PRUDENTIAL MARGINS
1993 General Insurance Convention
Key PointsSummary
Ž
The marginisthe result
of a reserving
philosophy
(ie.
how strongthe
reserves
shouldbe,howeverallocated
and presented).
Ž
Management may notrealise that
theyhavea reserving
philosophy,
but
theydo,even ifitisnotexplicitly
stated.
Ž
The reserving
process
aimstodetermine
thereserve
consistent
withthat
philosophy.
Ž
Consistent
reserving
ismore difficult
thanitseemsand much of what is
called
a marginmightreally
be part of the best estimate.
Ž
The best estimateitself
may have varying degrees of uncertainty
attached.
In practice,
thereisno single
bestestimate,
the most you can
sayisthatitislikely
toliewithina range. The width of the range varies
substantially
by class
of business.
Ž
Itisvital
thatthosewho relyon thereserves
appreciate
the variability
and so levelof comfortprovidedby thebestestimate
and the margins
(ie.
theimplications
of thereserving
philosophy).
Ž
The actuary
hasa responsibility
to communicatetheimplications
of the
philosophy.
Ž
those implications.
The management has an obligation
tounderstand
Ž
The ownershave an obligation
to understand
those implications.
127
PRUDENTIAL MARGINS
1.
INTRODUCTION
1.1
2.
Overview
COMFORT MARGINS
2.1 What is an Estimate?
2.2 What isa Margin?
2.3 When is a Margin Not a Margin?
2.4 When is a Margin a Margin?
2.5 Future Risks
2.6 Adequacy Margins
Margins
2.7 Contingency
2.8 Over-Useof Margins
3.
INSURANCE IS DIFFERENT
3.1 The Uniqueness of Insurance
Regulation
3.2 Existing
Limitations
of Existing
Regulation
3.3
Statutory
Reporting
3.4 Confidential
Who
is
Interested
in
Margins?
3.5
4.
IF PHILOSOPHY COULD FIND IT OUT
4.1
5.
ReservingPhilosophy
REPRESENTATION OF MARGINS
5.1 How Could Margins be Expressed?
6.
CONCLUSION
6.1
How Far Can We Go?
APPENDIX
Summary of Overseas Papers and Proposals
WorkingPartyMembers:
Caroline
Barlow
Roger Nye (Chairman)
MartinWhite
Helen Wincote
128
1. INTRODUCTION
Anyone readingthispaper to discover
what margin on reserves
would be
prudentisgoing to be disappointed.
There is no “correct”
answer to this
question
and we do not presumeto offerone.
The prime purposeisto discuss
thephilosophical
issues
and so to promote
discussion
both withinand outside
theactuarial
profession.
In particular,
we
hope thatthiswillbe of interest
to regulators
and insurancecompany
management as wellas thosedirectly
involved
in reserving.
We havelimited
thediscussion
tomarginson reserves,
although
much of itcan
be extendedtomarginson premiums,asset
valuation
etc.Indeed,
themargins
shouldbe considered
inthewidercontext
of therisktakeninthecompany as
a whole,notleast
theassetmatching.
This paper is the view of the authorsand does not necessarily
reflect
the
opinions
or practices
of their
employers.
1.1 Overview
Marginsprovidecomfort- formanagement,forshareholders
and owners, for
policyholders
and regulators
among others,
butmore importantly,
thesemargins
may be needed. The uncertainty
in theunderlying
estimate
of thereserve
is
oftengreater
thanisrealised
by thosewho relyon thefigures
and so reliance
on unmarginedreserves
can be misplaced.
The purist
view isthatreserves
shouldalwaysbe a bestestimate
and that any
“margins”
shouldbe disclosed
as freecapital.
Itisdifficult
to argue with this,
butinpractice
suchan approachcanleadtoproblems.Prudencematters
most
when estimation
ishard,(suchas US liability
or excess of loss reinsurance)therehasbeen a history
of“best”
estimates
proving
inadequate.
To counter
this,
theremay be more chanceof achieving
a “better”
bestestimate
if a prudent
approach is taken to determining
it.
Insurance
isinherently
different
from otherindustries
inthat,
even after
ithas
been sold,
thecostof theproducttothesupplier
(theclaimscost)
isunknown.
The company must protect
itself
against
unexpectedlosses
to survive
and so
meet itspolicyholders’
expectations.
A margin(ie.
excessprovisions
overbest
estimate
of liabilities)
isnotjustdesirable,
it is essential.
What constitutes
a “prudent”
marginisnotsomethingthat can be calculated,
it
isa matterofjudgementor philosophy.
The more capital
thatisdiverted
to the
pastclaims,
thegreater
theconstraints
on business
volumes and so on potential
profitability.
A company thatplayssafeina profitable
market can be accused
of not workingitsowners’capital
hard enough.(Of course,
a company that
129
worksits
capital
hardinan unprofitable
marketprobably
squanders
it).
On the
otherhand,a company with narrow marginsendangersboth owners’and
policyholders’
money. The issue
isreally
a decision
forthemanagement based
on the owners’risk-averseness,
subjectto satisfying
themselvesand the
regulators
(representing
thepolicyholders)
thatthispolicy
is not too risky.
Since management are responsible
for selecting
a margin,they need to
understand
the implications
of this
decision,
asdo shareholders.
The reserving
philosophy
and level
ofriskimplied
needstobe communicatedintermsthatare
clearand meaningfulto the recipient
in order to form the basisof the
judgement.
The actuary
therefore
hasa responsibility
to go beyondcalculating
the reserves
inline
withan agreedreserving
philosophy
and to communicate the implications
of sucha philosophy
for the company as a whole.
2. COMFORT MARGINS
2.1 What isan Estimate?
We make estimates
of futureclaimscost because we do not yet know the true
value.
