Case loss reserves represent an insurance company's estimate of exposure for unpaid claims. The estimate includes claims that have been reported and adjusted but not yet paid, and claims reported but not yet adjusted. In addition, a number of companies also establish allocated loss adjustment expense case reserves to reflect the anticipated cost of handling. The basic premise here is to establish dollar estimates based on a number of factors, including known facts, interpretation of loss circumstances, historical experience with similar cases, case law, and regulatory influence. Case reserves are based on the experiential estimation of anticipated pay out. As such, there is an element of uncertainty inherent within the dollar values. While multiple variations of corporate reserve philosophies exist, there is, however, one universal common denominator: timeliness.

Case reserves provide an important economic indicator of performance to the enterprise. Think of it as a financial “radar,” an early warning system so companies aren't caught off guard. Part of the fiduciary responsibility of any claim department includes the timely communication of loss exposures in financial terms to decision makers, such as program managers and pricing actuaries, in order to provide them with line-of-business loss experience feedback.

Untimely or inappropriate case reserves distort the actual line of business performance or experience indicators, creating an inaccurate base upon which the actuaries forecast performance and establish rates. Loss and loss adjustment expenses are the largest cost elements of each premium dollar earned, followed by producer commissions. The rest is profit from the sale. If the price does not cover its operating costs, the company will be unable to sustain long-term operations. Pricing changes must be approved by the state within which the product is sold. The approval process takes time. In addition, price changes create potential marketplace disruption. Insurance companies make concerted efforts through planning and actuarial analyses to avoid price fluctuations that create marketplace disruptions. It is important, therefore, that case reserves accurately reflect the anticipated exposures as soon as practicable in order to assist the actuaries in making timely and informed decisions relative to product price.

The importance that timely and accurate case reserves play in times of economic uncertainty, such as those that currently prevail, must also be understood. Property and casualty companies derive profit from two primary areas: investment portfolio and operations. When market conditions deteriorate or become uncertain, carriers focus their attentions on the operations side of the business to support overall profitability. If case reserves are late or do not reflect the appropriate loss exposure, the potential for decreased profitability increases. The goal here is for each side to offset softness or performance deterioration in the other. There is perhaps no worse phrase in the claim lexicon than “adverse development on known losses.” The financial reverberation of these words casts a long and unpleasant shadow.

Establishing Consistency

Inappropriate case reserves misrepresent the real picture as far as any valid statistical analysis is concerned. If the loss information represents fewer dollars being reserved, questions arise regarding the payouts and how long the company can sustain this velocity of payment (commonly referred to as the survival ratio).

A breakdown in underlying profitability caused by understated or overstated liabilities directly impacts a variety of constituencies. Agents are profit driven. In the event elements such as late-emerging adverse developments on known losses diminish agency profitability, the relationship between company and agent changes. New or renewal business may be directed to other markets that represent potential for profitability. In addition, loss of profitability by an agent creates the potential for adverse selection (questionable risks being directed towards unprofitable markets).

Uncertainty or loss of confidence in management's ability to deliver a consistent return on investment increases the potential for loss of investment dollars, a drop in stock price, and a potential rating reduction. Retention and seasoned business may be adversely affected as the result of policyholder dissatisfaction with erratic rates. Excessive loss reserves reduce an insurance company's reported profit, thereby reducing its tax liability. Overstated reserves may cause a depressed stock price. Conversely, understated loss reserves may prompt questions of insolvency. The potential for adverse economic consequences as a result of a lack of disciplined reserving is varied and significant.

Sound and consistent case reserves require adherence to fundamental or core technical skills. Timely coverage verification is critical. Coverage should be verified or potential coverage issues identified the same day of assignment to the claim handler. Coverage issues such as loss location, policy effective dates, primary/excess, and contractual or additional insured status require prompt verification. Resolution of coverage issues should be pursued aggressively. In standard lines of business, 14 calendar days from date of receipt by the claim handler is appropriate. Specialty losses such as environmental, construction defect, and asbestos often require more time to validate coverage. However, a due date should be established and monitored in order to maintain timeliness of coverage verification.

Liability is the pivotal determinant in establishing a reserve. Fact-gathering must be performed in an aggressive manner (generally within 30 days, depending on the line of business and whether litigation is involved) in order to make timely, informed exposure decisions. Influencing factors, such as contributory or comparative negligence and joint and several liability, should be clearly documented in the claim file to support the values established.

Verification and analysis of damages should commence as soon as practicable. Estimates should be secured, injuries verified, and lost-income claims documented. Documentation of the extent of the claimant's injuries and distinguishing actual treatment from diagnostic procedures establishes a more accurate injury value. The potential for adverse development on known losses increases significantly when claim departments deviate from thoroughly performing these fundamental adjusting skills.

Having reviewed a number of case reserve inventories, including personal, commercial, and specialty lines of business, I found a broader-than-expected variance in case loss reserves, indicating lack of awareness on the part of the claim staff of the purpose and corporate importance of prompt, accurate case reserving. Beyond loss reserves, a wider degree of variance was noted in the area of allocated loss expense reserves. Quite often, expense reserves do not reflect the likely or probable anticipated costs necessary to handle the case. A majority of you will be familiar with the pay-as-you-go expense reserving technique (often referred to as “stair-stepping”) found most often in this category. Late recognition of exposures and last-minute increases to cover imminent payments have a direct impact on corporate profitability. By delaying or failing to recognize loss or expense exposures, claim professionals waste the potential benefit of advance communication to aid corporate economic forecasting and planning.

Learn the Language

Communication of potential exposures and case reserve appropriateness requires the collective effort of both the claim and actuary departments to ensure timely and accurate exchange of economic information. Claim management must establish and maintain a close working relationship with the actuarial department to obtain maximum benefit from the reserving process. Beyond case-specific evaluation, claim handlers, supervisors, and frontline managers need a working knowledge of the fundamentals of actuarial science, including trend lines and development patterns, in order to manage case reserves more effectively and avert financial difficulties caused by inappropriate evaluations. Understanding how certain lines of business should develop and making certain that case reserves reflect the appropriate levels of exposure must be a key claim management priority.

The claim department also has the ability to advise actuaries on the technical and legal elements that make each case reserve unique. This ongoing dialogue between the claim and actuary departments develops the intellectual capital necessary to effectively manage the company's financial resources. Without it, the company's ability to make necessary adjustments relative to product development, pricing, and market participation is limited.

Prompt, accurate, and consistent case reserving is a discipline that must be cultivated and maintained in order to support the charge of fiduciary responsibility that is the claim departments' task alone. The property and casualty industry has made a concerted effort to educate its technical and managerial claim personnel concerning the function and purpose of case reserving. However, a growing percentage of the industry's most experienced technicians and managers are reaching the end point of their careers. Coupled with reductions in force and shrinking training budgets, this knowledge base is being depleted, creating the potential for continuing erosion of this important core skill.

Faced with challenging caseloads, legal and regulatory requirements, and high-pressure customer service demands, companies are allowing the global corporate importance of timely and appropriate case reserving to become obscured. It is for this reason that persistent case reserve assessments by claim management must be established early on and frequently reinforced in order to develop a discipline that supports timely and accurate case reserving in the claim organization. This, in turn, will ensure corporate financial strength.

Paul Swank is president of Swank Consulting Services, a firm that provides claim solutions to the property and casualty industry. He may be reached at www.swankconsultingservices.com.