Actuaries and Annual Reserving: How Does It All Work?
Annual reserving work is the process by which an actuary determines how much insurance policies are projected to cost an insurance company as of a specific date. This is typically done on an annual basis, and will inform an insurance company how much money needs to be kept in reserve.
This blog will explain what an actuarial reserve is, and outline how annual reserving works. We will also include an overview of the various methodologies used by actuaries to determine the amount that should be held in reserve.
First, what is an actuarial reserve?
An actuarial reserve is made up of the following provisions:
- a provision for claim liabilities, also called a claims reserve or provision for unpaid claims;
- a provision for premium liabilities;
- and a provision for other liabilities.
The provision for claim liabilities refers to an amount of funds set aside by an insurer to meet any future costs related to claims occurred or reported on or before the date of valuation. This blog will focus on this provision. The provision for premium liabilities estimates the liabilities in connection with the unearned portion of the premium if the insurance policy is not expired at the date of valuation and the provision for other policy liabilities is for any other provision related to the insurance policy, which is usually related to some insurance features such as profit sharing agreements.
Claims reserves have two main components :
- Outstanding Claims Reserves (also known as Case Reserves) – These are individual estimates usually established by claim adjusters on open claims reported/occurred on a claim-by-claim basis.
- Incurred But Not Reported (“IBNR”) Reserves – the IBNR reserve is calculated by the actuary and represent the future expected payments for claims that have occurred or have been reported, in excess of the case reserve amounts. It can be broadly defined to include a provision for development of known claims as well as a provision for unknown claims at the date of valuation.
What is annual reserving work?
Annual reserving work is when an actuary for an insurance company predicts the cost of future claims. Below, we’ll outline step-by-step how the annual reserving process works.
Appointment of an actuary
The law which regulates insurance companies in Canada (insurance companies that decide to be regulated under federal jurisdiction), the Insurance Companies Act, requires that an actuary be appointed by the board of an insurance company.
The appointed actuary is then required to provide an annual actuarial opinion on the valuation of the policy liabilities of the insurance company. This amount is then reflected on the audited financial statements of the company.
Analysis of data and determination of reserves
The actuary will issue a data request letter to the insurer. This data will normally include a claim listing from the insurance company with paid amounts, case reserves, and dates of losses. In addition, for conducting annual reserving work, the actuary needs to understand if there has been any change in management, case reserving approach or business plan for the insurance company.
The actuary will then analyze the data that has been provided, and use actuarial methods to project the future claims cost for the policies sold by the insurance company. This is the most substantial part of the process. The actuary will also take into account the time value of money and applicable accounting and actuarial standards when analyzing the data.
There are a variety of methodologies an actuary can employ for their analysis. The most common approach is for the actuary to examine historical patterns arising from similar claims made in the past. This involves an analysis of the way in which:
- claims are reported,
- interim payments are made,
- reserves are set and adjusted,
- final settlements are reached, and
- claims are finally closed.
For each policy year, the aggregate amount paid and reserved with respect to all known losses will develop over time until the ultimate loss is finally known (i.e., when all claims are closed).
The total loss for a group of claims will exhibit a pattern over time that is known as a development trend.
Although each policy year will exhibit a unique development pattern, these estimation methods operate under an assumption that, subject to adjustment for inflation and other trends, the development patterns of future years will be similar to the patterns of past years.
Put simply, actuaries will determine an opinion on current reserves by looking at patterns demonstrated by historical loss emergences, expected future losses and loss trends.
Some different methodologies of determining the actuarial estimate are outlined in below:
Paid and Incurred Loss Development Method
Loss development methods rely on the relative changes in the historical losses from one valuation date to the next. In other words, they look at how losses have changed over time.
Historical losses will generally be summarized in a triangular format to assist in comparing how losses emerge and develop. Using a triangular summary of the losses, “age-to-age factors” (also known as loss development factors) are calculated as a measure of the change from different valuation dates.
To assist in the selection of these age-to-age factors, various averages of the factors are calculated. The final selection of factors is based on judgment and consideration of the stability, consistency and credibility of the data.