The term“estimate”,
withoutfurther
qualification,
is undemanding - just
a roughcalculation;
thereisnormally
no guarantee
thatan estimate
willprove
adequate or inadequate.
Relianceon estimates
means thattherewillbe surprises
inthefutureas past
estimates
provetobe toohighor toolow and a prudentmanagement willseek
comfortthatthe net effectwillnot imperilthe continuedoperation
of the
company. Thisinvolves
usingestimates
thatarebelieved
to be higher than a
central
or best estimate.
One importantproblem is knowingwhat we mean by a “central”
or “best”
estimate.
Common sensesuggests
thatthis
shouldbe sufficient
on average and
hence should be an expected value or mean. Since most claims distributions
willbe positively
skewed,a medianwould be inadequate.
However, in practice
we can rarelybe confidentthat the estimate is the mean, or that the
assumptions
on which the calculation
isbasedare themselves
reasonable.
In
many cases,
thereislittle
information
from which to deduce an appropriate
distribution
fortheultimate
cost and so deduce the mean. We are often left
with a method which producesan estimate(orselecting
from a number of
methodsproducing
a number of different
estimates)
withno indication
of the
adequacyof thisestimate.
In thispaper,we willuse “best
estimate”
to denote
an estimate
of themean, unlessthecontext
dictates
otherwise.
130
On theone hand,actuaries
oftenfeeluncomfortable
declaring
their
estimate
to
be a mean or median on the basisof little
information.
On the other,the
meaning of central
or bestestimate,
althoughstatistically
imprecise,
is clear
enough to the layman to whom it may imply a reasonable
probability
of
adequacy.The extent
towhichthis
inconsistency
matters
varies,
dependingon
theopportunity
to explain
theintention
and theunderlying
uncertainty.
Itislikely
that,
although
thelaymanfeels
thatbestestimate
is a simple enough
concept,
itcouldmean somethingdifferent
todifferent
people. As well as the
confusion
betweenthemean and median,so-called
“best
estimates”
might well
excludeprovision
for claimshandlingexpensesor reinsurance
failure
say.
Strictly
speaking,
theformerisan inevitable
costand thelatter
certainly
has an
expectedvaluegreater
thanzero,so bothshouldbe provided
for as part of the
best estimate.
In view of thisuncertainty
surrounding
the adequacyof thebestestimate,
a
margingivesa feeling
of comfortthattogether
theyarelikely
to be adequate
or atleast
not too inadequate.
2.2 What is a Margin?
The truemarginon the reserves
isthe surplus
in what isavailable
to meet
outstanding
claimsand associated
costsover theirtrue underlying
cost.
However,sincethe true cost is unknown, so is the true margin.
An estimate
of the“true”
solvency
marginisthedifference
between the value
of theassets
and theinsurance
liabilities,
where theliabilities
consist
of a best
estimate
oftheclaims,
unearnedpremium reserve
and otherforeseeable
costs.
This difference
can be considered
as an estimate
of the totalmargin, since
ultimately
allthismoney would be available
to meet theclaims.Thiswould
include
notjustcapital
allocated
tothetechnical
reserves,
but much of the free
assets
too.In practice,
freereserves
arerequired
to absorbpossible
losses
on
futurebusiness
and investment
as wellas pastclaims.A margininexcessof a
(prudent)
bestestimate
isan artificial
allocation
of assets.
Itdependson how
comfortable
themanagement wishesto appear.
The totallevelof comfortisdeterminedby the totalof margins and free
reserves,
rather
thanjusttheclaims
reserves.
There is an argument that claims
provisions
shouldbe discounted
bestestimates
and thesurplus
allowed to fall
throughintoa central
pot,where itsadequacycan be assessed
in aggregate.
131
However theoretically
correct,
therearea number of practical
problemswith
takingtheapproachto suchan extreme.
Ž
Itwouldbe difficult
tonegotiate
theinitial
taxbill
down tothelevel
that
undiscounted
or marginedreserves
would produce as a matter of course.
Ž
The company would appear artificially
strong compared with its
competitors.
Ž
The potential
forpressure
to distribute
the margins or to use them to
support
new business
would be considerably
greater.
In principle,
ifitwere market practice
and ifthe levelof understanding
of
potential
forlosswas uniformly
high,thiswould be a workable system.
2.3 When is a Margin Not a Margin?
Often reserves
are deemed to include
marginswhen in practice
they do not,
becausethebestestimate
isdemonstrably
likely
to be inadequate.
One way of
categorising
thesenon-existent
margins could be as follows:•
Probable
Improbabilities
since there
are normally many possible
contingencies
which couldleadtoa claim(albeit
areunlikely
to do so),
itislikely
thatone or more will(eventhoughitisnotpossible
to say
whichinadvance)and therefore
thebestestimate
shouldinclude
some
provision
fortheexpectedvalueof contingencies.
For instance,
even if
itisanticipated
thata courtcasefora givenliability
claimwillbe won,
thereisstill
a non-zero
expected
claimcost,
whichwhen aggregated
over
a number of suchcasescouldinvolve
a considerable
sum.
8
LazyMargins- theso called
bestestimate
may excludeitems which are
eithervery likely
or inevitable
costs (eg. claims handling reserves).
Thereforea marginforsuchitemsisnot really
a margin.
•
.
Imaginary Margins
- those which are included because of known
inadequacies
inthemethodsor assumptions
used for the best estimate.
For instance,
in assessing
the net costof catastrophes
capable of
exhausting
an excess
of loss
programme,a “margin”
may be added to the
grosstoreflect
thegreater
skewnessof thenetdistribution.
This is not
a margin,but a necessary
part of the best estimate,
132
2.4 When isa Margin a Margin?
Therearetwo (genuine)
reasons
why thebestestimate
might prove inadequate:Underestimation
- eventswhichwere providedfor,but cost more than
Ž
expected.
