The Adjuster's Notebook: Getting Reserves Right (Part 2)

Editors Note: This is the second of a three part installment. Part 1 is available here. The final part will run tomorrow.

Part Two of Three: Your reserving philosophy.

In our first installment, we identified the insurance processes that are adversely affected by inaccurate reserving practices. Now we will review a sound reserving philosophy and the factors that make up accurate reserving.

Most insurance companies and third party administrators have a reserve setting philosophy stated in their claims management guidelines. If you are unsure as to what your company’s philosophy is, a safe, self-imposed philosophy reads something like this:  My goal is to ensure that the reserves on my cases are adequate to cover all loss costs while sustaining minimal variations from the time reserves are initially set until claims are fully paid and closed. 

With this philosophy in mind, it does not take much time to set up a spreadsheet to track the changes (variations) in your claims reserves over the life of the claim. How the reserves change over time is known in the insurance business as loss development. Loss development says the closer your opening reserves are to your closing paid amounts, the quicker and more accurate you are at recognizing the ultimate cost of your claims. Analyzing your changes over time is critical to acquiring accuracy in reserve setting.

Note: Good insurers and TPA’s know what their loss development factors are and will share them with their large, sophisticated insureds and self-insured clients.

Note: The stair-stepping of reserves is an unacceptable process whereby reserves are incrementally replenished after the reserve has been exhausted (paid out). The downfall of the program addressed in the opening paragraph was in large part due to step-reserving. Due to lack of adjuster experience and supervision, adjusters set medical and indemnity reserves at the nominal amount of $5,000.00. Once that amount was exhausted, they added another $5,000.00 to the reserve. When claims stay open for years, as they can in workers’ compensation, step-reserving will cause total case reserves to be underfunded, thus increasing the risk that future payments will not be fully funded.  In the opening case, the reality was that the ultimate cost of the self-insured’s claims was never objectively estimated. Consequently, profitability, capacity (the ability to write new business) and eventually solvency were adversely affected.

Over time, by tracking your loss development you should be able to keep your opening reserve and closing paid amount within 10%-15% of each other. If you can keep your initial reserves and final paid amounts that close, you’re doing pretty well at recognizing the severity (cost) of your claims.

• Rule for Reserving:  Every time you look at a claim you should check to make sure the reserve is sufficient to last through the claim’s finality. Every time you review the claim, your claim notes should reflect that the reserves are sufficient to take the claim to its end point. If not, acknowledge the shortfall, state the reason that they haven’t been revised (i.e. awaiting further medical records, etc.) and indicate when you believe a revision will take place.

• Rule for Reserving: It’s easy to get overly optimistic about an individual’s ability to return to work quickly. Similarly, claim representatives may underestimate the future settlement value of a claim if they are over confident of their ability to conclude the claim for a lesser amount. Reserves should always be based on the value of a claim, never on the perceived likelihood of a successful negotiation.

• Rule for Reserving: Don’t be afraid of big numbers. Recognizing large losses and setting reserves commensurate with the severity of the loss can be intimidating. It is not your fault that the accident caused a severe injury. Further, you had nothing to do with the underwriting of the risk. However, if you fail to recognize and acknowledge the severity of the loss in your loss reserve, the adversely developing claim will eventually find you in the claims manager’s office. That can be intimidating.

• Rule for Reserving: Consider the effect of inflation on your reserve. Because reserves reflect the ultimate cost of a claim and not the claim’s present value, reserves should account for such inflating cost as medical care, expensive advancing medical technology, drug development and cost of living increases within the context of a full and final settlement.

In our next installment we will review five methodologies for setting case reserves.

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Part 3, "Five methods for setting reserves," will run, tomorrow, March 20, 2020.

About the Author

Brian Francis is a Licensed Insurance Counselor. He also teaches continuing insurance education on behalf of the Michigan Association of Insurance Agents. He can be reached at brian.riskresearch@gmail.com.

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