May 9th, 2011

Workers Compensation Reserve Risk Development: The Cat That May Be Lurking in Your Balance Sheet

Posted at 1:00 AM ET

metropoulos_emil_gccibueler_aaron_gcci1Aaron Bueler, Global Head of Workers Compensation Specialty and Emil Metropoulos, Senior Vice President of Casualty Specialty
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Sudden natural disasters such as the tragic Tohoku earthquake in March are not the only catastrophes that can impact insurers’ balance sheets and policyholder surplus. Such well publicized natural catastrophes only account for about 10 percent of insurers’ notable capital and surplus impairments triggering regulatory action and concern . Of the remaining 90 percent, by far the single largest cause of impairments over the past 40 years (1969-2009) emanated from inadequate pricing and deficient loss reserves — resulting in approximately 40 percent of the cases.

Why Accurately Estimating Workers Compensation Losses Remains so Challenging

Loss reserves are arguably one of the most difficult risks on a cedent’s balance sheet to estimate and monitor. The workers compensation (WC) line of business represents the largest portion of the U.S. property and casualty (P&C) industry’s net reserves, contributing nearly a quarter of total current net loss and adjustment expenses. The risks of managing a long-tailed, heavily legislated line like WC are widely known: it has been nearly impossible to accurately estimate medical inflation, increases in longevity, changes in the workplace and constantly legislated indemnity, over the course of a 20-year time horizon. Moreover, developments in recent years have led to increasing loss costs, decreasing premiums and decreasing investment earnings in WC. The uncertain economic environment has also increased uncertainty in estimating ultimate losses.

Emerging Risks in Estimating WC Ultimate Losses

Reforms enacted in the mid-2000s resulted in lower premiums and loss costs and favorable frequency and severity trends. However, WC medical expenses, which are higher than the overall medical Consumer Price Index, have outpaced favorable lower claims frequency trends. According to the National Council on Compensation Insurance, medical costs now contribute a staggering 58 percent of total WC loss costs, up from 49 percent in 1991. The combined net impact of these trends resulted in deteriorating combined net ratios that grew from 99 percent in 2006 to 111 percent in 2009.

A Confluence of Macro-Economic and Market Competition Factors

Since the 2009 global financial crisis, much of the P&C industry has been on the road to recovery, yet WC underwriting results have continued to weaken. This is due to a conflux of factors, including decreasing payrolls; declining premium volume emanating from both competitive rate decreases and prior year return premium adjustments; the highest medical cost trends among all industry segments; and lower long-term investment returns. Furthermore, the Obama administration’s recent health care reforms create new and unprecedented uncertainties associated with potential medical loss cost shifts between WC and health insurers.

Historical Evidence of the Inaccurate Estimation of Workers Compensation Losses

Loss reserves for WC are essentially forecasts of losses that will be paid over five, 10 and 15 or more years. As a result, they are one of the most challenging risks to quantify on balance sheets. Under standard reserving methods, an actuary examines historic data, measures existing patterns and makes forecasts based on the assumption that those patterns will repeat. Alternatively, an actuary can adjust the patterns for forecasted changes.

Sometimes there is insufficient data to measure the pattern reliably on a given line of business. Yet other times, trends change, and the patterns from the past either simply do not repeat or are difficult to capture. The worst cases of adverse reserve development occur when there are material and unpredicted changes in the underlying trends, as we are experiencing in the current climate. The graph below illustrates the industry’s historically inaccurate estimation of WC. For example, for accident year 2000, the estimate of ultimate loss increased by around 25 percent from its first estimate at the end of 2000 to its re-estimate nine years later. The 1997-2002 soft market was underpriced just as WC medical cost inflation escalated erratically relative to previously assumed assumptions. The ultimate loss for an accident year is re-estimated year after year, and each year, the estimate becomes more mature and accurate. In the graph below, the initial estimate of the ultimate loss after one year of development is the “1-1″ line; the next re-estimate is the “1-2″ line after two years of development, and so on. Following this logic, the graph shows that the industry takes many years to fully appreciate the extent of losses in a soft market (as it did from 1997-2002).

wc-reserving-cycle_rev-small

How to Minimize Inaccurate Estimates of Workers Compensation Losses

Over the past 20 years, actuarial pioneers have worked to apply modern theories to loss reserves. In practice, however, these ideas have not been widely adopted. New reserve methods on long-tail casualty lines will need to offer demonstrable advantages that override the natural instinct to keep time-tested ways. Insurers require a solution with proven accuracy and results they can verify and explain. Programming advanced statistical methods may be too time-consuming for individual companies, so commercial software is needed. Up until recently, there haven’t been many practical, cost-efficient solutions available.

Improving the Actuary’s Best Estimate and Risk Estimation

Guy Carpenter has made great strides in this area with our reserve risk model, MetaRisk® Reserve. The model uses generalized linear modeling (GLM) to identify and display trends in an insurer’s WC data that previously were hidden under a chain-ladder method. With a clearer picture of the past, carriers can make forecasts that are better informed and more transparent.

The Mack and Bootstrapping techniques, which are the dominant methods companies use to measure loss reserve risk, are both based on the chain-ladder method. However, the chain-ladder method assumes that future trends will be the same as in the past. This may be a reasonable assumption for traditional point estimates. However, this assumption is detrimental to estimates of uncertainty since future trends will certainly be different from the past, and this uncertainty is being ignored, significantly understating reserve risk.

Under GLM, future trends and related uncertainty are explicitly estimated. The default is not to assume that future trends will be the same as in the past and understate loss reserve risk. It is possible under GLM to capture changing trends while stressing various dynamic and inflationary scenarios to current net loss reserve positions. The MetaRisk® Reserve X-ray output below reveals the underlying inflation trends that previously would have been nearly impossible to detect using the widely used chain-ladder-based method.

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Since loss reserve risk can account for the greatest drain on corporate capital, it is essential that cedents’ reserve modeling addresses previous models’ limitations while contemplating sound statistical principles. Furthermore, the factors that drive loss reserve risk also contribute to underwriting risk for long-tail business as well as correlation with the underwriting cycle.

Insurers may initially be drawn to GLM for its ability to measure loss reserve risk, especially since they increasingly are being required to report these numbers to regulators. For example, A.M. Best has added a new enterprise risk management section to its latest Supplemental Rating Questionnaire that inquires about several specific inflationary trends and scenarios, both anticipated and unanticipated, that could impact cedents’ net reserve position. However, in a broader sense, GLM will help insurers navigate the long-tail risks in the dynamic WC environment. The essential premise of this approach - particularly relevant in this environment - is that trends may change. The modeling displays the real trends in an underlying WC insurer’s data, whether they have been steady or changing.

This improved understanding of the past has led to important advantages and improvements. Forecasting decisions can now be well informed, transparent and explainable. In addition, reserve risk modeling can better contemplate the risk of a changing future, and the risk drivers that dynamic reserve modeling measures can be incorporated into a capital model. Now, insurers can better manage the risks of long-tail workers compensation business in the context of their corporate capital requirements.

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