Reviewing and Preparing Your Captive’s Reserve Analysis

Lucy Zhang and Enoch Starnes, ACI

An actuarial reserve analysis provides a professional opinion regarding the loss reserves required for unpaid claims incurred as of a specific date (commonly referred to as the evaluation date) and is typically prepared to meet regulatory or financial reporting criteria. They are also often required by external auditors as part of the audit process. The analysis is most frequently prepared for a self-insured trust, a captive insurance company, a corporation that uses a loss sensitive plan, or as part of the due diligence process for mergers/acquisitions or divestitures. For self-insured and large deductible programs, the reserve analysis is a key component in determining collateral. This post will specifically focus on how a reserve analysis relates to captives.

For a captive, a year-end evaluation of IBNR losses does not come as a surprise, as a reserve analysis is often required for regulatory, financial reporting, and external audit purposes. The reserve analysis establishes an estimate of outstanding liabilities (loss and loss adjustment expense), which includes case reserves, provision for unreported claims, and provision for case reserve development. The latter two components are often called IBNR. Having an accurate estimate of IBNR is especially crucial because the captive domicile regulator uses this information to determine if the captive is adequately funded. Determining and setting a reasonable reserve estimate for unpaid losses and loss adjustment expenses is one of the most important aspects when preparing the program’s financial statements. Reserve analyses are also used to support a captive’s Statements of Actuarial Opinion (SAOs). Before an actuary can begin their analysis, it is important to gather the necessary data. A credible reserve analysis requires good data in all areas.

Preparing the data and information for a captive reserve analysis is a vital and often overlooked step of the process. Typically, it involves gathering loss runs, exposure data, and policy information, but additional items may be needed depending on the captive’s circumstances. The policy information and exposure data can almost always be utilized regardless of their file format, but loss runs are another matter. For the level of detail actuaries often delve into for their reporting, Excel format loss runs are recommended, as they allow an actuary to examine the data in numerous ways that are unreasonable to pursue in other formats.

Timing-wise, companies generally do not start preparing the necessary loss data until they know a reserve analysis is needed, but this should not be the case for other required data. While loss data must be evaluated as of a specific date (such as year-end) and cannot be provided until after that point, the additional exposure and policy information can be prepared in advance of a report. By doing so, captives can ensure that their reserve analyses are completed in a timely manner without unnecessary delays due to additional data gathering.

It is also worth noting the importance of consistency, which can be crucial to efficient and accurate analysis. Supplying an actuary with data that is consistently formatted and detailed helps avoid misunderstandings about what specific parts of the data represent. As an example, if incurred and paid loss amounts reflect the impact of recoveries in the current version of a loss run, they should continue to do so going forward. This allows the actuary to be certain of how to handle specific sets of data from year to year. Some situations, such as a change in TPA, will lead to an unavoidable break in data consistency. When these occur, it is highly recommended that a captive review these changes with their actuary so that both parties maintain a firm, mutual grasp on the available data.

Reviewing the Analysis
Reviewing a reserve analysis may feel like an overwhelming task, as it potentially contains many technical terms and actuarial jargon. However, your actuary should be willing and able to provide a walkthrough and explanation of the calculations behind your reserve analysis. The basic methodology for the calculation of outstanding liabilities is:

  1. Data is limited for each historical period to the appropriate retention.
  2. Ultimate loss estimates are calculated for each period using one or more actuarial techniques.
  3. The ultimate loss estimates from each technique are compared, and a selection of estimated ultimate losses is made.
  4. Paid losses are subtracted from the selected estimated ultimate losses.

Multiple techniques should be used when calculating ultimate loss estimates. A common technique is to use loss development methods. The loss development methods provide three separate ultimate loss estimates based on incurred losses, paid losses, and case reserves. Other common actuarial techniques include the Bornhuetter-Ferguson (BF) method and the loss projection method. These methods are most often used for immature periods, as estimates from the loss development methods may be understated or overstated due to the absence or presence of large losses.

