By Michelle Bradley, ACAS, MAAA, ARM, CERA and Enoch Starnes
Through a series of blog posts, SIGMA has begun to address some common questions, requirements, and issues based on our previous experience with clients and auditors. Prior entries have focused on qualifications and factors surrounding the actuarial analysis. In this post, we’d like to dive into the analysis itself, specifically into reserve allocations. While a large portion of actuarial analyses consider organizations as a whole, situations will occasionally arise that require the actuary to allocate reserves to separate entities under the same risk coverage within a single organization. Though they each have their own benefits, these types of situations can undergo a great deal of scrutiny from auditors. Thus, being able to understand each available method is vital. Hopefully, this blog post will allow you to recognize the reasoning behind reserve allocations and (should it apply to you) help you decide which approach is right for your organization.
In the most basic sense, there are two ways to approach reserve allocations: before the required reserves are estimated, and after. Of these two, the former is typically the most common, though this is largely driven by specific needs and may only be more accurate if the loss data is reliable and credible.
Method 1: Specific Entity Analysis
The first method is technically not an allocation. The organization’s overall loss run is summarized for every entity. From there, each entity’s data set is analyzed separately using the standard actuarial method, such as loss development, ultimate loss selection, projection, etc., until reaching a reserve estimate. This approach is typically chosen in situations where the number of entities is small and the loss data is credible for each entity. If each entity does have credible loss history, it is especially useful because loss development factors and unique trends can be considered.
Unfortunately, the first method’s completion of separate analyses may contain a few pitfalls that many decision-makers are unaware of. The actuarial methods used could decrease greatly in credibility with larger amounts of entities and could be unreliable for entities that have relatively minor amounts of (or even no) losses. Beyond that, this method typically grows in cost, time, and effort more quickly than the post-estimate allocation approaches.
Method 2: Total Reserve Allocation
When the first approach is not reasonable, allocation approaches may give results that are more stable and reliable. Actuaries usually look to take this approach in cases that require reserve allocations for a large number of entities. Along with this, an often overlooked situation requiring the post-estimate approach involves one or two entities making up a significant portion of the loss data, with the rest being contained in multiple, smaller entities.
The post-estimate allocation approach may be done in multiple ways, but two are the most common and both usually begin the same. Loss data is considered as a whole and analyzed together leading up to the reserve estimate. Once the overall reserve indication is reached, the case reserves are then distributed to each entity, followed by IBNR, which can be distributed based on a couple different factors. The first is the loss data itself. IBNR is allocated after each entity is examined to determine what portion of the losses (e.g., case reserves) they contribute. The largest issue with this arises in less mature periods, where current case reserves may not be fully indicative of ultimate losses. For example, it may be known that multiple entities will incur losses over time, but the current data suggests that only one entity has taken on any losses. Thus, a second factor, exposure, is considered as well. Similarly to the loss data, the exposure (for example, payroll for workers compensation) determines what portion of IBNR should be allocated to each entity. Occasionally, these two factors are accounted for separately, but they are most commonly used in tandem to accurately allocate IBNR for both current and historical periods.
So, we now know two possible methods in approaching a reserve allocation, but what situations make such a process necessary? One common answer relates to mergers and acquisitions. When these occur, organizations may absorb the historical liabilities of whatever entity they acquire and wish to account for them separately for a period of time. Beyond this, internal accounting concerns often dictate separate reserve indications. This uniqueness can be driven by anything from loss history and development to policies, retentions, and collateral terms. Knowing these differences is essential to determining what type of approach to take when allocating reserves.
As always, these sorts of decisions are never as cut and dry as when they are presented on paper. There are many different factors that may affect the situation, meaning that you are ultimately best served by consulting your actuary. We at SIGMA are more than happy to discuss these types of decisions and, due to our extensive experience in this area, can provide a great deal of enlightenment. Whatever the case, don’t hesitate to contact us. We’d love to speak with you!
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© 2015 SIGMA Actuarial Consulting Group, Inc.