The company concerned is an established insurer that has recently acquired a number of smaller insurers around the world with the aim of becoming a multinational company. It is predominantly a commercial insurer. It focuses on placing large insurance programs for multinational and global enterprises and for this reason, it purchases a number of reinsurance agreements with some of the world’s largest reinsurers to protect itself against huge risks that would result in potential catastrophe claims. The company now has a global footprint and is therefore able to carry out insurance services for its clients wherever they may be operating. Many of the company’s customers are in the business of manufacturing, transport, real estate, distribution and agriculture. The organisation offers cover for liability, engineering, material damage, business interruption, marine and aviation risks. This assignment looks at the claims department of the company and its claims reserving philosophy. It also highlights how the claims reserving philosophy meets the requirements of its underwriters and the regulator and the effectiveness of the systems and controls it has put in place to maintain adequate claims reserves.
To ensure that there are always adequate funds to meet its current and future liabilities in respect of claim payment obligations, a company needs to accurately estimate and establish its claims reverse. (Source: CII Advanced Claims 2017 study text) It also does so, to meet the regulatory requirements of the Prudential Regulatory Authority. These reserves are later used for internal and external reporting to monitor the company’s financial performance. “Claims reserving for insurance companies is vital since it is a key indicator of whether a company is financially solvent” (Source: CII Advanced Claims 2017 study text)
The company’s estimation of the ultimate liabilities arising from claims made under their insurance contracts is its most critical accounting estimate. There are several sources of uncertainty that are considered in the estimation of these liabilities that the Company will ultimately pay for. The main assumption underlying these techniques is that a Company’s past claims development experience can be used to project future claims development and hence ultimate claims costs. (Source: Colina Holdings Bahamas Ltd 2014 annual report) As such, these methods extrapolate the development of paid and incurred losses, average costs per claim and claim numbers based on the observed development of earlier years and expected loss ratios.
“Historical claims development is mainly analysed by accident years, but in some cases will also be further analysed by geographical area, as well as by significant business lines and claim types.”
The Larger claims are usually separately addressed, either by being reserved at the face value of a loss adjusters’ estimates or separately projected in order to reflect their future development. “Certain exceptionally large claims may distort the claims development pattern. When projecting reserves, any anomalies should be removed from the statistics and analysed separately” (Source: CII Advanced Claims 2017 study text). In most cases, the claims manger will not make explicit assumptions regarding future rates of claims inflation or loss ratios. Instead, the assumptions used are those implicit in the historical claims development data on which the projections are based. The following are additional qualitative judgement that the company’s’ actuaries use to assess the extent to which past trends may not apply in future;
reflect one-off occurrences,
changes in external or market factors such as public attitudes to claiming
levels of claims inflation
judicial decisions and legislation
internal factors such as portfolio mix, policy features and claims handling procedures
In order to arrive an estimated ultimate cost of claims that present the likely outcome from the range of possible outcomes, the claims department takes into account of all the uncertainties involved. As explained above, the company only establishes loss reserves for losses that have already occurred. Therefore, it does not establish catastrophe equalisation reserves that defer a share of income in respect of certain lines of business from years in which a catastrophe does not occur to future periods in which catastrophes may occur. When calculating reserves, claims managers and actuaries take into account estimated future recoveries from salvage and subrogation, and a separate asset is recorded for expected future recoveries from reinsurers after considering their collectability. (Source: Aviva 2016 Annual Report). The Insurance Companies (reserves) Regulation 1996 however, requires the establishment of these reserves which are designed to smooth fluctuations in the loss ratios for some classes of business. (Source: CII Advanced Claims 2017 study text).
There is also a provision for the liabilities of insurance contracts made for outstanding claims and settlement expenses incurred at the reporting date including an estimate for the cost of claims incurred but not reported (IBNR) at that date.
It can take a significant period of time before the ultimate claims cost can be established with certainty and for some types of policies, IBNR claims form a significant portion of the liability in the statement of financial position. Included in the provision is an estimate of the internal and external costs of handling the outstanding claims. Material salvage and other recoveries including reinsurance recoveries are presented as other assets.
When it comes to liability claims, the economic assumption changes arise as a result of a decrease in the real interest rates used to discount claim reserves for periodic payment orders and latent claims. Market interest rates are used to discount periodic payment orders and reduced latent claims pay-outs. The estimated future inflation rate used to value periodic payment orders is increased so that it can be consistent with market expectations. This will be offset by a change in estimate for the interest rates used to discount periodic payment orders to allow for the illiquid nature of these liabilities.
The company actuaries use two main methods of actuarial valuation for liabilities arising under long-term insurance contracts.
