December 15th, 2014

Reserving Risks

Posted at 1:00 AM ET

“Dark matter” can be lurking on an insurer’s balance sheets in the form of a casualty catastrophe or an emerging and not as yet fully understood risk such as cyber. While there have been significant advances in quantifying the uncertainty pertaining to these risks, it is worth considering how they may manifest themselves in the future and what can be done about them now to protect from the “dark matter” downside.

Insurance cycles are not a new development but the reasons why they are likely to persist are beyond the scope of this report. The Guy Carpenter/Oliver Wyman Risk Benchmarks Report (1), published annually, clearly demonstrates that cycles are present. The figure below shows the reserve cycles present in various US insurance lines of business from accident years 1990 to 2013. The United Kingdom shows a similar but less pronounced picture. The exhibits show the movement in reserve at the end of the first year (the black line) to the ultimate position and each increase or release in reserves along the way. What can be inferred from these charts? It is clear that consecutive accident years tend to move in the same direction so there is clear correlation between accident years. The recognition of any deterioration or improvement tends to happen gradually with bad years slowly getting worse and good years slowly getting better. It is also very evident that lines of business are heavily correlated. With correlation across the dimensions of time and line of business, correlation is everywhere.

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So what causes these correlations between years and between lines of business? The answer is a variety of events, some known and some as yet unknown. One of them, inflation, can be a driver of claims costs that will impact multiple classes and may continue for some time, causing increases or decreases in reserves across years. Similarly, legal changes and developments can impact multiple liability classes and will likely affect all open claims impacting successive years. Also, historically, asbestos-related claims affected multiple product lines and many accident years. These events prompt the question of what emerging risks could manifest themselves in some super-cycles to come.

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Note:

1. Guy Carpenter and Oliver Wyman, Insurance Risk Benchmarks Report.

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