May 31st, 2016

Reserving and Capital Setting: Background and Challenges

Posted at 1:00 AM ET

Loss reserves are arguably one of the most difficult risks to estimate and monitor. In fact, inadequate pricing and deficient loss reserves have been the leading cause of property/casualty company impairments. According to A.M. Best, from 1969 to 2009 they triggered approximately 40 percent of all impairments - four times more than those emanating from natural catastrophes (1). There are many uncertainties in managing long-tailed, heavily legislated lines of business that can be triggered from emerging risks. Unforeseen inflation and anticipated legislative changes over a 10 to 30 year period present many demands. In order to prepare for emerging risk scenarios, future trends and related uncertainties need to be explicitly identified, contemplated and estimated.

The concept of emerging risks is not a new one in the context of (re)insurance; the market has always faced some new challenge as the world around us has changed. Aviation, for example was once considered an emerging risk. Now, it is well understood and the market for risk transfer has been operating for decades. The same will inevitably come to pass for many of the risks discussed in this report. The question is how to try and quantify them and then manage them now while they are less understood.

Reserving has always been the realm of actuaries and the strapline for the actuarial profession for a long time has been “Making Financial Sense of the Future.” This ambition to make sense of the future is particularly challenging in the context of reserving and capital setting for emerging risks. Most commonly used reserving techniques rely on the projection of patterns in past data around how claims arrive and are estimated and then paid, to infer what we need to set aside now to meet all of our liabilities. That is perfectly sensible if the past is a good guide to the future. But, in the case of emerging risks, it really is not. What history has taught us is to expect the unexpected. There may well be events or manifestations of risk that were unexpected at the time in our past data, but who is to say that future such occurrences will have the same shape or impact? New and more sophisticated techniques and tools go beyond commonly used reserving methods of the past. Generalized linear modeling (GLM) techniques and tools (such as those incorporated in Guy Carpenter’s MetaRisk® ReserveTM) can assist in detecting the emergence of new inflation trends as well as other disruptors early on. These tools allow (re)insurers to dynamically stress-test changing inflation scenarios and other emerging claims drivers. Then, capital should be set at a level to mitigate against such surprises and protect the balance sheet.

For many emerging risks discussed in this report the tail will be long so the capital will likely be largely contained in the reserving risk category. Most reserving risk assessments, including those that are incorporating the relatively new GLM techniques, still rely on the use of past data with the associated issues this presents. For these reasons we need to look beyond the traditional actuarial tool kit for solutions.

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Note:

1. A.M. Best Special Report: 1969-2009 Impairment Review.

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