Ž
Contingencies
- eventswhich were eitherunforeseen
or deemed too
unlikely
to reserve
forfully.
Thisisthecostin excessof the expected
valuecoveredunderprobableimprobabilities.
Each of theseisa sourceofriskand so represents
a threat
to the company. To
ensurean acceptable
likelihood
of continued
operation,
the company needs to
keep marginsrelated
tothesethreats.
Thesemarginsprotect
new business
from
theeffects
of deterioration
inpastclaimsand areindependent
of thelevels
of
new business
- inprinciple,
theycouldswamp thenew business.
The margins
willbe needed if the best estimateprovesinadequate,
although the best
estimate
may prove excessive.
Marginscan be seenas an allocation
of capital
to pastbusiness
and therefore
not available
to supportnew business.
The money iseffectively
given by the
company to pastbusiness,
withan good probability
of receiving
it back once
allclaimshavebeen settled.
Ifthebestestimate
provesultimately
to have been
inadequate,
thenthemarginwillnot be returned
infull.If it proves to have
been excessive,
then more than the original
margin will be returned. This
investment
ismade by thecompany largely
becauseof itsobligation
to new
policyholders
to remain in businessin order to meet their claims and is
necessary
to attract
thosenew policyholders.
In return,
the company has the
potential
forprofits
from that new business.
These margins can take two forms:Ž
Adequacv Margins- to increase
theprobability
of thereserves
proving
adequateforknown or anticipated
events.
n
Contingency
Margins-toprovideforabnormalclaims
or types of claim,
or othercontingent
liabilities
suchas reinsurance
failures
These marginscan either
be heldexplicitly
(whichmay appearstrong,
but be
taxinefficient)
orimplicitly
intheclaimsreserves
(which may appear weak, but
be tax efficient).
133
133
2.5 Future Risks
There are a number of itemswhich may be falsely
associated
withthe past
claimsreserves.
These include:Equalisation
reserves
Ž
Ž Cost of running off the company over and above the cost of
administering
the past liabilities.
Ifcapital
isallocated
to these,
itisnota marginon theclaimsreserves.
2.6 Adequacy Margins
These marginsarerequired
becausethereisuncertainty
intheultimate
cost of
claimsforwhicha reserve
is being established.
Possible
sources
of uncertainty
include
the following:
Range
and
quality
of
available
data.
The dataavailable
may be sparse,
•
may not be reconciled
to accounts
figures,
or may containundetected
errors.
•
Actuarial
model. The model(s)chosenforanalysis
and projection
will
neverexactly
match the actualclaimsprocess,
but the choiceof an
inappropriate
model willincrease
theprobability
of variation
from the
projected
cost.
•
Model parameters.
Pastclaimsfluctuations
willresult
inuncertainty
in
estimating
the parameters
of the model. The lessstablethe historic
experience,
thegreater
the uncertainty.
•
Model assumptions.The projection
of future claim payments will
involveassumptions
as to the’
levelof futureinflation,
the trends in
economic,legal,political
and social factors and possibly future
investment
returns.
The actual
trendsexperienced
arelikely
to differ
from those assumed.
•
Random variation.Future fluctuations
would resultin the actual
paymentsdiffering
from thepredicted,
evenifthetrueparametervalues
couldbe foundfora perfect
model.
134
In attempting
toquantify
theuncertainty
and assess
thelevel
of marginwhich
mightbe established,
one or more of thefollowing
techniques
may be used:
Ž
statistical
analysis
Ž
sensitivity
analysis- testing
the effect of changes to the model
assumptions
and/or the models themselves
Ž
analysis
of different
scenarios/what-if
testing
Ž judgement
An explicit
marginmay be established
based on the outcome of this analysis.
If statistical
analysis
has been carried
out,itmay be possible
to assessthe
probability
of adequacyassociated
witha particular
levelof margin,although
itmust be bornein mind thatnot allthe sourcesof uncertainty
listed
above
lendthemselves
to statistical
quantification.
In particular,
theriskofselecting
an inappropriate
model cannot be quantified
and so any marginto allowforthisuncertainty
must be arbitrary.
Alternatively,
an implicit
margin may be established
by deliberately
using
cautious
parameterestimates
and assumptions
in the reserving
calculation,
always assuming we can be sure that we are being “cautious”.
As partofthe“best
estimate”
reserve
calculation,
itmay be appropriate
to make
allowances
forfactors
suchas thefollowing,
whichrepresent
a deviation
from
pastexperience
and forwhich no historical
data may be available:
n
the emergenceof typesof claimwhich are not included
in historical
experience
becauseof changesinpolicycover or limits
l
theemergenceof new typesof claimwhere thelosshad not previously
been recognised
as coveredby insurance
(eg.latent
disease
claims)
n
typesof claimwhere thelegal
position
isunclear
(eg.pollution
claims)
The adjustments
to be made for such factors
are likely
to be difficult
to
calculate
becauseof the lack of relevant
historical
data and considerable
judgementwillbe required
intheselection
of suitable
assumptions.
In order
to make provision
forsuchfactors,
itwillbe necessary
to make assumptions
as
to thepossible
cost,
theprobability
of thecostactually
beingincurred
and the
timingof any resultant
payments,allof which willbe difficult
to quantify.
However,we can be confident
thattomake no provision
at all would be over-
135
optimistic,
not cautious.
As mentionedearlier,
strictly
speakingmany of theseadjustments
should in
wholeorpartbe included
inthebestestimate,
sincetheexpected
cost is greater
thanzero(eg.failure
of reinsurers).
2.7 Contingency Margins
Itwould not be reasonable
to expectalleventswhich couldpossibly
lead to
claimsto actually
do so and even reserves
with prudent margins will prove
inadequate
intheworstcasescenario.
