We debunk a critical loss reserving myth involving loss reserve upgrades that is pervasive in the insurance industry.
The Big Myth
Regular reserve upgrades means that the company is (and has been) under-reserved and a significant increase (“a big hit”) in reserves means no subsequent reserve increases will be required.
The Reality
This understanding of the reserving process contradicts a very simple arithmetic truism. Repeated total reserve upgrades does not mean under-reserving. Indeed, the converse may be true. If total reserves are not increased annually then the company is likely to be under-reserved.
Consider a company that writes the same volume of business in the next underwriting year as the last accident year. Suppose economic inflation is running close to an average of 5%, say, a year, for many years. Suppose further that economic inflation manifests itself also in the paid losses. This is not unusual!
This simple example is illustrated in this pdf article (1.40 MB) .
What does this mean in terms of loss reserving each year? The following are simple arithmetic facts.
- Each year the company needs to increase its total reserve by at least 5%.
- Each year the company needs to increase its premium (price) by at least 5%.
- The ultimates for prior accident years will remain consistent with each increase in total reserves.
- Ultimates increase by at least 5% from one accident year to the next.
The principal reason for these facts is that calendar year inflation projects both onto the accident years and development years- it also impacts all prior accident years.
The increases in total reserves each year should not be regarded as an upgrade. If my costs in running my business increase by 5% each year I should at least increase the price of my product by 5% to stay even. I do not regard this increase as an upgrade. On the contrary, if total reserves are not increased by at least 5% each year the company will be under reserved!
That the 5% increase applies to the premium and ultimates from year to year is obvious. That it applies to the total reserves (and still maintaining consistent prior accident year ultimates) may not be so obvious, to some.
I have modeled long tail liabilities from all over the planet. I have measured total inflation (economic and social) in excess of 15% per year on average for 20 years for some portfolios. So we now know why many companies have failed!
Visit the abovementioned URL for a simple arithmetic proof of the above mentioned facts.
Reading the following related paper may also prove useful.
“Will Your Next Reserve Increase Be Your Last” by Prof. Ben Zehnwirth, Dr Julie Sims and Mark Shapland, published in CONTINGENCIES, the publication by the American Academy of Actuaries in the Jan/Feb 2004 issue on Page 40-44 (PDF).
A scanned version of this publication is available pdf here (520 KB) .