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Risk Insider: David Hershey
Getting Reserve Analysis Right
David S. Hershey is the Risk Manager for Sprague Operating Resources LLC / Lexa International. He is a 2014 Risk & Insurance Risk All-Star and a 2014 Liberty Mutual Responsibility Leader. He can be reached at [email protected].
For those insureds who carry deductibles or self-insured retentions, the concept of year-end valuations for your known and IBNR financial obligations is not exactly a surprise.
Actuaries provide risk managers a report that is based on a tried and true formulation (usually very conservative), to determine the expected financial obligation (a combination of short- and long-term liability), that reduces your company’s bottom line along with the other usual and customary business expenses.
The intent of this article is focus on those who may not realize some advance preparation and understanding of how the reserve analysis process works can provide a significant impact on the amount of funds set aside for the payment of current and future (known and unknown), claims expenses.
Let’s consider a workers’ comp example.
The basic approach to calculating the amount of cash needed to fund your claims reserve starts with your loss runs.
If your actuary is unwilling or unable to provide a thorough and understandable explanation of the science and philosophy surrounding your reserve analysis, you may want to consider a new provider.
Your insurer produces loss runs that contain two key figures: incurred and paid loss amounts.
The incurred amount is the insurer’s best estimate as to the eventual cost of the total claim. The paid amount is that portion of the claim which the Insured has already paid and has or will expense during a prior or future period.
The difference between the two (incurred – paid), is the amount of the outstanding reserve or the estimated amount of the claim that remains to be paid (such as continued treatment and future indemnity during the recovery period).
The funds that are of concern in determining the amount of the reserve can be calculated by the following equation: suggested insured reserve amount = insured’s payments per claim + remaining reserve amounts capitated by the insured’s deductible or SIR.
Total outstanding reserve (applying the per claim deductible cap of $500,000), in this example is determined to be $1,950,000.
To calculate the amount of claim money initially needed to be reserved by the insured, each individual claim whose deductible has not already been satisfied, less any amounts paid by the Insured and then summed revealing the minimum amount the insured should be expecting to pay for future claim obligations resulting from the designated policy period.
Claim amounts due in excess of the deductible or SIR will be paid by the insurer and therefore will not impact the insured’s balance sheet or income statement.
The preceding example provides the insured a very basic approach in determining the annual claim reserve adequacy. Actuaries will apply different factors to the initial reserve ($1,950,000), to factor the probability of claim growth due to changes in treatment (as an example) and for inflation. The common terms used to describe these modifications are trending and development.
Trending and development factors can be obtained by individual insured history, broker factors, a ratings agency or from your insurer.
The goal from the perspective of most risk managers is to accurately project future monetary commitments from known and unknown claims without over reserving, the result of which can cause an unnecessary restriction of cash that could be used for other purposes.
The selection of the factor that is best for you should be a collaborative effort and in most cases is flexible. A lack of attention and understanding of the basic process by which the annual reserve analysis will most likely result in an inefficient use of your company’s capital.
If your actuary is unwilling or unable to provide a thorough and understandable explanation of the science and philosophy surrounding your reserve analysis, you may want to consider a new provider.