However,although
a reserve
for each
of theseeventscannotbe justified,
the aggregate
expected cost of a large
number of unlikely
eventscan still
be significant.
Therearetwo typesof suchlow probability
risks
- those which are known and
identifiable
and those which are not.
The possibility
offuture
reinsurance
failures
isa known risk.
A given reinsurer
mightbe seenasacceptably
secure,
but if the programme is spread over several
“secure”
companies,
the chanceof one becominginsolvent
can become worth
reserving
for.With suchrisks
itmay be possible
to assess
the amount of any
potential
loss,
but thelikelihood
isconsiderably
more difficult.
By definition,
theseeventsarerareand so therewillbe little
experience
on which to base a
bestestimate
letalonea margin,
buttoleavethem outaltogether
would result
ina negative
margin.
The riskof a new latent
claimtype,
notyetrecognised
is an example of a risk
whichisimpossible
to reserve
forwithany reasonable
accuracy
and yet there
willalwaysbe unforeseeneventswhich leadto claimsand theircost can be
significant.
Calculating
contingency
marginsisa veryinexact
science
and often a thankless
task.They are as difficult
to justify
or defendas theyare to calculate
in the
first
placeand so iftheyareexplicit,
theybecome easytargets
for criticism
by
theInlandRevenue or thoseinside
the company who would see the reserves
reduced.
Sincetherehave alwaysbeen unexpectedor unforeseen
events the expected
valueofthese“contingency
margins”
sits
better
inthebestestimate.
However,
this
amountmay be smallincomparison
withthefull
cost of any one event and
so a contingency
margingreater
thantheexpectedvalue may well be justified.
2.8 Over-Use of Margins
Often the margin is not attributed
to specific
items,but each is implicitly
covered.There isa dangerwithany implicit
margins that they can be used
136
repeatedly.
The existence
of a marginbecomes an excusenotto estimate
one
specific
cost,
thenanother,
and another.
As long as these items are not costed,
the adequacy of the margin to cover all of them can never be tested. It is
therefore
difficult
to justify
usingimplicit
marginsfor miscellaneous
items
instead
of estimating
their
value,
(until
thatis,
the number of and difficulty
of
estimating
such items is appreciated).
Discounting
The most common form of implicit
marginisthe futureinvestment
income
earnedon thereserves.
Thisisveryappealing,
making thecalculation
of the
bestestimate
simpler,
avoiding
theneedtodebateinterest
assumptions
with the
Revenue and havingthe forceof common marketpractice.
However, with
interest
ratesfalling,
thismarginisreducing
and inshort-tail
classes
could be
dangerously
low forthemiscellaneous
items it has covered in the past.
3. INSURANCE IS DIFFERENT
3.1 The Uniqueness of Insurance
In the financial
reportingof businesses
in other industries,
the general
accounting
conceptsof prudence,going concern,consistency
and accruals
(matching)
willbe applied.
However,thereareno general
regulatory
controls,
which restrict
the ability
of businesses
to tradeiftheirfinancial
positionis
unsatisfactory.
Insurance
isdifferent.
No otherindustry
hasthetwincharacteristics
ofpayment
in advanceand thatthe cost,
timingand even the delivery
of the productis
unknown. However,itisvital
tothebuyerthatiftheproduct(theclaim)does
need to be delivered,
the insurer
willbe aroundand ableto deliver
it.The
primaryaim of much of theinsurance
regulation
ispolicyholder
protection.
3.2 ExistingRegulation
The accounts
of most companiesarerequired
by the Companies Act to give a
trueand fairview;and auditors
certify
whetheror not the accounts,
in their
opinion,
do so.
In thecaseof insurance
companies,
therearecertain
exemptions
and Schedule
9/10of theCompaniesAct provides
thataccounts
should not be deemed to be
otherthantrueand fairjustbecause they take advantage of the exemptions.
Thiswould appeartomean thatauditors
couldgivea “true
and fair”
certificate
to accounts
whichwould notbe trueand fairfora non-insurance
company. In
practice,
auditors
certify
thatthe accountsconform to the Acts relating
to
insurance
companies.
137
Regulation
52 of theInsurance
Company Regulations
1983requires
thatDTI
Returnsarecompiledinaccordance
withgenerally
accepted
principles,
which
would seem toimplythatsubject
totheexemptions,
theReturnsshouldgivea
trueand fairview.
Althoughitis not a closely
definedconcept,“trueand fair”is generally
understood
and couldnotbe claimed
forprovisions
containing
material
margins.
On the otherhand itisacceptedthatthereisusually
no one “trueand fair”
view;itispossible
thatseveral
different
views could all be “true and fair”.
Provisions
are based on estimates
and when thereare several
estimates
all
legitimately
claiming
tobe a “best
estimate”,
a highbestestimate
could be used
intheaccounts
withoutnecessarily
beingthoughtto contain
a margin.
From theactuary’s
pointof view,themajoranomalyisthatprovisions
can be
basedon undiscounted
estimates,
so thattherecould,
inpractice,
be a significant
margininprovisions
forclaimswhicharenotgoingtobe paidfora number of
years.However,itcan be seenthatthereare effectively
negative
marginsin
some partsoftheindustry
from timetotime,whichthemselves
servetoreduce
or eliminate
themarginarising
from not discounting.
Implicit
discounting,
under which an allegedly
undiscounted
provision
is
established
whichisinadequate
on an undiscounted
basis,
butwhichwould be
sufficient
iffuture
investment
incomewere takenintoaccount,
isforbidden
by,
inter
alia,
theABI SORP and isgenerally
regarded as improper.
