A balancing act: attaining the correct loss reserve level requires knowing how much to save today to pay claims in the future.

During 2003, huge increases to carried loss reserves--some ranging into the billions of dollars--were announced by property/casualty insurers such as American International Group, CNA, Employers Re, Hartford Financial Services Group, and Travelers Property Casualty. The loss reserve increases came on the heels of upward reserve adjustments for the property/casualty insurance industry of approximately $11 billion in 2001 and $22 billion in 2002. The size and frequency of these reserve movements have generated discussion about the adequacy of the current reserves carried by the property/casualty insurance industry and the integrity of those responsible for quantifying these liabilities.

Insurance regulators, rating agencies and other financial analysts are frustrated by these revisions. The finger of blame for reserve changes has been pointed squarely at company management and appointed actuaries. Management is responsible for selecting and carrying its best estimate of ultimate loss reserves in company financial statements. Actuaries, who may be part of the management team, are specifically responsible for providing estimated reserve amounts and for furnishing public opinions about the reasonableness of the carried reserves.

Understanding Loss Reserves

The largest liability item carried on property/casualty insurers' balance sheets is usually the loss reserve--which is an estimate. It also is the most volatile item. Reserves are unlike other balance sheet items such as unearned premium reserves or the values of assets such as stocks or bonds. These other items can be measured and valued with considerable accuracy at any point in time. The unique nature of the loss reserve makes estimating its value nearly always the most uncertain part of preparing insurer financial statements.

Loss reserves--including those for loss adjustment expenses--are estimates of the amounts to be paid in the future to settle claims related to insured events that have already occurred. The "future" could be a short period of time--reimbursements for damage to an auto may be resolved in days or weeks--but, for most property/casualty insurance coverages, it more likely will be a longer period of time. As an extreme example, many claims in workers' compensation insurance for medical payments continue for longer than 40 years after initial reporting. In medical professional liability, some claims are reported 15 years or more after an insured event occurs.

Items that affect final claims payments, such as economic conditions, jury verdicts, and statutes often change from the time a claim is reported to when it is finally settled. The large number of variables, known and unknown, that determine the final payment amounts contribute to the volatility of reserve estimates at any point in time and make the reserve estimation challenging and complex. It is more realistic and meaningful to develop a range of probable reserves rather than a single point estimate due to the variability of external factors. However, for presentation in a financial statement, a single value must be selected from the range of probable reserve values. It is virtually certain that estimates made at early dates will not exactly match final settlement values.

Some industry observers recently said changes in reserve levels indicate a failure on the part of actuaries. However, broad external factors make all estimates of reserves inherently imprecise. Since both the amount and future timing to settle unpaid claims are vastly uncertain by their nature, reserves must be estimated considering a wide range of possibilities. Similar to valuations of long-term assets, estimating future claim costs requires contemplation of many potential factors as they develop--often for many decades. When considering so many possible outcomes for distant time horizons, two distinct reserve estimates by two well-trained actuaries may materially depart from one another even though both estimates were based on reasonably supportable views of future conditions. Similarly, reserve estimates made by the same individual at different periods of time also may show material movements due to reassessments of the probabilities of future conditions. Therefore, ascribing failure to all actuary for reserve increases is similar to criticizing experts who develop and use sophisticated asset valuation models when major declines occur in the stock market.

Reserving Drivers

What is driving the recent reserve changes, which seem so high? Much of the changes in 2001 and 2002 can be traced to increases in liabilities for asbestos, construction defect and mold damage. It is reasonable to remove the impact of asbestos losses from any reserve change examination, as it is doubtful that anyone could have contemplated the impact of recent years' judicial interpretations on policy coverage and their impact on the ultimate value of affected claims. Of the reserve increase in 2001, nearly 24% was due to asbestos. In 2002, the increase due to asbestos liability was approximately 33% of the total reserve movement. The large impact of asbestos reserves is an important lesson to actuaries and other industry observers about uncertainty and adverse outcome created by external factors.

Making Progress

The work of actuaries is advancing on maw different levels. In the Casualty Actuarial Society, the Committee on Reserves is devoted to research on reserving theory, practice, and principles. COR fosters progress by promulgating research through its call paper program and its use of working parties. Working parties are designed to bring the best minds available together to focus on critical immediate issues. Currently, a working party devoted to reserve variability is under way. Also within COR, a newly formed group has been dedicated to investigating circumstances underlying large reserve changes and insolvency that may be due to reserving issues.

Mary Frances Miller is the president of the Casualty Actuarial Society. Gail M. Ross is the immediate past president and chairman of the CAS Board of Directors. Both arc, members of the American Academy of Actuaries.