With reserve shortfalls still making headlines, just how effective are current reserving strategies? asks Nigel Allen

Monitoring reserving developments in the international insurance industry is like watching Old Faithful in Yellowstone National Park, keep your eye on it for long enough and you are guaranteed to see it erupt. According to Standard & Poor's, the first nine months of 2005 saw the US property/casualty market stump up a further $16.5bn in reserve strengthening for accident year 2002 and prior. The most recent announcement was by AIG, which reported a hike of approximately $1.82bn to its net reserve for losses and loss expenses, following a review of its principal property/casualty insurance operations. But while billions of dollars are pumped into deficient reserves, are the necessary steps being taken to ensure that such extreme under-reserving does not happen again going forward?

According to a recent special report by Gerard Altonji, managing senior financial analyst with the property casualty division of AM Best, entitled "Asbestos and environmental losses edge toward peak in 2004 as funding gap narrows", the estimated US property/casualty market's A&E reserve shortfall was put at $34bn, with asbestos accounting for $10bn and $24bn on the environmental side. Up until 2001, funding levels for environmental liabilities had far outweighed those of asbestos. However, a period of massive asbestos reserve strengthening has resulted in current funds amounting to some 70% of the $65bn ultimate loss estimate for asbestos. In contrast, reserving for environmental liabilities has slowed, with current reserve estimates suggesting that the industry is only funded up to 57% of the estimated ultimate environmental liability sum of $56bn. According to Altonji's report, the rating agency is concerned that "a second, more slowly moving wave of losses" related to pollution and the resulting bodily injury, property diminution and natural resource damage claims may be starting to gather pace.

In a reserving study conducted by Moody's at the end of 2005, entitled "Filling cavities: Core reserves no longer the main concern for US property/casualty insurers", the agency highlighted the marked improvement in overall US property/casualty reserving. Having funnelled some $50bn into non-asbestos funds since the late 1990s, the agency reported that at year-end 2004 the sector's reserving shortfall was "modest", with non-asbestos reserves deficient by $4bn to $8bn, or between 1% and 2% of carried reserves. It is interesting to note, however, that of the adverse reserve development which occurred between 2000 and 2004, excluding asbestos and environmental reserves, 42% was accounted for by US reinsurers, despite representing only a small portion of the industry's total surplus. The report suggests that US reinsurers still have "lingering deficiencies" in their loss reserves at the end of 2004, estimating the figure at $5bn for non-proportional casualty business.

Releasing funds

In contrast to the ongoing torrent of cash being channelled into reserves for accident years 1997-2002, reserves for years 2003 and 2004 appear to be flowing in the opposite direction, as insurers and reinsurers release redundant reserves. 2004, according to Standard & Poor's credit analyst Sid Ghosh, was the first year in which the market witnessed substantial reserve releases by the US property/casualty sector for the 2003 accident year. "We had some preliminary concerns," admits Ghosh, "that accident year 2003 was still too immature and that the industry was being impatient to release reserves too soon." Despite these concerns, Ghosh points out that accident year 2003 is still developing favourably after two years, which he adds "increases our confidence that this year is holding up pretty well. And this is not just for 2003, but also 2004 which is beginning to develop in a similar way."

According to Moody's, the first six months of 2005 saw US insurers and reinsurers release some $7.3bn of reserves for accident years 2003 and 2004, counterbalanced by some $7.4bn in reserve strengthening. James Eck, vice president and senior analyst at Moody's, believes that the reserve releases are simply a reflection of "the early view that they were a little bit too conservative, in contrast to previous accident years where they were not conservative enough." But he warns that there are still a number of years to go before 2003 and 2004 can be considered "sufficiently seasoned to tell whether these judgements are appropriate".

The blame culture

For years the brunt of the blame for the reserving deficiency epidemic has fallen squarely at the feet of the reserving actuary, with accusations that they are signing off on reserve estimates that are "wildly inaccurate". Charged with the onerous task of setting the bar for reserve levels, it is perhaps not surprising to many that all fingers of blame should point at the actuary, but it is vital to remember that they do not operate in seclusion.

Nicholas Line, chief actuary at Markel International, turns attention to the role of the underwriter in the reserve estimation process and the importance of ensuring that the actuary is kept fully informed of any rate changes which an underwriter makes. While this may seem a fairly obvious statement to make the simple fact of the matter is that this has not been happening, and actuaries have been working with incorrect rate change information. "If you get the wrong rate changes then you are effectively pointing the actuary in the wrong direction," he adds. "And the way that actuarial methods are set up, it may take a while to realise that you are pointing in the wrong direction, because some of these classes take five or ten years to develop." However, this is now changing, he believes, as companies seek to implement improved rate monitoring systems. "Lloyd's has also been very proactive in trying to encourage the use of more objective rate indices." A further issue he raises is the fact that the actuary is there only to advise management on how to proceed, "the reserving strategy is the responsibility of the directors of the insurance company."

Kevin Lee, an associate analyst at Moody's believes that actuaries do take a disproportionate amount of the blame. "Reserving is the responsibility of at least three parties - actuaries, management and the claims department," says Lee, adding that the importance of the last group cannot be overstated. "In the past year in particular much of the adverse development has stemmed from certain professional liability lines and excess casualty lines where litigation lags tend to be extremely long and reserving for these types of businesses are more of a claim-by-claim reserving exercise and less an actuarial one." Sarah Hibler, senior vice president at Moody's, is convinced that the industry is taking steps to integrate these various groups more closely in the context of reserves. "Over the last couple of years, we have seen that companies are trying to better integrate claims, actuarial and accounting elements. Regular meetings between underwriters, claims personnel and actuaries are occurring much more frequently than they were five years ago."

Professor Ben Zehnwirth, CEO of Insureware, is adamant that the finger of blame should be pointed at the practices employed in estimating reserves. "The standard paradigm for loss reserving and pricing long tail liabilities is fundamentally flawed," he believes. Zehnwirth cites two factors which have contributed to this, firstly the failure to adequately recognise the impact of inflation. While he acknowledges that general economic inflation is usually factored in, he believes that "superimposed" or "social" inflation, which sit above economic inflation, can go unrecognised for years, "Neglect of this critical characteristic of long-tail lines leads to chronic and massive under-reserving and under-pricing," he says. The second factor is volatility. "The standard actuarial paradigm gives no information about past volatility, but without adequate allowance in reserves for volatility, companies are risking their survival."

Under control?

It is clear from the recent studies into reserving trends that while reserves for accident years 1997-2002 remain deficient, the US property/casualty sector has taken massive financial steps to rectify this. Furthermore, the changing regulatory environment, in the form of legislation such as Sarbanes Oxley, has also played a key role in forcing companies to reassess their reserving strategies, with heightened levels of regulatory scrutiny, according to Ghosh, resulting in "more diligent reserving practices". But while these funding shortfalls are slowly being filled in, the question remain as to whether the industry is implementing adequate measures to ensure that come the next major softening of the cycle it will not fall foul of the same reserving errors.

"The key issue is whether companies will be able to maintain these standards," says Ghosh. "If one looks at the industry's historical performance ... then I would have to say that we are not so confident that the current level of reserves will remain adequate." Nicholas Line believes that the industry has done much to address the "systematic problems of the past" both in terms of the information which is provided to the actuary and the way in which underwriting procedures are managed, but he concludes, "If reserving shortfalls continue to happen there will be a lot of red faces, because there won't be any more excuses."

Nigel Allen is editor of Global Reinsurance www.globalreinsurance.com

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