The InlandRevenue taketheviewthattheyarenotdirectly
concernedwiththe
provisions
whichcompaniesestablish
intheir
CompaniesAct accounts
or DTI
returns.
They may contend,
however,thatpartof a provision
isnotallowedin
taxcomputations
and itishighly
unlikely
that they would agree to a provision
whichisgreater
thanthatintheaccounts
and returns.
The taxlaw relating
to insurance
companiesis,in principle,
the same as that
which appliesto other companies,but may appear different
due to the
uncertainty
intheprovision
for claims.
In general,
theRevenue Authorities
willnormallyallowprovisions
which area
reasonable
estimate
of theultimate
cost,
on the basis
thata run-off
lossisas
likely
asa profit
(ie.
a median).The Revenue contendthattoconformwiththe
law,long-tail
liabilities
(atleast)
shouldbe discounted
forthe time valueof
money but theview isnotaccepted
by much of theinsurance
industry
and its
tax advisers.
138
of ExistingRegulation
3.3 Limitations
There area number of themesbehindtheregulation
forfinancial
strength
of
insurers.
In the UK, forgeneralinsurers,
theyinclude
the following:Ž
Assetsand liabilities
shouldbe assessed
prudently.
Ž
The insurer
shouldbe abletomeet allfuture
liabilities
in the event that
itceased immediately
to write new business.
Ž
A “margin”
of “solvency”
isrequired
beforeany new business
may be
written.
Ž
The quantum ofnew business
whichmay be written
islimited,
the limit
being governedprincipally
by the available
(explicit)
margin. The
calculation
requires
a testrelated
to both premiums and claims.
Ž
Theremay be absolute
minimum levels
ofexplicit
margin(inthis
context
alsoreferred
toas capital)
thatarerequired
asa condition
of continuing
inbusiness,
or of starting
inbusiness
as an insurer.
Thisisa fairly
comprehensive
list,
but by no means as comprehensive
as the
requirements
relating
tolife
insurers.
For instance,
life
insurers
arerequired
to
have regardto thetermsatwhichnew business
isbeingwritten
and the effect
of thisbusiness
on thecompany’sfuturefinancial
strength.
They are required
to have regardto thenature,
term and suitability
of theassets
to the liabilities
when preparing
their
financial
statements.
They arealsorequired
to testthe
financial
position
of the company in the event of sharp changes in investment
marketconditions.
These additional
requirements
and prudential
supervision
generally
of life
insurers
areimplementedthroughcertain
duties
delegatedto
appointed
actuaries.
The only explicit
margin requirement
in existing
legislation
is against
new
business
(ie.the RequiredMinimum Margin). Increasingly,
regulators
are
considering
“risk
based”capital
requirements
whichareintended
to reflect
the
principal
threats
to insurers’
finances,
including
reserve
inadequacy.
The theoryiseasyenough tograsp;
thepractice
is far more difficult:Ž
How prudentisprudentgivenvaryingskewnessand variance
of loss
distributions?
Ž
Given the vestedinterests,
why shouldthe publictrust
the published
figures?
139
Ž
Can outsideexperts,armed with DTI Returns,advisewith any
confidence
on thefinancial
strength
of a company?
Ž
How can regulators
ensurea company doesnottraderecklessly
and turn
a satisfactory
position
quickly
intoan unsatisfactory
one?
3.4 Confidential
Statutory
Reporting
There is a case for complementing the DTI Returns with a confidential
Financial
Strength/Health
report.
This might cover areas such as investments
held,a statement
of reserving
philosophy
but alsoinclude
a series
of broad
comparative
tests
on the reserves
including
the effect
of variation
in certain
assumptions
forthemain classes
of business
a company writes.
Thiswould be complex,in thatitnecessitates
theDTI determining
what isa
fair/reasonable
level
of variation
totest,
what assumptions
tovaryand how to
takeaccountof thevariety
of reserving
methods in use. However, the report
couldbe the first
stagein a sensitive
screening
processto indicate
which
companiesareinneed of further
investigation.
The successful
implementation
of this,
however,relies
heavily
on theprofessionalism
of the person providing
theinformation
for the report.
Such a requirement
could have a profound impact on the management of the
company. Once theregulator
addresses
(orappearstoaddress)
the strength
of
the company from thisperspective,
the management would do too, if only in
orderto be ableto answertheDTI’squestions.
This in turn would generate
questions
inside
thecompany and promotea widerunderstanding
of the issues
involved.
This cutsacrossthe principle
of freedom with information,
but the balance
betweenadequatepolicyholder
protection
and overly-restrictive
regulation
is
hard to achieve. Policyholders
and shareholders
have a rightto know
information
aboutthecompany finances
which affects
theirdecisions
to deal
with it. However, publicly
available
information
is potentially
subjectto
misinterpretation
and couldincorrectly
suggest
financial
difficulties
whichcould
lead to undue concernand perhapshastenan unnecessary
closureof the
company. Equally,
suchdetailed
information
may be of considerable
valueto
a competitor.
The questionof achievinga balancebetween protection
and freedom is
inextricably
linked
withthatof actuarial
certification
ofreserves,
although
itis
wider,sinceadequacy of the reserves
is not the only potential
cause of
insolvency.
In termsof communicating
the strength
of reserving
outside
the
company,the issuesbecome considerably
more complex and the possible
solutions
cannotbe attractive
to all concerned.
140
in Margins?
3.5 Who isInterested
Differentinterested
partieswillhave different
views, sometimes widely
diverging,
aboutwhere thelines
shouldbe drawn. Broadly,
a “safe”
company
withhighreserves
willappealtodifferent
people than one which cuts margins
to the minimum and presumablytakessimilar
risksin otheraspectsof its
business.
Policyholders,
Potential
Policyholders
and Regulators
Theirinterests
are clearly
in a securecompany thathas the ability
to meet
liabilities
as theyoccur.Thissuggests
thatthe reserves
shouldbe as highas
possible.
