Authored by Dave Wolfe
The alternative test is to monitor reserves, not to accurately measure the reserving process. For insurance companies, the reserving process is fundamental to the financial reporting process. The reserving process can refer to different components of the process to internal or external personnel at the insurance company. The claims department is at the frontline when a claim is reported and a case reserve needs to be posted. An internal actuarial department performs work in support of the recorded loss and loss adjustment reserves (reserves) in the insurance company’s statutory financial statements. Either the internal or external appointed actuary relies on reserving methods or models to opine on a company’s Dec. 31 recorded reserves. Company management is responsible for the financial reporting process including the recording of loss and loss adjustment reserves and controls over the entire process.
One of the state insurance regulators’ primary functions is solvency regulation for which the risk-focused examination is a key tool. The primary purpose of a risk-focused examination of an insurer is “…assessing and monitoring its current financial condition and prospective solvency.” Conservatism in the recorded reserves is preferable to understated reserves when viewed in light of solvency regulations. It has been 40 years since the National Association of Insurance Commissioners (NAIC) June 1980 Plenary Session where the first formal statement of a loss reserve opinion requirement was adopted and nearly 30 years since what is now referred to as a Statement of Actuarial Opinion as required by the NAIC Property and Casualty Annual Statement Instructions was required. This Statement of Actuarial Opinion has operated as a regulatory control over the reserving process by helping to mitigate the risk of insurance company loss reserves being “too low” (deficient or inadequate) or “too high” (redundant or excessive).
In terms of reviewing the recorded reserves of the property/casualty insurer, one approach is through the review of the One Year Loss Development and Two Year Loss Development tests in the Five Year Historical Data exhibit of the insurer’s Annual Statement. These tests are retrospective because they show development in management reserves for years prior to the December 31 Annual Statement that is in question. The ratios measure changes in management’s prior year(s) estimates of ultimate losses relative to the corresponding prior year(s) policyholder surplus.
As an example for the Two Year Development test in an Annual Statement as of Dec. 31, 2019, the 2019 result shows the change in management’s ultimate loss estimates for 2017 and prior relative to the policyholder surplus as of Dec. 31, 2017. An important consideration in interpreting these tests is the leverage ratio for the insurer as defined by the ratio of the insurer’s recorded reserves to policyholder surplus. For an insurer that is more thinly capitalized (higher ratio of reserves to surplus) the results of Annual Statement Loss Development tests are properly viewed for the potential impact on the policyholder surplus. For a more strongly capitalized insurer with a low leverage ratio, the resulting Loss Development tests may only show a small change relative to surplus, but may hide what could be considered a material change to management’s prior recorded reserves. As an example, an insurer with a leverage ratio of 1 to 2, a One Year Loss Development test result of plus or minus 5% would imply an approximate corresponding 10% increase or decrease in management’s recorded reserves as of the prior Dec. 31 valuation.
An Alternative Test akin to the One and Two Year Loss Development tests is to use management’s corresponding recorded reserves as the denominator instead of policyholder surplus. The recorded reserves are also in the Five Year Historical Data and are the sum of lines 22 and 23. This Alternative Test more directly measures changes in management’s reserves and is not subject to possible misinterpretation based on the insurer’s leverage ratio.
The numerator of the One and Two Year Development tests are based on changes in management’s ultimate loss estimates. The numerator is from the Annual Statement Schedule P – Part 2 Summary. The Schedule P- Part 2 Summary documents changes in management’s ultimate loss and defense and cost containment expenses (DCCE).
The Alternative Test above has a shortcoming. The reserves used as the denominator are loss and all loss adjustment expense reserves (i.e., also include Adjusting and Other expense). Thus, the Alternative Test result would understate either favorable or adverse changes in management’s reserves. As Adjusting and Other expense is typically the smallest component of management’s recorded reserves, this shortcoming would usually not distort the Alternative Test indication. An adjustment to remove the shortcoming is to remove the Adjusting and Other expense in the denominator of the Alternative Test. The amount to remove is Column 21 – Column 22 from the Schedule P- Part 1 Summary of the insurer’s prior year Annual Statement.
The Alternative Test is another tool that can be used in monitoring management’s reserving process.
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