The difference between the paid method and the incurred method is simply the data used to calculate the age-to-age factors.
With the paid method, only payments are reviewed at the different valuation dates. The advantage of the paid method is that, by excluding the information contained in case reserves, it avoids possible distortions from inconsistent setting of individual case reserves.
However, case reserves, if consistently established, can provide valuable information on the loss emergence patterns. The incurred method takes into account both payments and case reserves. The selected development factors are subsequently applied to paid or incurred losses to obtain the estimates of ultimate losses.
Expected Loss Method
This method relies on a priori losses that can be estimated using a variety of techniques including what is known as a “frequency/severity approach” and an “ultimate loss ratio approach”. An a priori loss may refer to the projected loss ratio based on the available data. This is basically a starting point to estimate losses.
Under the ultimate loss ratio approach, a projected ultimate loss ratio is estimated and applied to the earned premium. This projected ultimate loss ratio is determined from the most recent pricing analysis or based on a combination of historical loss ratios and actuarial judgment.
Under the frequency/severity approach, an average cost per claim is selected and ultimate claim counts for each policy year are estimated. The product of the ultimate claim count and the selected average cost per claim by policy year is then used as an estimate of ultimate losses.
The Bornhuetter-Ferguson method was introduced in 1972 by Ron Bornhuetter and Ron Ferguson.
This method relies on both the loss emergence patterns estimated in the loss development method as well as a priori estimates of the ultimate losses. While the loss development method is used to estimate loss emergence patterns, the a priori losses can be estimated using a variety of techniques including the frequency/severity approach and the ultimate loss ratio approach as described above.
This method is useful because it avoids potential distortions which may arise in the loss development that results in the inconsistent emergence of losses, or outlier large losses.
Expected Emergence Method
This method uses incurred losses and selected loss development factors to determine expected losses that will emerge between a previous valuation date and current valuation date.
The expected emergence is compared to the actual experience, and the previously selected ultimate losses are then adjusted by the emergence difference to calculate the indicated ultimate losses.
The Practice of Discounting
Due to the lag between the time claims are incurred, reported and ultimately paid, the actuarial reserve should consider the time value of money.
When an insured pays premium for a policy, part of the money will be allocated to pay any future claims. These funds are invested by the insurance company, with the investment returns helping to cover future claims.
If, for example, it is expected that $100 in losses will be paid over the next five years, it is not necessary to set aside $100 now to satisfy this obligation or liability because in a fully funded program, the money will be invested and interest will be earned between the time the funds are reserved and when the claims are paid. The consideration of this interest is called discounting.
Preparation of the Report
A full report, including an actuarial opinion determined using the above methodologies, is prepared by the actuary and then provided to the insurance company. The actuary also has the responsibility of presenting the findings to the Board on an annual basis.
The Report will typically include supporting exhibits and information for financial reporting purposes.
It is important to note that determining reserves is a completely separate exercise to determining how much in premium should be charged. This is a process known as “ratemaking”, and considers a number of different components in addition to reserving.
What else does an actuary do?
Annual reserve reporting is not the only service an actuary can provide to an insurance company. At Axxima our highly skilled team of actuaries can deliver a wide range of creative actuarial services such as:
- Quarterly valuation of policy liabilities (as opposed to an annual)
- Financial proformas and multi-year projections
- Annual ratemaking including experience rating
- Self-insured retention studies
- Internal surplus targets and development of surplus policies
- Financial Condition Testing including ORSA and FCT
- Education sessions for Boards and audit committees on changes in regulatory guidelines, accounting, and actuarial standards
Need the services of an actuary?
Get in touch with the professional insurance actuaries here at Axxima for all your actuarial needs. Our team of highly qualified actuaries are accredited by the Canadian Institute of Actuaries and are experts at analyzing data, factoring statistics, and determining probabilities. What truly sets the actuaries at Axxima apart is their unique ability to deliver results of complicated analyses in an easy-to-understand way. Axxima’s actuarial team provides a wide range of creative services covering diverse property and casualty insurance programs.