Article

The reserving process – an alternative test for monitoring reserves

Oct. 20, 2020 · Authored by Dave Wolfe

The alternative test proposed here is to monitor reserves. For insurance companies, the reserving process is fundamental to the financial reporting process. The reserving process can refer to different components of the process to internal or external personnel at the insurance company. The claims department is at the frontline when a claim is reported, and a case reserve needs to be posted. An internal actuarial department performs work in support of the recorded loss and loss adjustment reserves in the insurance company’s statutory financial statements. The actuary, either internally or externally appointed, relies on reserving methods or models to opine on a company’s Dec. 31 recorded reserves. Company management is responsible for the financial reporting process including the recording of loss and loss adjustment reserves and controls over the entire process.

One of the state insurance regulators’ primary functions is solvency regulation for which the risk-focused examination is a key tool. The primary purpose of a risk-focused examination of an insurer is to assess and monitor its current financial condition and prospective solvency. Conservatism in the recorded reserves is preferable to understated reserves when viewed in light of solvency regulations. It has been over 40 years since the National Association of Insurance Commissioners (NAIC) June 1980 Plenary Session where the first formal statement of a loss reserve opinion requirement was adopted. On the same plane, it has been over 30 years since what is now referred to as a Statement of Actuarial Opinion as required by the NAIC Property and Casualty Annual Statement Instructions was required for all property and casualty insurance companies. This Statement of Actuarial Opinion has operated as a regulatory control over the reserving process by helping to mitigate the risk of insurance company loss reserves being “too low” (deficient or inadequate) or “too high” (redundant or excessive).

Traditional review of reserves

In terms of reviewing the recorded reserves of the property/casualty insurer, one approach is through the review of the One-Year Loss Development and Two-Year Loss Development tests in the Five-Year Historical Data exhibit of the insurer’s annual statement. These tests are retrospective because they show development in management reserves for years prior to the Dec. 31 annual statement that is in question. The ratios measure changes in management’s prior year’s estimates of ultimate losses relative to the corresponding prior year’s policyholder surplus.

As an example for the One-Year Development test in an annual statement as of Dec. 31, 2022, the 2022 result shows the change in management’s ultimate loss estimates for 2021 and prior relative to the policyholder surplus as of Dec. 31, 2021. An important consideration in interpreting these tests is the leverage ratio for the insurer as defined by the ratio of the insurer’s recorded reserves to policyholder surplus. For an insurer that is more thinly capitalized (higher ratio of reserves to surplus) the results of annual statement Loss Development tests are properly viewed for the potential impact on the policyholder surplus. For a more strongly capitalized insurer with a low leverage ratio, the resulting Loss Development tests may only show a small change relative to surplus but may hide what could be considered a material change to management’s prior recorded reserves. As an example, an insurer with a leverage ratio of 1 to 2, a One-Year Loss Development test result of plus or minus 5% would imply an approximate corresponding 10% increase or decrease in management’s recorded reserves as of the prior Dec. 31 valuation.