generation of business are a function of the prior years' profitability.
In the case that a significant reserve issue arises, management becomes concerned about the impact to earnings, to the balance sheet, and perhaps even to the capital levels and solvency of the company. A comprehensive communication plan for shareholders, analysts and other stakeholders is often put in place hurriedly as it is recognized that poor communication will exacerbate the issue by further damaging credibility of the firm and potentially the executive management team.
Shareholders, analysts, and others will seek assurances that the problem has been addressed and that it will not recur, drawing attention to the reserving process. Questions as to why the problem happened will focus on how foreseeable the issue was and whether errors have been made in the reserving process.
An effective governance system recognizes that a reserve deficiency is merely the last stage of an issue that has been developing for some time—and in the case of a material “surprise,” the problems may have been building over several years. Experienced insurance company management will be familiar with the root causes (and will generally take early actions should a problem start to emerge) and so we aim to provide audit committee members with insight into these root causes and to know what questions to ask.
Governance Over the Reserving Process
All directors encounter three fundamental philosophical challenges in their work with the companies they oversee:
- Knowledge—What can we know and how can we know it?
- Conduct—How should we as directors evaluate the information?
- Governance—How should the board exercise its authority in the best interests of shareholders?
The matter of reserving for P/C insurance and reinsurance companies engages board members in each of these areas. For example, knowledge of the company's ultimate liability for unpaid claims is inherently uncertain and must be estimated. Each director must determine how to engage with their colleagues on the board, members of management, and external parties central to the reserving process. Ultimately, the board or its audit committee must ensure that the overall framework employed for establishing and booking reserve estimates is adequate.
Board members cannot and are not expected to perform the function of actuaries. However, they can structure meetings, pose robust questions, and ask for independent analysis in a manner that creates an appropriate process for their oversight of the loss reserving process.
Meeting structure is essential to good governance. How often to meet, what subjects to discuss, how much time to allocate to a given subject, whom to involve, who will present, and how to follow up are indispensable areas in which the board can promote a culture of openness and accountability and facilitate an honest appraisal of a company's reserves for unpaid claims. Attention to these basic details will go a long way to ensure an effective and robust process.
Typically, the audit committee and the board should review reserves on a quarterly basis corresponding with the financial reporting cycle. Reserve estimates should be the exclusive topic of regularly scheduled audit committee meetings (usually quarterly) to avoid the risk that other potentially urgent quarterly reporting matters will crowd out the reserve discussion. Regular invitees should include the chief financial officer, chief actuary, lead reserving actuary, controller, general counsel, head of internal audit, and lead partner of the firm's external auditor. At least once a year, and more often if issues emerge, the company's chief executive officer, head of claims, and the independent auditor's actuarial specialist should attend. The involvement of this last group helps to ensure that matters discussed are widely known throughout the organization and are understood at the highest levels.
Periodically, directors should meet in executive session with the chief actuary to assess whether an acceptable level of resources has been made available. Resources broadly include adequate time in which to prepare actuarial analyses, qualified and experienced professional staff, computing technology, access to data and a healthy working environment. During these executive sessions, directors should also probe whether actuarial recommendations are free from any undue influence. Informal interactions between independent directors and senior executive officers through off-site lunches or dinners can touch on these topics as well.
Many new directors and company executives may be unfamiliar with the loss reserving process and the arcane language associated with it. Accordingly, companies should hold periodic education sessions to familiarize participants with the basic data concepts and methods routinely employed in actuarial work. It is ultimately incumbent on individual directors to understand the key assumptions relied upon to develop actuarial estimates and the sensitivity of the result to changes in the assumptions.
The company should provide a standard reserving package of information to the directors at each of the quarterly reserve meetings. This should be the basis of the chief actuary's presentation and the consequent discussion.
Standard Reserving Package
We recommend that the standard reserving package at each quarterly meeting for directors generally include the following types of information:
- Reserve projections by class of business.
- Reserves carried by class of business.
- Ranges of reasonable estimates by class of business.
- Actual reported paid and incurred losses in the recent period relative to expectations.
- Assessment of projections for the current accident period separate from prior periods.
- Current projections of ultimate loss vs. initial selections.
