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.