The Analytically Based - Data Driven Broker: Reserve and Cash Flow Analyses

Timothy L. Coomer, Ph.D.

RISK66.comBlog 1: Intro to SIGMA & Scope and Data Requirements
Blog 2: Loss Development Factors
Blog 3: Reserve and Cash Flow Analyses
Blog 4: Trending, Pure Loss Rates, and Loss Projections
Blog 5: Confidence Interval and Retention Level Analyses
Blog 6: Loss Cost Analysis

Now that we understand the data necessary for an actuarial analysis and the factors used to develop the losses found therein, let’s turn our attention to SIGMA’s most common request: the reserve analysis, which provides an organization with an estimate or range of estimates of their total liability accrued as of the evaluation date. In this blog post, we’ll take a moment to cover the exact methodology involved in a reserve analysis.

The ultimate cost of claims incurred for a specific time period may not be known until several years after the close of that period. The evaluation of the ultimate value of claims requires estimating future contingent events. In our second blog post, we discussed applying loss development factors based on past loss experience to current losses in order to estimate ultimate losses.

By subtracting actual paid losses from the estimated ultimate losses, we can calculate the estimated required reserves as of the evaluation date. This is the amount required for future payments on claims that have been reported and claims that have occurred but have not been reported as of the evaluation date.

The estimated required reserves can be segregated between case reserves and development on known claims and incurred but not reported losses (IBNR). Case reserves are calculated as reported losses minus paid losses. This is the amount established by claims adjusters, as shown on the loss run. Development and IBNR is defined to include development on known claims as well as a provision for claims that have occurred but not been reported.

Allocated loss adjustment expenses, defined as those expenses assignable to specific claims, such as legal costs, are typically included in the reserve amounts. Unallocated loss adjustment expenses, defined as expenses not assigned to individual claims, are usually calculated separately based on claims handling agreements.

Since losses are usually settled over an extended period of time, future investment income may be considered when funding estimated required reserves. Payout percentages based on unique payment patterns, or industry data if historical data is not sufficient, are used to allocate the estimated liabilities to the periods in which they are expected to be paid. The estimated liabilities are then discounted to reflect the timing of future loss payments.

It is important to note that the timing of future payments could differ from the estimated payout due to random variations in the payments of large claims and the future yield on the underlying assets is susceptible to significant changes in economic conditions. Therefore, while the recognition given future investment earnings is important, discounting does add an additional uncertainty to an already projected amount.

More and more, actuarial firms are beginning to move away from single point reserve estimates and towards a range of estimates. These ranges allow one the freedom to present the actuarial results to an organization’s decision-makers and discuss where they fit inside that range based on recent claim knowledge, settlements, changes in reserving philosophy, etc. When deciding whether or not to use a range of estimates, remember to stay in close contact with your actuary, as their knowledge of the industry could provide crucial insight.

Reserve analysis methodology is a complex subject with numerous inputs and outputs. As such, we’d like to offer additional information for anyone wanting to gain a better understanding of both. Below are links to a few relevant RISK66 documents and videos covering this topic that we think may be useful.

 

PDF Resources:

  • Actuarial Analysis Map - This diagram helps explain the flow of data and computation necessary for a loss projection and reserve analysis.
  • Reserve Analysis Snapshot - A brief definition and description of a reserve analysis and how it is utilized by risk management professionals.
  • Reserve Analysis TechTalk - An article about IBNR (incurred but not reported) losses, which is an important but often misunderstood component of establishing loss reserves.

 

Video Resources:

 

As always, feel free to contact us with any further questions, and we’d be more than happy to discuss them. We hope you’ll join us for our next post as we turn to another of SIGMA’s most common analysis requests: loss projections. Have a fantastic day!

 

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