Inpractice,
highreserves
mustbe financed
and thecostwouldbe high
premiums in the short-term.
. Providers
Investors.
Capital
and Potential
investors
Some investors
lookforstable
long-term
profits,
some look for high short-term
returns,
whileotherslookformaximum long-term
profits
withlittle
concernfor
volatility.
The strategy
chosen by management should match the risk/reward
profile
of theownerswithinreason.For publicly
quotedcompanies,
thistends
to work the otherway round,ie.risk-averse
investors
willbe attracted
to
companiesthatareseenassafeand viceversa.Investors
shouldexpectto know
thelevel
of riskbeingtakenand therefore
tounderstand
(inbroadterms)inter
alia,
theimplications
of thereserving
philosophy,
This assumes that sufficient,
comprehensible
information
isavailable
tothem,oratleast
totheir
investment
analysts.
Many investors
arelessrisk-averse
thanmanagement,sincetheimpacttothem
of insolvency
can be reduced by diversifying
the portfolio
over several
companies.
Profitable
Companiesand Unprofitable
Companies
Prudencedictates
thatsome profit
should be held back for margins on the
reserves.This pointmay be clearer
to a profitable
company, than to an
unprofitable
one. In poor years,optimistic
reserving
is very tempting.
Massagingtheresults
isnoteasily
defensible,
howeverunderstandable
and there
is a great danger is that it could be done repeatedly. If each layer of
management decidesto lessenpotential
criticism
by reducing the reserves
slightly,
withoutrealising
thatthis
hasalready
been done tothefigures
that they
received,
theultimate
published
reserves
couldbe severely
inadequate.
Management
Theoretically,
management shouldhave the same objectives
as shareholders.
However,iftheshareholders
demand highshort-term
returns,
thismay not be
consistent
withprudenceand may notbe appropriate
for managing an insurance
company.
141
Staff
The continued
profitable
operation
of the company provides
the staffwith
employmentand so prudentmanagementiscrucial
to them. However,growth
isnormallygood foremployment prospects,
thoughitmay run contrary
to
prudence.
Most will
understand
growthmore easily
thantheimplications
ofthe
reserving
philosophy
and so willequatesuccess
withgrowth,even if stronger
reserves
would really
be preferable.
Auditors
Often,auditors
would preferto erron thesideof stronger
reserves,
sincethe
main dangerforthem isbeingsuedifa company becomesinsolvent.
Indeed,
withreserves
scrutinised
ata detailed
level,
theymay arguethatthereserves
on
each class
of business
shouldbe prudentin isolation.
This could lead to very
substantial
margins.
over the whole company.
InlandRevenue and Other Tax Payers
The Revenue’sposition
was discussed
earlier.
Iftheyareundulygenerousto
insurance
companies,
the additional
revenuemust be found from othertax
payers.These arelikely
to object
ifinsurance
receives
special
treatment.
4. IF PHILOSOPHY COULD FIND IT OUT
4.1 ReservingPhilosophy
The reserving
philosophy
isan integral
aspectof thefinancial
management of
thecompany.The level
of thereserves
directly
affects
thelevel
of free assets
and so the solvencymargin. This in turn affects
the levelof futurenew
business
and investment
riskthecompany can affordto take. If the reserves
aretoocomfortable,
thenthecompany may be constrained
inotherplacesso
limiting
thepotential
for profit.
Similarly,
otherfactors
willinfluence
theneed fora marginon reserves.
Ifthe
assets
and liabilities
were perfectly
matched(saythrougha reinsurance
policy
witha securereinsurer,
whichcoveredany deterioration),
then there would be
no need for margins on reserves.
The managementtherefore
needstodecideon a risk/reward
strategy,
basedon
a holistic
viewofthecompany’sfinancial
structure,
incorporating
new business
levels,
natureof the risk,
reinsurance
requirements
and of course reserving
philosophy.
Ultimately,
mathematical
techniques
(including
thecalculation
of
the reserves)
are decision
supporttools,
not decision-making
toolsand the
decision
comes down to judgementbased on whateverinformation
can be
obtained.
142
Essentially,
the reserving
philosophy
boils down to iding a criterion
for
drawinga linebetween capital
allocated
to thepastclaimsand the solvency
margin.There areseveral
factors
whicharelikely
toinfluence
the judgement,
including:(a)
The overall
financial
strength
of the company
(b)
The hardnessof the market
(c)
The risk-averseness
of the owners
(d)
The confidence
of the management in the reserving
Thisissomewhat misleading
sincetheeffect
of thesefactors
can be to tempt
the management away from prudence.
(a)would suggest
thatifthecompany issound,thelevel
of the margins is less
importantthan ifclaimsvolatility
couldleadto insolvency.
However, ifa
company reserves
weakly,
whileitisstrong,
itwillbe verypainful
to strengthen
reserves
duringloss-making
years.Again,allocation
of capital
to marginson
reserves
is artificial
and affectsthe perceived
strength
more than the true
strength
of the company.
(b)can pullin any direction.
In a hard market,the demand forcapital
to
supportprofitable
new business
isat itsheight.However,thisis the easiest
time to buildup financial
strength.In a softmarket,the temptation
on
management is(wittingly
or unwittingly)
to permitthe truefinances
of the
company to weaken.
(c)isalmostimpossible
tomeasureinmost cases,
butmay be inconsistent
with
the more informedview of management (eg.demand from shareholders
for
short-term
profits).
(d)isthe onlyfactorwhich consistently
directs
judgementappropriately.
If
management lacksconfidence
in thereserving
either
because of inadequate
information
or a trackrecordof under-reserving,
thentheywillbe inclined
to
allocate
more capital
to past claims.
