October 23rd, 2013

The Reserve Cycle

Posted at 1:00 AM ET

leong-jessica-bio-sep-2013Jessica Leong, Lead Casualty Specialty Actuary

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In 2012 the insurance industry enjoyed more reserve releases, but many sources say that the releases of the last decade will soon run out. But when? Most insurance commentary reports on the reserve cycle but does not often attempt to explain why it exists. If we can understand the drivers of the cycle, we can do better in predicting where we are and where we are going.

Guy Carpenter & Company has begun to look at the reserve cycle in a different way: by studying the booked ultimate loss by accident year. We chose accident year because actuaries typically analyze losses according to their year of accident. The estimate of the ultimate loss for a particular accident year ideally should not change over time if the initial estimate was correct. However, using U.S. industry data, we find that as a particular accident year is re-estimated periodically, a cycle appears.

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Guy Carpenter’s analysis reveals two trends:

1. Those accident years that start to go bad, keep getting worse (and vice-versa)

2. A series of good accident years has in the past been followed by a series of bad accident years.

These trends help us figure out what the drivers of the cycle really are, and point out some misconceptions:

  • There is no “cheating” phase. Because we are releasing now does not mean that reserves are lower than they should be, and therefore the industry will need to shore up reserves in the future. Instead, our analysis shows that the industry moves to the right answer over time.
  • If there is no cheating phase, why do we see periods of reserve deterioration after periods of reserve release? To answer this question, we applied the standard actuarial chain-ladder method to the industry data to estimate reserves, for just the workers compensation line, as an illustration. We were able to produce much the same cycle. That means that the cycle would exist anyway without human intervention in setting reserves, so long as we used the industry-standard actuarial algorithm.

Guy Carpenter will be releasing a full briefing on why we have a cycle and where we think it is heading.

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