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We have consistently had 20% to 25% savings on closure of our liability claims, and thus have always believed that our case reserves were strong. A recent claims audit showed that our case reserves were 10% redundant, but an actuarial study indicated that there was a 20% deficiency in our reserves. How can I decide who is right?
Each of these indications may be correct. The problem is that each one is answering a different question!
Consider the savings on closure statistics. These provide an accurate indication of how strong case reserves are immediately prior to closure. The problem is that the total claims reserve contains only a relatively small proportion of claims that are very close to settlement. The reserve also contains a significant percentage of claims that are one or more years away from settlement, and much can, and often does, happen in the interim.
Typically, savings on closure statistics will indicate that final reserves are, on the average, redundant. This does not tell us anything, however, about how adequate initial or interim case reserves are. Nor does it include a provision for incurred-but-not-reported claims.
In most cases, the claim will settle for an amount close to the final reserve. On a certain percentage of claims, the settlement amount will be zero or some amount much less than the final reserve. This usually accounts for most of the savings on closure.
Most adverse development in the case reserves will occur at interim points in the life of a claim, rather than just prior to settlement.
Another serious problem with savings on closure statistics is that they represent a cross-section of claims that is quite different from that of all currently open claims. Consider a simple example (see Figure 1) in which 75% of the claims settle within the year they are reported. These are usually small, easy claims with little potential for adverse development. The average final reserve is $1,000 and the average settlement is $500. On these claims, the average savings on closure is 50%.
Another 20% of the claims are medium in size and medium in difficulty and settle within the first year after they are reported. The average final reserve is $5,000, the average settlement is $4,500 and average savings on closure is 10%.
The remaining 5% of all claims are large, difficult claims that will take two or more years to settle and that have significant potential for adverse development. The average final reserve is $10,000, the average settlement is $15,000 and the average savings on closure is -50%.
The blue area represents all claims that would be included in the average savings on closure statistics for calendar year 1996. Note that there is one block each of easy, medium and tough claims in the blue area.
The red area represents all claims that are unsettled as of year-end 1996. This area represents the total claim reserve. Note that the red area does not include any easy claims, one block of medium claims and two blocks of tough claims.
In the above example, the average savings on closure for calendar year 1996 is 10%. However, it is negative 20% for the claim reserve. The savings on closure percentage is misleading because it represents a very biased sampling of claims (if your purpose is to draw a sample that is similar to the mix of claims in the total case reserve).
Assume that there are exactly 100 claims per year (of injury). Figure 2 details the calculation of the savings on closure for each calendar year. Similarly Figure 3 documents the calculation of the savings on closure for all currently open claims.
Let's compare the relative proportion of types of claims in the savings statistics and in the current year's total case reserves (in terms of number of claims). While easy claims comprise 75% of all claims closed in any given year, they account for two-thirds of all currently open claims. Finally, while tough claims account for only 5% of all claims closed, they represent one-third of all currently open claims.
If savings statistics are to be used at all in estimating the degree of redundancy or deficiency in the case reserves, they should represent a cross-section of claims that is similar in mix to the types of claims that comprise the current case reserves. Savings on closure statistics seldom, if ever, satisfy this criterion. One exception to this rule is the runoff situation where all claims are at least three years old.
A professional claims audit will provide you with critical information in terms of whether or not case reserves are being properly set in relation to the facts that are evident in each claim file. It is important to know this and take corrective action if unreasonable case reserves are being established. Otherwise, it may, at a minimum, create problems with your excess insurer or reinsurer. However, it should be recognized that even the best claims auditor can only be expected to develop a reserve estimate based on what can reasonably be anticipated based on the known facts at the time. When there are few facts in the file, such as might likely occur for claims that have only recently been reported, then it is quite possible that even the best claims audit will leave case reserve inadequacies undetected. And, of course, a claims audit will not provide an estimate of the reserve or IBNR claims.
An actuarial study is the only one of the three approaches that you mentioned which, if properly performed, is designed to answer the questions of how adequate or deficient the total claim reserves are.
Would you like advice from an experienced colleague on a risk management, benefit management or actuarial problem? Four quarterly features in the Perspective section of Business Insurance can give you some answers.
Ask A Casualty Actuary, Ask A Benefit Actuary, Ask A Benefit Manager and Ask A Risk Manager answer written questions from readers on risk and benefit management issues and actuarial problems.
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. Christopher E. Mandel, director of risk management at KFC Corp. in Louisville, Ky., answers risk management questions. And Dennis J. Nirtaut, managing director of compensation and benefits for Andersen Worldwide S.C. in Chicago, answers employee benefit plan questions. Address your questions to ASK, Business Insurance, 740 N. Rush St., Chicago, Ill. 60611. Please give us your name, title and employer; however, we will consider unsigned letters.