- Assessment of catastrophe losses and individual large losses.
- Trends in claim frequency and severity by class of business.
- Ratios of paid claims to incurred claims by accident year or underwriting year.
- Diagnostics such as loss ratios by accident period, average ultimate claim size, average outstanding claim size, and claim frequency per unit of exposure.
- Tracking of reserve positions of peer and competitor companies by class of business.
- Reference to overall industry analyses published by rating agencies, equity analysts, brokerage firms, and consulting firms.
- Comparisons of reserve position to those estimated by third parties such as the company's auditors or external consultants.
- Rationale for any significant changes in key assumptions underlying estimates.
- A watch list of potential problem areas or vulnerabilities in the reserve position.
The analysis for each class of business should be updated quarterly, with an in-depth review being undertaken at least annually.
While the above will provide the needed transparency, it is also incumbent on the actuary to provide information in a streamlined way, supported, for example, by additional focused exhibits to highlight key points. Creating a balance between the needed transparency and highlighting key points can be challenging for some actuaries who are prone to operate in the detail. One solution to this is for directors to receive a summarized subset of the above information on a one-page dashboard that is designed to highlight changes from quarter to quarter. Having the chief actuary design and produce such a dashboard for the board is in itself a valuable exercise. Second, we recommend that directors be encouraged at these meetings to ask robust questions, explore matters and draw attention to areas of concern. Well-placed questions and responses can lead participants to better understand the issues presented, heighten awareness of vulnerabilities, identify areas for improvement, and allow management to align future activities and analysis accordingly. We would, however, avoid overly prescriptive mandates regarding how an analysis should be carried out, preferring to let the professionals exercise their judgment, informed by the knowledge of what matters to the directors as revealed by the questions they ask.
By following these simple suggestions, the loss reserving process may be rendered comprehensible, even for directors who are initially unfamiliar with the process. Through a series of well-planned meetings focused on constructive engagement with the company's accounting, finance, and actuarial staff, and aided by independent analysis, directors can become well-equipped to provide effective oversight of the loss reserving process and better fulfill their fiduciary responsibilities to the company's shareholders.
Why Reserving Issues Matter
Unpaid claim liabilities, or reserves, comprise the largest individual liability line item on the balance sheet for most property/casualty insurance companies.
For the total U.S. insurance market as of year-end 2018, booked reserves were 87% of surplus and nearly 11 times net income. For companies writing long-tailed lines of business such as workers' compensation, where claims emerge slowly and take years to pay, reserve leverage is even greater. For 53 specialty companies predominantly writing workers' compensation, reserves were 147% of surplus and close to 18 times net income. These multiples mean that relatively small changes in reserve estimates have a dramatic impact on surplus and net income and can transform a net gain into a net loss.
The COVID-19 pandemic will further strain the insurance industry—while not directly impacting prior year reserves, its impact likely will be significant and unpredictable.
The P/C reserve deficits of the early 2000s were widespread. We reviewed reserve development of the top 30 U.S. insurance companies (based on net written premium volume) over a 10-year period starting at year-end 2002. By 2012, reserves for this group of companies were 28.6% deficient, relative to the positions held as of year-end 2002. This deficiency represented 31.6% of year-end 2002 surplus and was 5.0 times 2002 net income. Six of these companies, or 20%, realized adverse development on 2002 and prior claims in excess of their posted year-end 2002 surplus. While these results reflect U.S. company experience, these trends were evident in the worldwide P/C industry, with a number of high-profile non-U.S. companies needing to strengthen (increase) their reserves and the failure of the leading Australian P/C insurer, HIH.
We foresee a new round of reserving issues emerging. In November 2019, the U.K.'s Prudential Regulation Authority (PRA) notified CEOs and chief actuaries of U.K. P/C insurers that reserve adequacy and the associated governance and controls would be a priority area of regulatory focus. The PRA highlighted that “some firms have reported material reserve strengthening and we see increasing areas of emerging risk, particularly in some U.S. casualty lines….” Similarly, several U.S. insurers have recently reported sizable reserve strengthening. The COVID-19 pandemic will further strain the insurance industry—while not directly impacting prior year reserves, its impact likely will be significant and unpredictable—but even before the pandemic the market was showing signs of reserve deficiencies to come.