The net premium method and the gross premium method
Under the net premium method, the premium taken into account in calculating the provision is determined actuarially, based on the valuation assumptions regarding discount rates, mortality and disability. The difference between this premium and the actual premium payable provides a margin for expenses. This method does not allow for voluntary early termination of the contract by the policyholder, and so no assumption is required for persistency.
The gross premium method
This method uses the amount of contractual premiums payable and includes explicit assumptions for interest and discount rates, mortality and morbidity, persistency and future expenses. These assumptions can vary by contract type and reflect current and expected future experience.
CLAIMS RESERVING PHILOSOPHY AND THE UNDERWRITING DEPARTMENT
As mentioned in the opening statement, the Company principally issues general insurance contracts to commercial customers and risks such as fire, business interruption and liability covers are taken up. These risks are usually under cover for a duration of a twelve months period.
For general insurance contracts, the most significant risks arise from fires, natural disasters and accidents. For longer tail claims that take some years to settle such as liability cases, there is also the risk of inflation. These risks do not vary significantly in relation to the location of the risk insured by the underwriter, type of risk insured and by industry. Underwriters use information of the above risk exposures to mitigate potential loses by diversification across a large portfolio of insurance contracts and geographical areas. The variability of risks is improved by careful selection and implementation of underwriting strategies, which are designed to ensure that risks are diversified in terms of type of risk and level of insured benefits. This is largely achieved through diversification across industry sectors and geography. In addition, there are strict claim review policies to assess all new and ongoing claims, regular detailed review of claims handling procedures and frequent investigation of possible fraudulent claims. These are all policies and procedures that have been put in place to reduce the risk exposure of the Company. The Company has further enforced a policy of actively managing and promptly pursuing claims, in order to reduce further exposures that may impact the business. Issues of inflation is mitigated by taking expected inflation into account when estimating insurance contract liabilities.
The company has also limited its exposure by imposing maximum claim amounts on certain contracts as well as the use of reinsurance arrangements in order to limit exposure to catastrophic events. The purpose of these underwriting and reinsurance strategies is to limit exposure to catastrophes based on the company’s risk appetite as decided by management and the board. The overall aim has been to restrict the impact of a single catastrophic event to approximately 78% of shareholders’ equity on a gross basis and 0.9% on a net basis. In the event of such a catastrophe, counterparty exposure to a single reinsurer is estimated not to exceed 30% of shareholders’ equity. The Board may decide to increase or decrease the maximum tolerances based on market conditions and other factors. The company uses its own risk management software to assess catastrophe exposure. However, there is always a risk that the assumptions and techniques used in these models are unreliable or that claims arising from an unmodelled event are greater than those arising from a modelled event.
In the recent past, the Company took advantage of the transitional rules of IFRS 4 that permit only five years of information to be disclosed upon adoption of IFRS. As required by IFRS, in setting claims provisions the company gives consideration to the probability and magnitude of future experience being more adverse than assumed and exercises a degree of caution in setting reserves where there is considerable uncertainty. In general, the uncertainty associated with the ultimate claims experience in an accident year is greatest when the accident year is at an early stage of development and the margin necessary to provide the necessary confidence in the provisions adequacy is relatively at its highest. As claims develop, and the ultimate cost of claims becomes more certain, the relative level of margin maintained should decrease. However, due to the uncertainty inherited in the estimation process, the actual overall claim provision may not always be in surplus. As underwriters aim to maximise the company’s profitability, they are in constant liaison with the claims department and actuaries. Their focus on pricing is to not only look at the claims trends but use information supplied by the claims department to identify profitable and unprofitable areas of the various classes of business. A more diversified portfolio is less likely to be affected across the board by a change in any subset of the portfolio. The company has developed its insurance underwriting strategy to diversify the type of insurance risks accepted and within each of these categories, to achieve a sufficiently large population of risks to reduce the variability of the expected outcome.
“The value of good liaison between the underwriting, claims and actuarial departments is highlighted most clearly when considering the uses and interpretation of claims data. Each of these parties has their own clear responsibilities and requirements but each needs to consult with the other two in order to achieve a full understanding” (source: CII Advanced Underwriting 2017 study text)
EFFECTIVENESS OF THE CLAIMS RESERVES SYSTEMS AND CONTROLS IN A COMPETITIVE MARKET
The claims department together with the actuaries regularly review the company’s claims handling procedures to identify areas for improving this vital function. This activity has in the recent past intensified with management introducing focused initiatives to reengineer the claims processes. This move has generally been attributed to the following factors:
Improvements in technology has enabled the company to accelerate the recognition and adjustment of claims. Claim adjusters are able to use advanced intelligence or “smart” systems that allow them to evaluate the settlement value of claims more quickly.
