September 14th, 2011

Reserving Cycle Analysis Suggests Tightening Ahead

Posted at 1:00 AM ET

mango_don_gcciDon Mango, Head of Global Advisory
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In recent years there has been a steady stream of reserve releases from insurers, which helped support financial results in the face of a weakening market and significant catastrophe losses. Heading into 2012, Guy Carpenter’s analysis of the reserving cycle suggests that the tide may be turning, and we may be heading into a period of reserve shortfalls.

Figure 1 shows the U.S. reserving cycle over the past 30 years. The blue line represents the first-year evaluation of industry ultimate loss indexed to one. The other lines show the revisions to that figure at one-year increments: red represents the two-year evaluation, green represents the three-year evaluation, etc., up to the grey line, which shows the ultimate computed loss figure 10 years after the accident year.

Figure 1: US All Lines of Business Reserving Cycle, Net of Reinsurance

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The chart clearly illustrates the recent excess reserve phenomenon, as subsequent-year evaluations reduced the ultimate loss figures for accident years and increased available reserves that could be released to support results.

It also shows a clear cycle whereby the industry’s booked ultimate loss goes up for seven or eight accident years, and then down for seven or eight accident years. Within each cycle, the two-year evaluation serves as a good proxy for the ultimate loss figure: a sharp two-year increase will lead to an even sharper ten-year increase, and vice versa.

Finally, the chart suggests that the industry is about to enter a new and challenging cyclical phase. If the trend continues, ultimate losses may again begin to exceed the one-year evaluation for each accident year as soon as 2011 - marginally for a year or two, and then dramatically for several years thereafter. Such a move would lead to a steady drawdown of reserves, leaving less (if any) available for release in service of bottom-line financial performance.

While this chart offers a striking and sobering perspective on the reserve cycle, there are a few key caveats to consider. First and foremost, this research is still very new, and fundamental aspects of it - such as what specific factors drove the inflections seen in years such as 2000 and 2004 - have yet to be fully explained. It also reflects only the U.S. market - a large proportion of the global market, but not necessarily indicative of the situation in all regions around the world. Still, Guy Carpenter utilizes this and other proprietary research to help clients prepare for a potentially challenging reserve adequacy environment in the years to come.

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