How Actuaries and Companies Establish Reserves
Establishing reserves for unpaid claim liabilities is both a technical and a business process requiring professional and commercial judgment. Financial statements record insurance liabilities as a point estimate of a certain amount. However, actuaries typically calculate a range of reasonable estimates, and management selects a point estimate from somewhere within that range. Over time, actual results will almost always differ from the exact point estimate, and may sometimes fall outside the range of estimates that was considered reasonable at the time.
Reserving actuaries deal with aggregate company and industrywide data and use statistical projection techniques to estimate future total liabilities for each line of business.
The inherent uncertainty and variability of reserves stems from potentially significant time lags between when insurance agents write contracts, when claims are filed, and when the insurance company makes its final payment on each claim. In some lines of business, referred to as short-tailed, claims are filed, adjusted, and paid quickly. Think of an automobile loss that involves minimal physical damage and no bodily injury—a straightforward process, which increasingly is largely automated. In other lines, referred to as long-tailed, years may pass from the occurrence of an insured event, to the filing of a claim, to the settlement of the claim. Think of a complex commercial insolvency directors and officers case involving multiple parties and protracted litigation. As a simple rule, it is usually easier to estimate reserves for short-tailed lines and more difficult to estimate reserves for longer tailed lines.
In the reserving process, actuaries do not typically study the underlying individual insurance policies or set case reserves on individual claims (claim adjusters set individual case reserves). Instead, reserving actuaries deal with aggregate company and industrywide data and use statistical projection techniques to estimate future total liabilities for each line of business. They consider various features, such as whether the data shows changes in the severity of claims (whether claims are costing more to settle than anticipated) or whether the data shows changes in the frequency of claims (whether the number of claims being filed differs from the number anticipated). Key assessments are the numbers and amounts of claims that have not yet been reported to the company—the so called incurred but not reported or IBNR claims.
Questions to Ask
One topic that we encourage directors and officers to ask the actuary about is the impact of industry cycles on reserve adequacy and application of standard actuarial techniques. Sample questions to ask the actuary on this topic include:
- Where do you believe we are in the underwriting cycle?
- What evidence supports/contradicts your position?
- Have you made any specific adjustments to your methodology to account for cycle effects, for example to loss development factors or a priori loss ratios? Loss development factors are a core assumption in the methods that use claims triangulations; a priori loss ratios are those assumed in the original pricing of the business. It may be instructive for the actuary to offer a “teaching” session to explain, at a high level, how methods work.
- For the current period, what is driving the actual vs. expected differences and how have you modified your estimates to account for this in the future?
- Do your methods rely on rate indices?
- How rigorously do you track rate changes?
- How is inflation in loss costs incorporated into rate calculations?
- Do you monitor the migration of business between standard and nonstandard markets?
- Does the quality of your data depend on market cycles?
- Does your opinion on where the market is going influence your judgmental selections?
Alongside the technical, a key topic that officers and directors should explore is whether the actuary has felt pressured to change or slant any numbers. For example, they could ask:
- Do you feel you have an appropriate level of professional freedom to conduct your work?
- Are you free to speak with leaders throughout the organization regarding the business written and claims filed?
- Do you have unfettered access to claims and other data necessary for your work?
- Are you comfortable sharing bad news with senior management?
- Have you ever been asked or encouraged to change your opinion?
- Do you have adequate resources to conduct your work?
- Are you routinely apprised of company developments that may have a bearing on the reserving process, especially developments that might increase reserves?
- Is the reserving function sufficiently independent from the pricing function?
- Does the actuarial function suffer high employee turnover?
- Do you have difficulty recruiting new staff?
Directors and officers also should try to discover whether cognitive bias may be influencing the actuaries' views. They could ask, for example:
- Are you familiar with the literature covering cognitive bias in decision-making?
- What steps do you and your staff take to combat cognitive bias?
- Do you have a peer review process in place?
- Do you track your estimation performance over time?
- Do you benchmark your results against external information?
- How quickly do you respond if incoming claims data is inconsistent with your prior selections?
