3 - Reserving Bases Flashcards
Reasons for estimating reserves
- Estimate liabilities for:
—-> Published accounts
—-> Solvency supervision
—-> Internal management accounts, business plans &
budgets - Independent actuarial opinion may be needed on
reasonableness of booked reserves by law - Provide management info on business performance
by area i.e. by business line, distribution channel etc. - Estimate recent claim costs for premium rating
- Value the insurer for mergers & acquisitions
- Negotiating commutation for buyer/seller
- Transfer a book of business to another company
- Ascertain tax liabilities
- Test adequacy of case estimates for large claims w
lack of data (periodic tests conducted to ensure
resilience)
What is a commutation?
- Prematurely closing a reinsurance contract and agreeing on an amount to settle all current & future claims
- Traditional reinsurance covers only a portion of liabilities e.g. above the excess or a quota
- In commutation, the reinsurer takes over the all of the liabilities (like reinsurance to close process)
Considerations for reserving purposes:
Published accounts
- Legislation & accounting principles
——-> Going concern, break-up or run-off basis?
——-> True and fair view (not defined, auditors opinion)
——-> Best estimates with margin, or prudent
assumptions throughout w-out margins
——-> Interpretation: how terms are to be understood?
——-> Should reserves be discounted or explicit
margins needed? (required under IFRS17 &
solvency II because returns earned on reserves)
Types of reserving bases and their meanings
Run-off basis: reserves assuming no new business sold and allow existing liabs to run-off
Going concern: assume company continues in operation for the foreseeable future
Break-up: If the company was to stop EVERYTHING completely, what reserves would we need to run-off liabilities
Implicit vs explicit margin for reserves:
- Discounting required by solvency II & IFRS17 and if
explicit margin is needed legislation should say so. - If reserves are not discounted, they will be larger
(hence resulting in an implicit margin)
Considerations for reserving purposes:
Solvency accounts
- Regulation and professional guidance
——-> Going concern, break-up or run-off basis?
——-> Risk margin - There may be one-sided pressure for margins if
actuary has to sign off on reserves sufficiency - For M&A, conflict of interest b/w seller & buyer
- Best estimate reserve should be provided
- Discounting allowed
- Risk margin required (calculated using insurer’s
capital model or standard formula) - Technical provisions (best estimate reserves + risk
margins) comprise claims (IBNR, Outstanding, IBNER)
& premium provisions (URR UPR) relating to the
fture claims
Considerations for reserving purposes:
Management accounts
- Need results for making various management
decisions - Reserving principles need to be agreed upon w
management - Best estimate basis most likely & sensitivity testing (for
realistic picture of performance) - Margins used to smooth results (UK insurers usually
prudent because of management for reputation) - But margins delay profit release and act as a buffer
- Auditors alert to margins because it also delays tax
pmts (delayed profit release)
Considerations for reserving purposes:
Mergers & acquisitions
- Liabilities shown in balance sheet are starting point
for negotiations - Buyer will want to:
—-> Understand reserving bases
—-> Know if there’s potential surplus in book (because
of margins and delayed profits)
—-> Make range of estimates to scenario test insurer
business (buyer will be more prudent than seller)
—-> Buyer willing to buy insurer possibly to achieve
greater economies of scales & synergy - Both parties may use different bases than used for
published accounts
Considerations for reserving purposes:
Commutation
- Similar considerations to M&A but data & factors
considered with more detail - Reinsurance recoveries no longer an asset to insurer:
this impacts the books of insurer - Price of the transfer depends on:
—–> Relative importance of commutation b/w parties
—–> Actual/perceived financial strength of parties
e.g. insolvent parties more eager to transfer liabs.
so prepared to offer lower price
Considerations for reserving purposes:
Transfer of liabilities
plus scenario
- Similar considerations as M&A
- Also consider LOCAL regulation e.g. when insurer
transfers book of business to other insurer within the same insurance group (for tax benefit maybe)
e.g. Insurer 1 might pay generously to transfer liabs to insurer 2 under the same group in diff. country w favourable tax laws so that this insurer 2 can record a profit and pay less tax on that profit
Countries have laws which make it compulsory for liabilities transfers under the same group to be at arms length.
i.e. transfer price should be comparable to what would be paid to external insurer (avoid tax evasion)
Considerations for reserving purposes:
Tax purposes
- Tax regulations
- Penalties for over-reserving & delay of tax pmt or acceptance of booking of reserves over best estimate
Choice of reserving method considerations:
Depends on:
- Class of business (short-tailed vs long-tailed)
- Quality/extent of data (short-tailed business has
abundant data so chain ladder method used) - Exposure period (if period considered is in 2 years time => recent data requires adjustments and statistical methods using historical data may not be suitable)
- Types of claims (bodily injury vs motor claims)
- Age of business & claims development data available (recent business might not be sufficiently developed)
- Key factors affecting development of claims
(quantifiable? => statistical methods. Things like court
decisions? => pragmatic approaches)
—–> Need to allow for inflation in excess current economic inflation & social/cultural inflation - Historical trends & patterns (if historical patterns & trends do not affect claims development, stochastic w interactions may be more suitable)
- Purpose of the reserving exercise
- Use a variety of methods to arrive at the estimates required because each approach has adv./disadv.
- Be aware of limitations & implicit assumptions of each method
- Consider appropriateness for the purpose of reserving exercise
- Need to MONITOR emerging experience against expected–> more desirable to model IBNER & IBNR reserves individually because some lines of business are more prone to reopened claims/judicial decisions than others
What would cause IBNR to increase?
- an increase in no. claims or
- if claims stayed the same but we have access to more information s.t. avg claim cost for reported claims increases
Compare Ratings basis vs Reserving basis
ASSUMPTIONS
- Rating: Realistic assumptions without margins
Reserving: Depends on purposes & overriding rules & guidance wrt. the purpose
UNUSUAL EVENTS
- Rating: Adjusted to avoid distortion of premiums
- Reserving: Made to allow for worst case scenarios
PERIOD CONSIDERED
Rating: Only future periods considered in setting premiums e.g. when products are sold, when claims incurred
Reserving: Liabilities both incurred in past and will incur future (UPR needs to be set for future liabs. which will arise as well as outstanding, IBNR & IBNER for already incurred)
OTHER CONSIDERATIONS
- Reserving basis: there is a whole flashcard on this
- Rating basis:
- –> Levels of prudence req. by management
- –> Risk appetite (may set high premiums to avoid attracting certain risks)
- –> Competitive consideration
- –> Social/Regulatory pressures
- –> Profit loading: depends on uncertainties involved in risk & competitive considerations
How to allow for inflation in reserving?
- Future inflation assumption may be implicit e.g. chain ladder method assumes future inflation is similar to past inflation.
- Inflation should be considered as an important variable explicitly (look at the results w diff. possible future inflation assumptions)
- Explicit allowance for inflation may be easier to apply to some methods e.g. Avg. Cost/Claim method
- Should be considered in excess of general economic inflation (e.g. CPI, social/cultural & wage inflation) which may reflect:
- —–> Historical inflation levels seen in the claims
- —–> Future changes in average sizes of claims due to change in law e.g. court decisions, mandatory cover
- Should document:
o The “direction” of inflation:
—–> could be by calendar year or origin year
o What inflation represents (increase in what?)
Could be an increase in:
—–> Average claim size
—–> Burning cost per unit of exposure (due to increase in average claim size/frequency or both)
