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Q Does Governmental Accounting Standard 10 call for the setting up of a reserve by public entities for any future third-party administrator fees or in-house claims staff costs? If so, why, and how should the reserve be estimated?
A The answer to your first question is yes for pools and no for all other public entities.
What does GASB 10 call for in the case of pools? It calls for the setting up of an accrual for future third-party claims administrator fees (or in-house claims staff costs) if those fees or costs are related to the handling and settlement of claims incurred prior to the statement date. Whenever we refer to TPA fees in this article, we are also talking about in-house claims staff costs.
Let's take an example. If the statement date is June 30, 1995, then a pool should set up an accrual for all future TPA fees which will be incurred in adjusting claims where the incident date was on or prior to June 30, 1995.
Since TPA fees are typically charged on a fiscal year basis, regardless of when claims were incurred, coming up with an estimate for this accrual presents some challenges. We will describe two common methods later.
Why does GASB 10 require such an accrual by pools? To understand this, let's consider why insurance companies are required to set it up.
There are two types of loss adjustment expenses: allocated and unallocated. Allocated loss adjustment expenses consist of all expenses that are routinely assigned to an individual claim file. Examples include attorneys fees and investigation costs.
Unallocated loss adjustment expenses consist of all expenses that typically are not assigned to individual claim files, for instance, the salaries of in-house claims adjusters, claims department overhead and/or TPA fees.
Let's suppose the insurer's statement date is Dec. 31, 1995. Let's also suppose that the insurer will cease operating as of that date.
If that was the case, the insurer would of course need to have loss reserves to cover all losses arising from policies which expired on Dec. 31, 1995. It would also need to have ALAE reserves, as well as ULAE reserves for the same reason.
In other words, the accrual is required because the insurer must fulfill its obligations. If it is going to stop operating, it must pay for some other entity to adjust its claims.
This same way of thinking has been applied by GASB 10 to pools. If the pool were to stop providing coverage on June 30, 1995, it would still need to continue paying a TPA to settle existing and unreported claims for years to come.
Of course, two or three years down the road, TPA fees should be much less than they would have been if the pool had continued to provide coverage. Nevertheless, they will continue because many claims will probably still be open.
I suspect that one reason GASB 10 calls for the accrual of an ULAE reserve for pools, but not for the other public entities, is fairness. Why should a new pool member pay for ULAE costs dues to claims arising from years prior to its joining? Correspondingly, if an entity leaves a pool, it should pay its share of future ULAE costs due to exposure periods when it was a member.
Estimating an appropriate accrual for ULAE or future TPA fees can be tricky.
By their very nature, ULAE payments are not allocated to specific claims-so there is no natural way to split such expenses between those due to claims arising from incidents which occurred prior to any given date and those arising from incidents due to claims arising from incidents which occurred subsequent to a statement date.
There are two commonly used methods for estimating ULAE reserves. The first one is quite simple and is widely used by insurance companies. It is often called the "Calendar Year Paid Ratio Method."
Under this method, the ratio of total ULAE payments to total loss payments for the most recent two or three years is examined.
For example, the ratio of ULAE payments to loss payments (for all years combined) may have been 7.8% for 1992-1993, 8.2% for 1993-1994 and 8.0% for 1994-1995. We then might select 8.0% as a representative ratio. To estimate the ULAE reserve, we would then apply 100% of the representative ratio to the accrual for incurred but not reported losses and 50% of the representative ratio (or 4%) to case reserves for losses. The total of these two pieces would be the ULAE reserve to be carried.
While this method is rather arbitrary, it is also widely used. It is based on the idea that more unallocated expenses will be needed to settle claims which have not been reported yet than to settle known cases.
The second method is more complicated, but perhaps more accurate. I say "perhaps" because the only way to really tell is for claims people to keep accurate records of how much time they spend on each claim-and this is rarely done.
This second method is based on average ULAE costs per open claim. This method is also based on forecasts of how many claims incurred prior to the statement date will still be open during each of several future years.
For example, a pool might have an average of 300 claims open. Let's say that was the case during fiscal 1995 and that the pool paid $100,500 in TPA fees during that year. Then the average TPA cost per open claim would be $335 (= $100,500/300).
We would take that average and inflate it by, say 5% per year for each future year and multiply it by estimates of the average number of claims that would still be open during each future year-that were due to incidents occurring prior to June 30, 1995. So we would apply an average of $351.75 (= $335 x 1.05) to the average number of open claims (due to incidents occurring prior to June 30, 1995) during fiscal 1996. If that average were 175 (given 300 claims open on June 30, 1995 and 50 on June 30, 1996), we would then come up with an estimate of $61,556.25 (= $351.75 x 175) for TPA fees during fiscal 1996-due to claims from fiscal 1995 and prior years.
If we estimated that 25 claims would still be open on June 30, 1997, then the average number of open claims during fiscal 1997 would be 37.5 (the average of 25 and 50). We would multiply that average by $369.34 (= $351.75 x 1.05) to get $13,850.25 as the portion of the ULAE reserve we expect to be paid during fiscal 1997. And so on and so forth. The total ULAE reserve would then be calculated by adding together all of these yearly pieces.
The hard part about applying this second method is forecasting how many claims will still be open at each future June 30. This can be reasonably estimated by keeping a past record of how many claims are still open as of each past June 30 that are due to incidents occurring in different fiscal years.
Another way to go about it is to ask the claims adjuster to predict how many existing claims will still be open one, two, three or more years from now. The only problem with this approach is that is does not include any provision for incurred-but-not-reported claims.
To recap all this, let's look at a table which breaks out future ULAE fees into those due to claims incurred prior to July 1, 1995 and those due to claims incurred after June 30, 1995.
In the table, that total of $88,406 represents the ULAE reserve that should be carried by the pool as of June 30, 1995.
As stated before, GASB 10 does not call for the reflection of an unallocated loss adjustment expense reserve for public entities other than pools. However, a strict adherence to representing things on an accrual basis would call for also establishing such a reserve for non-pools.
The fact that GASB 10 does not call for such a reserve is a concession to the "pay as you go" approach to treating liabilities.
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This month's column on actuarial issues in the casualty field is written by Richard E. Sherman, president of Richard E. Sherman & Associates Inc. in Ashland, Ore. William J. Miner, an actuary with Watson Wyatt Worldwide in Chicago, answers actuarial questions in the benefits field. Susan M. Werner, director of risk management at Hardee's Food Systems Inc. in Rocky Mount, N.C., answers risk management questions. And Dennis J. Nirtaut, managing director of compensation and benefits for Arthur Andersen & Co. S.C. in Chicago, answers questions on employee benefit plans.
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