The result from the four steps above provides the estimated required reserves. There are two components to estimated required reserves: case reserves and IBNR. Case reserves come directly from the loss runs as inputs by the claims administrator and are computed as the difference between the incurred losses and the paid losses. IBNR is the actuarial estimate that includes development on known claims as well as a provision for claims that have occurred but not been reported as of the evaluation date.

Your actuary may also include a reconciliation of reserves exhibit in the analysis. The reconciliation of reserves table is a quick snapshot of the movement and changes that occurred between loss evaluations. This reconciliation typically includes three parts – payments made during the time period between evaluations, loss accruals made during the time period, and adjustments to prior period ultimate losses. Often, an actuary may also perform a roll forward to estimate reserves as of a future date. This will provide information on the expected changes in reserves.

If the data allows, other metrics your actuary should consider when performing a reserve analysis are pure loss rates, loss development triangles, claim severities, and claim frequencies. In short, it is important to consider multiple methods and metrics to accurately estimate the amount of funds needed for the payment of current and future claims. As the required reserves amount is often the largest liability in a captive’s financials and can have a very significant impact on income and surplus, it is very important to maintain good communication with your actuary.

Building a Better Report
It is relatively common that a company glosses over the methodology used to complete their actuarial report, but this does not have to be the case. By working closely with their actuary and understanding the ways their reports are being built, a captive can drastically improve the benefits gained from the report and help ensure it is as accurate as possible. Between yearly evaluations, actuaries are often happy to discuss the various aspects of their analysis and the methodology being used. Having this type of discussion can then lead into supplementary ways of analyzing the data that may not have been considered if the actuary did not have additional context. For example, an exposure base being used in an actuary’s report may not be reasonably correlated to a captive’s losses but was provided due to a lack of other options in the captive’s initial years. By examining this with an actuary, it may be determined that another exposure base more closely correlated is now available and should be used.

Another improvement revolves around the ability to prevent “surprises” in an actuarial report. In some cases, a captive’s loss experience over the last twelve months might lead to a significant change in their reserving requirements that they were unaware of. In order to prevent this, a captive should stay in close contact with their actuary and keep them informed of any pertinent loss emergence, such as severe claims or environmental risks. Discussions stemming from this contact can help the actuary prepare their report accordingly and help the captive understand how such changes might impact the results. Alongside this, regulatory changes may lead to necessary adjustments in a captive’s reserve analysis. As mentioned before, making the actuary aware of this fact prior to report preparation ensures the actuary can adapt in a timely manner.

Captives can also avoid surprising changes to their reserve estimates by reviewing interim reports. While annual reserve analyses are often required by regulators, many captives choose to have biannual or quarterly analyses completed for their review. Choosing to do this can help a captive understand how their reserves change over time and get ahead of any changes they may need to make leading up to the “official” reserve analysis. By recognizing loss experience early and making appropriate adjustments to manage that, a captive can even improve their financial position.

Captive reserve analyses may initially be difficult to parse for anyone lacking experience in the actuarial field, but that does not mean captive professionals cannot better understand and utilize them. We hope this article has provided you with more thorough knowledge on all the facets of a reserve analysis and leaves you better equipped to engage with your actuary. At SIGMA, we are committed to helping others feel more comfortable with actuarial analytics and work with numerous captive clients in this regard. If you have any questions regarding the ways in which captive reserve analyses can be utilized, or would like to discuss any other actuarial or captive-related topics, feel free to contact us

© SIGMA Actuarial Consulting Group, Inc.

One comment on “Reviewing and Preparing Your Captive’s Reserve Analysis”

  1. Hey Lucy, Great article with a lot of in-depth information. Just wanted to add that loss reserves are often the biggest liability on the balance sheet of an insurance company. A higher percentage of insolvencies have been due to inadequate loss reserves.

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