Reserving Considerations for Adjusting and Other Expenses
Loss adjustment expenses (“LAE”) are incurred in connection with the recording, investigation, and settlement of insurance claims. The cost of LAE for Property & Casualty (“P&C”) insurers is significant. On an all lines of business combined basis1 the year-end 2022 reserve for net unpaid LAE equaled 19.2% of the net loss reserve.
In general, LAE is divided into two categories namely Defense & Cost Containment (“DCC”) and Adjusting & Other (“AO”). This dual categorization of LAE is required for external reporting such as in the statutory annual statement or the Insurance Expense Exhibit. Some insurers may choose to use more detailed categorizations for internal reporting or management purposes.
The distinction between the two categories often depends2 on whether a loss adjustment expense is associated with a specific claim. Historically, the term “allocated loss adjustment expense”, where the “allocation” refers to associating the LAE to a specific claim, was used to refer to what is now known as DCC. The AO category refers to all LAE that has not been categorized as DCC.
Financial Importance
The year-end 2022 reserve for net unpaid AO equaled 33.7% of the LAE reserve3, or approximately 6.5% of the net loss reserve. For the P&C industry in general, unpaid AO represents a significant contributor to financial success.
For some lines of business, the percentage of unpaid LAE that is categorized as AO tends to be higher than average. For these lines of business, including auto physical damage and homeowners, the AO reserve is a significant portion of the overall reserve, elevating the importance of estimating adequate AO reserves.
The AO percentage is lower for some other lines, including for commercial multiple peril and other liability. However, those lines tend to have relatively high premium and incurred loss volumes, hence the dollar value of the unpaid AO can be high, which also elevates the importance of estimating adequate AO reserves.
Single or Multiple Methods
Actuaries must adhere to the Standards of Practice (“SoP”) published by the Actuarial Standards Board (“ASB”). Those include SoP 43 on the subject of estimating P&C reserves, which applies to reserving for both losses and LAE.
That SoP encourages actuaries to select a reserve informed by the results of multiple approaches4. In some cases, the actuary can choose to rely on a single approach but must, in the report in which the reserve selection is communicated, “discuss and disclose the rationale” for using only a single approach.
AO Reserving Approaches
A commonly applied approach is generally known as the “paid-to-paid” method. Reserve estimates using this approach can be distorted and inaccurate if the insurer is growing, shrinking, or has recently made a change to their reserving practices.
The method relies on a selected “paid-to-paid” ratio that is multiplicatively applied against a “base” to estimate the reserve. The base is a reserve estimate such as the loss reserve, which is an estimate of the future payments on claims presently incurred but unpaid. The ratio is often actual calendar year AO payments ratioed to loss payments for a recent prior time period.
In some cases, complexities are factored in including an estimate of the percentage of AO paid when a claim file is reported and recorded, and the percentage remaining to be paid in the future. Another complexity is estimating the breakdown of the incurred but not reported (“IBNR”) reserve between what part is “pure” (not reported or recorded) versus “pipeline” (reported but not recorded).
Several other approaches are often applied that are variations of the paid-to-paid approach. These approaches attempt to mitigate the distortions that can impact the paid-to-paid approach. The variation is usually made to the ratio that is a fundamental input to the approach. In the Kittle approach, the ratio is selected in consideration of both recent prior paid and incurred values instead of just the paid values. In the Mango-Allen approach, the ratio is selected in consideration of expected loss values.
A chain ladder approach is also commonly applied. It is usually based on accident year statistics, not calendar year as used in the paid-to-paid approaches. The actuary considers the growth (“development”) over time of the actual cumulative AO paid to date for a given accident year. Development factors are selected and applied to the cumulative AO paid to date in order to estimate the unpaid AO for a given accident year, and then summed up over all accident years.
The approaches discussed so far are applied on a dollar basis. The Johnson claim count approach is different because it is based on claim counts. Guidance on AO reserving encourages actuaries to consider a claim count approach in tandem with dollar approaches.
The Johnson approach first estimates a current “cost per open claim”, which represents the expense incurred by claims staff to perform a single “unit” of work on a single claim for a single year. That cost is often estimated over a recent prior period of time and then projected into the future, during which the claims presently incurred but unpaid will be paid and settled.
An estimate must also be made of the “weighted number of open claims”. That metric reflects how far into the future, and the volume, of claims presently incurred but unpaid will remain open and incur additional AO. The reserve estimate is a product of the cost of future AO work and the number of claims remaining open until all are settled.
Assistance
Soundly estimating the reserve for unpaid losses, DCC, and AO, is very challenging. The magnitude of AO, and LAE generally, necessitates use of a thorough and in-depth analysis to inform selection of the reserve estimate. The actuary must carefully consider characteristics of the insurer at hand, and any changes in their recent past or anticipated future practices, when choosing the approaches to apply and whether any variations will be used.
For more information on AO reserving, or help with completing any reserve analysis, please contact John W. Gradwell, ACAS, MAAA, CPCU, Are, Consulting Actuary with Huggins Actuarial Services, Inc. with extensive experience in these services.
1Based on Bests’ Aggregates and Averages 2022 consolidated statutory P&C balance sheet.
2Details on the categorization is provided in the Statement of Statutory Accounting Principles No. 55.
3Based on the 2022 Bests’ Aggregates and Averages consolidated Schedule P Part 1 Summary.
4The SoP uses the phrase “…multiple models or methods appropriate to the purpose, nature and scope of the assignment and the characteristics of the claims…”
