Banking on Case Reserves

A claim representative can affect an insurer's bottom line in many ways, probably none more substantial than activities relating to case reserving. Although an occasional inadequate or inaccurate reserve may have little or no effect on an insurer, habitual undervaluation of claim reserves can distort the rate-making process, eventually undermining a carrier's ability to write business competitively and ultimately affecting solvency.

Reserving errors can be caused in several ways. Initial reserves may be inaccurate because they are determined based on limited information. Alternatively, reserve inaccuracy can be the result of the claim representative's poor planning, lack of expertise in estimating claim severity, or unwillingness to re-evaluate facts. In these cases, the claim representative may set a modest initial reserve but then raise the reserve by a few thousand dollars to issue payments. Later, the reserve is increased again when more bills arrive. This process is called "stair-stepping" the reserve.

On a claim that concludes in 30, 60 or 90 days, stair-stepping has little effect except to reveal the claim representative's poor claim handling practices. But if the claim remains open for several years, as many liability and workers' compensation claims do, the incremental increases in reserves during those years would not be properly reflected in the insurer's rate-making process.

This does not mean that claim representatives cannot adjust a reserve during the course of a claim. However, they should make those adjustments because of new information or changes in the circumstances of the claim, not because of poor planning or other poor practices. For example, if the estimate for car repairs is $5,000, the claim representative would set up a reserve of $5,000. If hidden damage is then found and the estimate is revised to be $10,000, the claim representative should change the reserve to reflect this increase in the repair estimate. Likewise, if an estimate to repair is lowered, the reserve should be changed to reflect the decrease. Because these changes are based on changes in the facts of the claim, they are not considered stair-stepping.

Reserves should reflect the ultimate cost of a claim and not the claim's present value; therefore, the reserve should account for the claim's future settlement value. For example, a catastrophic injury claim may take years to settle. During that time, inflation may increase the cost of medical care, or new and expensive medical technology may be developed. The reserves for such claims should anticipate those increased costs.

Claim representatives may underestimate the future settlement value of a claim if they are overconfident of their ability to conclude the claim for a lesser amount. Reserves should always be based on the value of a claim, never on the perceived likelihood of successful negotiation and settlement. Analysis of verdicts rendered in similar cases helps show the potential value of a claim and discourages the tendency to base reserves on negotiation expertise.

Some inadvertent errors in setting reserves can be detected using computer software that stores claim information. Some claim information systems provide a data entry check. For example, the software might require that the reserve amount be entered twice to allow the person inputting the data a chance to verify the amount. Additionally, claim managers can review reports of reserves from the preceding day for unusual entries or reserves established in excess of authority. For example, a report listing all reserves of $100,000 or more might uncover a $10,000 reserve that was incorrectly entered as $100,000.

Although the exact timing may differ among insurers, the setting of the initial reserve(s) usually occurs early in the claim handling process. Claim representatives often establish claim or case (loss) reserves in conjunction with identifying the policy. An insurer's claim information system often determines the types of reserves that are established, such as one reserve for property damage and another for bodily injury. Some systems require separate reserves for each claimant in a claim, and some systems require separate expense reserves for the costs of handling the claim. For example, in a claim for an auto accident, an individual reserve may be set up for damage to the insured's vehicle, damage to the other party's vehicle, medical expenses for the insured, and bodily injury for the claimant.

Insurers can establish reserves on claims using any of several methods. These are six common methods:

Reserving errors can occur when any of these methods are used inappropriately, but, because the method most influenced by the claim person is the individual case method, it can be the most problematic. Using this method, a claim representative sets an individual or case reserve for the claim or cause of loss based on his expectation of what the insurer will pay. That expectation is derived from the claim's circumstances and the representative's experience in similar claims.

Bodily injury claims are particularly susceptible to error under the individual case method because of the subjective nature of the evaluation and the vast array of factors that can be considered in these cases. (A sampling of those factors is shown in the sidebar.) Additionally, at the time the initial reserve is set, much of the information is often unknown. It is a best practice for claim representatives to review the appropriateness of the reserve every time they see the file. Doing this will ensure that changes in the known facts will be reflected in a timely reserve change. Documentation supporting the need for an increase or decrease should be made part of the claim file.