- How comfortable are you with changes to key assumptions?
Directors and officers should also seek to uncover information about the effectiveness of communication by asking the actuary, for example:
- Are you routinely in contact with the heads of business units, claims, and risk management?
- Do you have routine involvement with the chief financial officer, chief risk officer, chief executive officer, and general counsel?
- Are your meetings with other company officials formal or informal?
- How frequently do you meet?
- Are meetings documented?
- Do you believe that other officers and directors understand the importance of the loss reserve estimate to the health of the company?
- Do you believe that other officers and directors understand how actuarial estimates are used?
- Do you believe that other officers and directors understand the implications of reserve estimates for capital adequacy, capital allocation, and pricing of new and renewal business?
- Does your function have a clear statement of purpose?
- Are you directly involved in the company's disclosure committees?
- Do you have contact with equity analysts that cover the company?
- Are you routinely involved in reviewing and commenting on the company's regulatory filings?
- Do you routinely set forth the rationale for any changes in estimates?
- Have you been asked to change how your work is documented?
- Do you regularly attend industry forums to learn about trends and new developments?
Loss Reserve Estimates
Another topic that might prove illuminating is the uncertainty of loss reserve estimates. Directors and officers should feel comfortable asking the actuary to explain:
- How do you determine your range of reasonable estimates?
- How does the range of reasonable estimates compare with the range of potential outcomes?
- How do these ranges compare with the reserves output from the company's economic capital model?
- What would the external environment have to look like to observe an outcome at the extreme ends of these ranges?
- Do you rely on stochastic methods or simple judgment when establishing ranges?
- Have there been any large losses or a jump in frequency of losses from an unexpected or unusual source?
Directors and officers also should examine whether the actuary is comfortable with the company's data, as reliable loss reserve estimates depend on quality data. They could ask, for example:
- Is the company's data quality sufficient for your work?
- Is the company's data fully credible or do you rely on external supplements?
- How do you determine reserving classes?
- Are there significant manual processes involved in obtaining and segmenting data?
- Are any segments of the business in run-off?
- Have there been any changes in case reserving or claim settlement practices?
- Are any of the case reserves set by third parties?
- Are there new classes of business being written where there is little/no claims data on which to base the estimates?
Unpaid Claim Liability Estimate
Finally, we recommend that the directors and officers ask questions to make sure they fully understand the relationship between the company's booked reserves and the actuary's central estimate of unpaid claim liabilities, by asking the actuary questions like:
- How is your estimate of unpaid claim liabilities communicated, i.e., is it a range, a central estimate, etc.?
- Where do the carried reserves fall in your range of reasonable estimates?
- Is any difference between management's best estimate and the actuarial central estimate explained and well-documented?
- Does the difference, if any, change materially over time?
Directors need not rely on their meeting format and personal inquiries alone to assess the reserve process. They also can ask the internal auditor to evaluate and report on the operational practices of the actuarial function. Likewise, external auditors will naturally examine the company's actuarial process and controls and may employ actuarial specialists to provide a second opinion on the sufficiency of the company's reserves for unpaid claim liabilities.
The directors also can ask third-party actuarial consultants, or the auditor's actuary, to provide an independent estimate of the reserves. These independent reviews provide perspective beyond what may be achieved through reliance on the company's management and actuarial staff alone. In particular, asking the third-party actuary to describe the different assumptions driving any material differences in estimates can provide the board with insight into the company's actuarial bias. For example, are the differences caused by different development patterns, different expectations for the more recent years, or by the choice of which methods are producing the most reliable answers.
Best’s Review contributors: Brian Z. Brown served as the global practice director for Milliman’s Casualty Practice and as president of the Casualty Actuarial Society. Michael D. Price was the president and CEO of Platinum Underwriters Reinsurance Ltd. and served as the chair of the audit committee of Hanover Insurance Co. Patricia A. Teufel was a principal at KPMG in charge of the U.S. Actuarial Services practice and a former president of the CAS. Steve Wilson was group chief actuary of the Zurich Insurance Group as well as chief risk officer for Zurich’s P/C segment. They can be reached at firstname.lastname@example.org.