March 18th, 2010

How’s Your Reserve Risk?

Posted at 3:00 PM ET

Spencer M. Gluck, Senior Vice President

The merits of enormous stimulus packages are being debated while enormous budget deficits are on the rise. How long will their impacts last? When - if ever — will there be the political will to rein them in? Is there a serious bout of inflation in the future? No one can pretend to know the answer to these questions, and it may be futile to enter the debate. But what is not debatable is the tremendous economic uncertainty faced today. There may be uncertainty about whether inflation will rise, but there is no doubt that the risk of future inflation is at a level not seen in a generation.

What will inflation do to your loss reserves? Will rising prices affect settlements of claims that are currently open? Of claims that are currently unreported? It would be hard to imagine otherwise. The United States hasn’t seen high inflation in over 25 years. The times when inflation held sway were not the best of times for the casualty insurance business, with serious deterioration in both reserves and underwriting results.

But when it comes to loss reserve risk, inflation is hardly the only thing that will concern you. Guy Carpenter & Company, LLC used its groundbreaking “Dynamic Reserve Model” (DRM™) to analyze over 25 years of casualty industry loss development data. We found that there’s a great deal of reserve variability, even in industry-level data, even in a time of relatively stable inflation. Some of the reserve variability is underwriting cycle related. It is widely known that industry reserves tend to be set at inadequate levels during soft market cycles , but this practice is typically attributed to managements’ unrealistic optimism, at best, and outright “cheating,” at worst. In fact, it’s more than that. It turns out that the underlying actuarial indications are cyclically inaccurate, even before optimistic judgments are overlaid, further exacerbating the problem. Even the most conservative management may be starting out behind the curve.

So where is the insurance industry today? The casualty underwriting cycle is on the way down, as it has been for a number of years. When will the bottom be reached? We don’t know, except to say not yet, not now. The industry reserves at year end 2009 haven’t yet been analyzed, but historical patterns suggest that the industry is entering a period of loss reserve shortfalls. Even your most basic actuarial indications may be off at this time. With the combination of the unfavorable cyclical position and the unusual inflation risk, casualty business looks very risky right now, regarding both existing reserves and new business.

What can Guy Carpenter do to help? With DRM™, Guy Carpenter’s analytical unit will show you the changing trends in your own data and in the corresponding industry-level data. We will give you the clearest picture of what has happened and what is happening. Of course we can’t tell you what will happen but we will give you the best information to see what might happen. Guy Carpenter will quantify the impact of that range of possibilities, so that you understand your exposure.

And lastly, Guy Carpenter can show you how these risks can be mitigated through risk transfer. There are solutions available for your existing reserves, and even more importantly, for the new reserves that you continue to accumulate through ongoing underwriting.

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