143
5. REPRESENTATION OF MARGINS
5.1 How Could Margins be Expressed?
The existence
of themarginsoffera degree of comfort to all those mentioned
above.They therefore
need tounderstand
theform and extent
of that comfort
and so needtounderstand
thesignificance
ofthemargins.
This in turn requires
the marginto be expressed
or explained
in a form that is both meaningful
(intuitively
appealing?)
and comprehensible.
Possible
ways of expressing
margins include:(a) As a confidence
interval
(b) As a % or multiple
of thestandard
error
(c) As thedifference
betweendiscounted
and undiscounted
reserves
(d) As some arbitrary
amount/percentage
of reserves
(e) No explicit
definition
All of thesecould be consideredeitherin aggregateover allclasses
or
separately
foreachdistinct
class
of business,
although
for (a) and (b) the latter
willnormallyleadto higherreserves.
Key tothechoiceof a method of expression
willbe the role and sophistication
oftheaudience
forthereserve
and so themargin.The choicewillalso depend
on whethertheyrequire
a range{(a)and (b)}ratherthan a point estimate
{(c)-(e))
to indicate
the levelof comfort(and likelihood
of discomfort)
and
whethertheywishto concernthemselves
withthereserving
philosophy
or are
content
torelyon others’
judgementas regards
adequacy.
(a) Confidence Interyals
Thisisa widelyunderstood
concept- or atleast
an easily
explained
one. The
ideathaton average,
theanswerwillbe outside
the range one time in 20 should
be familiar
to theclientele
of most betting-shops.
However, the method is the
most demanding of assumptions.
A confidence
interval
requires
a probability
distribution
- for example the error
termina model couldbe assumedtobe some standard
parametric
distribution
or an empirical
claimdistribution
couldbe calculated
from pastdata. This
makes heavy assumptions
aboutthe continuing
suitability
of themodels and
distributions
chosen,
assumptions
whichareunlikely
tobe understood
by many
of thoseinterested
in the reserves.The models can alsobe criticised
for
restricting
thevariability
to a narrowrangeof thepossible
events(eg.thatof
which thereis experience
in the pastdata)and so incorrectly
stating
the
inherent
variability.
Inpractice,
suchargumentscouldconvince
you nottoleavebed inthemorning
144
and thoseunlikely
to understand
theassumptions
willbe more content
witha
rangethattheycan atleast
partially
understand
than none at all or something
incomprehensible.
One apparent
problemwiththeapproachisthatwithsparse
or erratic
data,the
rangeislikely
to be exceptionally
large,
whichwillinhibit
decision-making
on
thebasisof thereserves.
Ifthereisthatdegreeof uncertainty
in the reserving
process(although
not necessarily
the claimsexperience)
this is an important
pointto be communicated,
not covered up.
of theStandardError
(b) Multiple
A poorman’sconfidence
interval
- itoffers
a range,
but one which it is difficult
to communicatemeaningfully
to the layman.
The demands on theassumptions
areless,
inparticular
thereisno need foran
explicit
distribution,
howeverthefigures
may be misleading
withhighly
skewed
distributions.
Discounted Reserves
(c) Difference
Thisisrelatively
simpleto quantify
and has theforceof widespread
practice,
especially
for tax purposes.The troubleis that it is a somewhat arbitrary
calculation
independentof the inherentvariability
and possible
sources of
unpleasant
surprises.
Although(luckily)
many shorttail
claimsare reasonably
stableand many long-tail
claimsare highlyvolatile,
the method is at best a
compromiseand itisdifficult
to communicatethelevel
of comfortimpliedor
relate
itto an intuitively
appealing
reserving
philosophy.
(d) Arbitrary
Amount/ Percentage
of Reserves
This isverysimpleand calculation
istrivial
and althoughthe amount of the
reserveissimpleto communicate,
thepractical
consequence
of it is not. This
starts
withan estimate
of thetruereserve
and addstheexplicit
margin.
A fundamentalcommunicationproblem with this is that having given a best
estimate,
thiscanoftenbe takenasthetruelevel
in that the margin is regarded
as the truemargin. So thismarginforprudenceisseen a sparecapital
that
mightotherwise
be spentrather
thana provision
forclaimsthat might well be
needed.
(e) No Explicit
Margin
Examples of thisinclude
usingtheimplicit
(unquantified)
margin held by not
discountingor assuming future development which is worse than
average/expected.
Suchan implicit
margincanbe assumedtooffset
items such
as claimshandlingexpensesand theriskand costof reinsurer
failure
without
actually
estimating
whetherthisimplicit
margin is in fact sufficient.
145
In practice,
theexistence
of a wide rangeof methodsinpractical
use indicates
thatthereisno right
method.They allhaveadvantages
and limitations.
By and
largethemore powerfultheyareascommunication
tools,
the more demanding
thereliance
on (possibly
false)
assumptions
and data.
6
CONCLUSION
6.1 How Far Can We Go?
The reserves
form an integral
partinthefinancial
strength
of thecompany and
thereisa realneed,particularly
of themanagement and regulator
for a clear
indication
ofthelevel
ofcomfortthattheyoffer.
The actuary
has an obligation
todo more thanjustestimate
thelevel
of thereserves,
but also to communicate
inmeaningful
termstheleveland implication
of their
strength.
Many of the toolsavailable
forcommunicationsuch as stochastic
reserving
methods and simulation
techniques
have theoretical
weaknesses in some
circumstances,
but thenso do more basictechniques
and so does judgement!
The reserving
may lookcomplexand unrewarding
to management, but it is the
actuary’s
responsibility
totranslate
and so conveythespirit
of the message if the
messageitself
is inaccessible.
