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).