THE SCRYING GAME by Alex Murray
- in 'Post Magazine' on 19 May 2005

Reserving
With reserving being seen as more of an art than an exact science, Alex Murray reports on the problems insurance companies face in calculating what to put aside for future claims

As Independent Insurance showed a few years ago, reserving is more of an art than a science. Calculating what an insurance company puts aside for its future claims can go wrong, sometimes for the most innocent of reasons. While these cases made the headlines, there is not an insurance company in the market that does not face day-to-day issues over reserving.

A householder and their insurer may know exactly what their fire or flood claim will cost, but this is not so straightforward in large and more complex commercial losses. How much is that new contract worth? What exactly is the legal liability on the failed product? Would the lease have been renewed? Many insured companies are working at the frontiers of their business and precise knowledge about what they do is not easy to quantify. Without reliable information, exact reserves are impossible.

Maths lesson

One reason future claims have been so difficult to calculate is the vexing subject of costs. The broken leg that might cost £20,000 if paid immediately may cost four times that after the insurance company has fought the case for several years, due to the added legal costs, inflation and increases in legal awards.

Then there are the sensitive issues of competing interests and influences on the reserving process, which are central to the success or failure of insurers. Premiums, paid claims and operating costs are known quantities, leaving reserves as the significant variable in calculating the outcome of an account and, therefore, projected profitability. Reputations and the associated rewards can stand or fall on these calculations. In addition, there is the commercial requirement to avoid tying up capital in unnecessary reserves, when it is needed for investment.

The transfer of business between groups of shareholders, which may benefit or suffer from a valuation based on over- or underreserving, provides an additional twist, as the recent Highway case has illustrated (see box).

One group that generally wants reserves to be on the higher, or more conservative side, is claims managers. They cannot pay real claims unless there is real money set aside. It is they that have the responsibility for making all the difficult decisions as to how precisely to fix the reserves on losses that present so many challenging technical issues.

The position of influential brokers is not always so clear. The drive to obtain a claims settlement most favourable to their clients does not always sit comfortably with their arguments, when renewal premiums are being negotiated, that potential liabilities have been exaggerated by insurers.

To complicate the issue even further, the insurance company's auditors and the industry's regulators usually recommend caution and prudence - despite the consequent negative effect on the overall balance sheet and profit of the business. These parties are, however, matched by the tax authorities that can see reserves as a way of reducing profit and tax liabilities in the short and medium term.

The problems do not stop there. Most insurance contracts involve co-insurers and reinsurers taking different layers of the risk. These additional companies may take opposing views on any particular claim. It is not unknown for the insurer of, for example, the first £1m layer not to raise any reserve, while the insurer of the next layer may reserve heavily.

Multinational view

On top of these potentially tangled relationships, captive insurance companies and local insurers on multinational, global contracts may also have their own views on reserving.

So, reserving - like many other key business decisions - comes down to a judgement call, but one where all kinds of professional and organisational politics are in play.

The traditional approach to calculating reserves has relied on retrospective audits and a compartmentalised approach to interpreting the information with claims managers, actuaries, finance managers, underwriters, and even brokers providing separate inputs that are not always given the appropriate balance.

A more sophisticated approach is called for, blending all of these inputs and utilising a range of specific skills, in addition to a sound actuarial approach. This approach should consist of independence from vested interests to achieve more objectivity; an understanding of the technicalities of the business written; familiarity with the reserving practices and approaches utilised; an appreciation of financial management; and balancing of claim, risk and portfolio reserves, both current and projected.

Growing regulatory governance is likely to bring increased pressure on insurers to make certain that reserves are all accurately stated and that these disciplines are incorporated in this complex area of the insurance business.

- Alex Murray is a director at FitzGerald Consulting

CASE STUDY: HIGHWAY

The recent attempted takeover of Highway Insurance by Chaucer was marked by allegations from Lloyd's Names that the company had over-reserved to cover prior-year claims by as much as £40m.

The issue centred around Highway transferring several years of open claims from Lloyd's Syndicates 37 and 2037 outside the market. These accusations have raised concerns over the practice of Part 7 transfers, which allow business to be moved from Lloyd's into the company market or vice versa.

The transfers are enabled by the Financial Services and Markets Act 2000, and moving business from Lloyd's into the company market cannot be carried out without addressing reserves carefully. Highway denied the report, stressing its reserves had been prudently set and raising doubts over the methodology behind the claims.