Competitive cost pressures have forced management to identify the “fair value” of claims and to take all necessary actions to settle claims expeditiously and control the claim costs.
The company has invested heavily into developing fraud detection systems. Claims suspected to be fraudulent or claim demands that seem inconsistent with available information are tagged and specific strategies are being developed to address them.
The above initiatives may change the way in which claims are reported, recognised, and settled and will therefore introduce significant distortions into the historical actuarial data used for reserving. “Methodologies commonly “adjust” the historical data to simulate what the experience would have looked like in the new claims handling environment.”(Source: Evaluating Reserves in a Changing Claims Environment)
The company’s actuarial practice is based on a deterministic view of reality meaning it is implicitly assuming that future transactions where the amount is unknown, can be adequately described by a single number, the estimate, and that sums, products and other functions of these amounts can be described by the corresponding functions of the individual component estimates. This is a good approximation if the relative variability of the amounts involved is low, but becomes increasingly doubtful as variability increases. When variability is high, the deterministic approach can give highly misleading results, particularly when non-linear functions are involved. For example, if the average claim size is £10,000 a pure deterministic approach implies that every claim costs £10,000 and that there would never be any claims in excess of £10,000. Where variability is high, a stochastic approach is used which takes into account the range of possible values of each amount, together with their respective probabilities. This approach allows variability to attain some form of a value. By using the deterministic approach, it is considered sufficient to set up provisions equal to the expected value of outstanding claims (Source: The philosophy of reserving, by Robert Buchanan). However, if looked at from the stochastic approach, there is roughly an even chance that such provisions will prove inadequate. If the company continues to consistently set provisions on such a basis and release all the “profit” disclosed thereby, so that no surplus is retained, it will only be a matter of time before it fails.
“‘One problem which is susceptible to the size of loss approach is that of shifts in emphasis by the claims department on priorities in settling large versus small claims. Such a shift can cause major distortions in the loss projections of nearly all reserving methods.” (Source: Adjusting Incurred Losses for Simultaneous Shifts in Payment Patterns And Case Reserve Adequacy Levels)
The importance of accurately estimating and reserving claims cannot be overstated. It is therefore, just as important to ensure that claims are properly dealt with and overpayments are not made. Within the claims process, there is a possibility of paying more for a claim than is justified by the details and circumstance of the losses. This “leakage” is usually an avoidable overspend in a settlement. Reserve adequacy Levels if gone unchecked distort the ultimate claims pay out pattern and more than necessary reserves are likely to be set. In hindsight, the company may be seen to be needing more funds than is actually needed.
Rather than approach the valuation of outstanding claims as a succession of isolated estimations, the company can use an approach which draws on the concept of Bayesian estimation and is related to the Bornhuetter-Ferguson approach to valuation.
Where the outstanding liability at a point of time cannot be measured reliably, management should use the estimate which was made when the business was written modified as appropriate for actual intervening experience to give a “time series estimate”.
Seeing that the company is a growing commercial risk carrier, management should look into establishing equalisation reserves as they are required to make an annual contribution to the equalisation provision by providing a specified percentage of the net written premium for certain business classes.
Where cases of liability are concerned, the actuaries must also be aware of the potential distorting effects of a shift from outside legal assistance to internal legal staff positions. These distortions may include changes to the average expense cost for outsourced firms, as well as issues concerning the allocation legal staff costs to individual claims. As such, the actuaries need to recognise that a shift between outsourced and legal staff utilisation can have substantial impact on the reserving statistics.
The personnel used for the purposes of setting and monitoring reserves should be appropriate in terms of skill and experience. If management wants to satisfy themselves of appropriate skill and experience, they need to consider the value of using appropriately qualified, experienced and proven specialists.
Regard should be given to the relevant judicial developments, changes in legislation and economic assumptions.
Claims reserving is one of the key most important elements in determining any insurer’s level of funds required in order to meet current and future liabilities. The philosophy applied plays a role in how this liabilities in terms of outgoing funds will be met while maintaining the solvency of the company as a whole. The management of the philosophy is complex in nature and requires continual review, development and skill. Regular review of the reserving strategy, ultimate claims service and actuaries is required to minimise unexpected claims costs. The use of reinsurance, subrogation and recovery, and the control of fraud are vital tools in the managing of the total company outlay of claims and future liabilities. The company has a suitable reserving philosophy with the desire to improve it over time and with this continue to develop a strong claims service making it a global leading insurance service provider.