Another method of setting claim reserves is the roundtable method, under which the file is reviewed by several other claim personnel. Ideally, at the start of this process, the reviewers should not know the reserves recommended by the primary file handler. After evaluating and discussing the claim, they may reach a consensus reserve figure, or they may calculate an average of all the figures. Because this method is time-consuming, it is not appropriate for setting initial reserves. However, for serious or prolonged claims, it is a suitable method to review initial and ongoing reserves.

Claim representatives may use the expert system method. The details of a particular claim are entered into the computer, and the program applies the appropriate rules to estimate the amount of the loss and the loss adjustment expenses (LAE). An expert system can provide greater consistency in reserving than the individual case method. While similar in operation to the formula method, the expert system includes more subjective information, such as loss location or the name of the treating physician, in creating the reserve. This and the roundtable method can minimize stair-stepping.

Claim representatives may also set claim reserves using the average value method. This method is useful when there are small variations in loss size for a particular type of claim and when claims can be concluded quickly. The average values are usually based on data from past claims and adjusted to reflect current conditions. Auto physical damage claims are often successfully reserved based on this method. In some cases, an initial reserve is made based on the average value method, but claim representatives are required to modify the initial reserve within a specified number of days to reflect each claim's circumstances.

Another method of setting claim reserves is the formula method, by which the insurer determines and creates a formula for setting a reserve to be used by the representative based on the facts of a claim. For example, a formula may be based on the assumption that a certain ratio exists between the medical cost and the indemnity (or wage loss) in a workers' compensation claim. Based on an insurer's loss history with many similar claims, the indemnity reserve may be set at a certain percentage of the medical reserve. The formula method may also be used to set the additional living expense reserve under a homeowners policy if the home is destroyed by fire. The reserve may be set as a certain percentage of the coverage limit.

The loss ratio method of setting claim reserves is used to establish aggregate reserves for all claims within a type of insurance or a class of loss exposures. The actuarial department uses this method when other methods of establishing claim reserves are inadequate. For example, in medical malpractice insurance for physicians and surgeons, claims are often reported long after the expiration date of the policy that provided the coverage. To ensure that the insurer has adequate reserves for those claims, the actuarial department may project reserves using the loss ratio method.

The National Association of Insurance Commissioners Annual Statement is another example of the use of the loss ratio method of setting reserves. The Annual Statement requires minimum reserves for certain types of insurance, such as workers' compensation. The minimum reserve is a specific percentage of the earned premiums for the year. For example, for workers' compensation insurance, the minimum reserve required by the Annual Statement may be 50% of earned premiums. If case reserves are lower than that amount, the Annual Statement uses the set percentage. If case reserves are higher than the set percentage, the Annual Statement uses the case reserves (Figure 1).

Additionally, insurers are required by law and good accounting practice to establish reserves for losses that have been incurred but not reported (IBNR). Although the term refers only to incurred but not reported losses, unreported losses account for only a portion of the reserve in many cases. Often, the IBNR reserve also includes an amount for reported losses for which the case reserves are judged to be inadequate. A reserve for claims that have been closed and then reopened may also be included in the IBNR reserve.

Actuaries analyze the insurer's experience by comparing paid losses to case reserves to determine whether the insurer typically under-reserves or over-reserves claims. If the insurer typically under-reserves claims, the IBNR reserve will be set at an amount to cover the ultimate cost of the claim.

Regardless of the method used for setting reserves, the claim representative can have a positive or negative impact on the insurers' bottom line due to their reserving practices. Following reserving best practices and the insurer's own reserving guidelines will help ensure that the results are more positive than negative.

Donna J. Popow, J.D., CPCU, AIC, is senior director of knowledge resources and ethics counsel for The Institutes in Malvern, Pa. She can be reached at popow@TheInstitutes.org.