The question
we started
withwas what constitutes
a prudentmargin. The
answer isgenerally,
ifyou defineprudent,I’ll
giveyou the margin. Most
actuaries
would feeluncomfortable
withthatsincethe definition
of prudent
would be oftenbe too demanding (eg.the worst case scenario).
This is
therefore
a communicationexercise
- to explain
and interpret
from the range
of legitimate
representations
of themargin,withcaveats
where necessary.
It
would be easierto leavethe definition
of the margin as vague and noncommittal
as possible,
but thecredibility
of actuaries
ingeneralinsurance
has
alwaysrested
on providing
a service
that is of use.
146
APPENDIX
Summary of Overseas Papers and Proposals
Inthecourseofresearching
this
paper,we were given a number of papers from
abroadwhichdeal,to some extent,
withtheadequacyof claimreserves.
The
following
isa brief
summary of therelevant
sections.
It is not comprehensive,
sincemany coveredconsiderably
widerissues
and thereareundoubtedly
other
relevant
papers.The main purposeisto alert
readers
to theexistence
of these
papers.Moreover,thisismerelyour interpretation
and may differ
from the
views of the authors. The comments are not intended to be critical
or
judgemental
inany way and readers
areadvisedto read the papers themselves
before drawing any conclusions.
The choice
facedby theauthors
ofsuchpapers(including
ourselves)
is between
making firmstatements
aboutwhat constitutes
an adequatereserve,
which is
likely
to soundoverlysimplistic
and leaving
thedefinition
of adequacy to the
judgementof thereader(aswe have done)whichmightbe seenasoptingout.
AUSTRALIA
1.
Outstanding
Claims in General Insurance:
Institute
of Actuaries
of
Australia
- Discussion
Draftof Professional
Standard300
(forcomments March 1991)
Thismainlydiscusses
theissues
forconsideration
when setting
reserves
inbroad
terms.Itrecommends specifying
a “central
estimate”
- median present
value
(paragraphs
1.1& 1.4)and thenreserving
more strongly,
thedifference
being
the“prudential
margin”.
Quotations
from the paper are:The actuaryshouldnot spreadthe effect
of any changes (of valuation
Ž
assumptions)
overmore thanone valuation.
(3.8)
The riskfreerateof returnwillnormallybe theappropriate
discount
Ž
rate.
(3.11)
The actuary
shouldnotrecommend or supporta provision
which is less
Ž
than the central
estimate of
the present value of the corresponding
liabilities.
(5.4)
The actuaryshouldnot recommend or supporta provision
which is
Ž
excessive.
The actuary
shouldnotinclude,
aspartofthecentral
estimate
or prudential
margin,any provision
forcontingent
eventswhich have a
remoteprobability
of occurrence.
(5.5)
The actuaryhas a responsibility
to consider
thereasonableness
of the
Ž
provisions
adopted or recommended includingthe extent of any
prudential
margins.
(5.6)
147
2.
MarginsforPrudenceinOutstanding
ClaimsProvisions
by JR.Cumpston
(for8th General Insurance
Seminar of the Institute
of Actuaries
of
Australia
13-16September1992)
The paperillustrates
thetheoryofestimating
confidence
intervals
using run-off
tables
published
by theAustralian
Insurance
and Superannuation
Commission
1977-89.The confidence
intervals
are expressedas the percentage
margin
required
forreserves
witha chosenprobability
of adequacy.
3.
Prudential
Marginsand ClaimsReserving
Policy
inGeneralInsurance
by
JR.Trowbridge(for8thGeneralInsurance
Seminar of the Institute
of
Actuaries
of Australia
13-16 September 1992)
A generaldiscussion
of the principles
and optionsas well as the problems
involved.The paper makes some suggestions
for percentages
which would
constitute
highor low marginsforcertain
classes
of business.
CANADA
4.
Recommendations for Propertyand CasualtyInsuranceCompany
Financial
Reporting(CanadianInstitute
ofActuaries
- 10 January 1990)
Thisincludes
an outline
ofreserving
practice
and considerations.
There is little
direct
comment on what marginswould be appropriate.
There is a comment
aboutlanguage
in thereports
that:
“...proper
provision...”
ismore thanbarelysufficient.
It(ie.
proper provision)
isa good and sufficient
provision
determinedfrom:
adequateand appropriate
assumptions
and methods consistent
with
a.
soundactuarial
principles...
where more conservative,
applicable
statutory
requirements.
b.
(Sections
6.06 and 7.06)
5.
Discussion
Draft on Provisionfor Adverse Deviations (Canadian
Institute
of Actuaries
- 5 November 1992)
This givesfirmerguidancethanmost on what constitutes
a suitable
margin.
Companiesare definedas beingin either
a “high”or “low margin situation”
dependingon whethera number of “significant
considerations”
apply. A guide
highmarginfactor(applied
to discounted
reserves)
would be 15% and a low
factor
would be 0%. Iftwo or more “significant
considerations”
exist,
then at
least
the average of the high and low should be used.
148
USA
6.
Statement
of Principles
Regarding
Property
and Casualty
Loss and Loss
AdjustmentExpenseReserves(Casualty
Actuarial
Society
May 1988)
“A reserve
shouldtakeintoaccountthedegreeof uncertainty
inherent
in its
projection.
A reservestatedat itsultimate
valuemay includean implicit
provision
foruncertainty
due tothetimevalueof money. Ifa reserve
is to be
stated
atpresent
value,
itmay be appropriate
to include
an explicit
provision
foruncertainty
in itsundiscounted
amount. Further,
an explicit
provision
for
uncertainty
may be warrantedwhen the indicated
ultimate
reservevalue is
subject
to a highdegreeof variability.”
(Line 308)
There was a discussion
of riskmarginsinlossreserves
at the CAS Spring 1993
meetingat Dallas,
although
we understand
that no paper was produced.
149