Insurance literature is replete with articles, analyses, studies and discussion documents related to industry loss and loss adjustment expense (L&LAE) reserves, the impact of L&LAE reserve adequacy on insurance pricing cycles, as well as the correlation between inadequate L&LAE reserves and the failure rates of carriers. However, we found negligible justification for the terminology or analysis of “industry L&LAE reserves” nor a rigorous discussion of the impact of under-reserving L&LAE on solvent carriers, or the resultant over- statement of reported income associated with under-reserving.

In an effort to initiate thoughtful review and dialogue on these issues, Demotech undertook this study to investigate two questions:

Is the term “industry loss and loss adjustment expense reserves” a meaningful one?
Has the relationship between underreporting of L&LAE and the resulting overreporting of income been thoroughly discussed? If not, why not?

Some of the research on industry loss and loss adjustment expense reserves

A review of previous research and articles on this subject indicates the focus of researchers is either an industry-wide analysis of the relative adequacy of L&LAE or the relationship of inadequate L&LAE reserves to the failure of carriers.

In Charles Bryan’s May 2014 review of Stan Khury’s paper “Testing the Reasonableness of Loss Reserves: Reserve Ratios,” Bryan reminded us that the actuary’s increased role in setting and evaluating loss reserves came about during the late 1980s after changes to the required components of actuarial opinions were instituted by the National Association of Insurance Commissioners (NAIC). The NAIC had revised these requirements following a report issued by the U.S. House of Representatives which highlighted deficiencies in the evaluation of loss reserves regarding the issue of solvency. Bryan noted an A.M.

Best report that stated “Deficient loss reserves (intrinsically linked with inadequate product pricing) and rapid growth were the most dominant causes of insolvencies.”

In recent annual reports (2010, 2011, 2012 and 2013) entitled “U.S. P&C Industry Statutory Reserve Study,” Aon Benfield studied industry-wide, rather than individual company, reserves by looking at an aggregation of NAIC Annual Statement data. In its June 3, 2014 report, Aon Benfield reported the overall industry redundancy of $6.5 billion is equivalent to 1.1% of booked reserves. Further, they noted that the industry-wide redundancy in personal lines of $9.3 billion was less than the $10.1 billion reported at year-end 2012.

In its “GC Briefing, Industry Reserve Update – Which Way is the Cycle Turning?” issued in April 2014, Guy Carpenter focused on industry-wide trends when it noted, “Seventy percent of the improvement for accident year 2012 can be attributed to two lines: homeowners and private passenger auto.”

In the May 31, 2012, issue of PropertyCasualty360, Meyer Shields, an analyst at Stifel Nicolaus, suggested that the (then) industry reserves of $573.7 billion were but $5 billion [less than 1%] above the minimum adequate level. (Ruquet)

In their report “What May Cause Insurance Companies to Fail – and How This Influences Our Criteria,” Brennan, Clark, and Vine discovered seven key factors that led to company failure. Two major factors were underpricing and underreserving. They cited one example of California-based workers’ compensation insurance companies becoming insolvent following rate deregulation: “The underpricing and inadequate reserving that ensued came to light late in the decade and resulted in several companies that were heavily concentrated in the market becoming insolvent.” They then went on to discuss global P&C companies that failed due to industry- wide underpricing and the resulting inadequate reserves.

Darrell Leadbetter and Suela Dibra referenced a study by the Financial Services Authority (FSA) in the United Kingdom in “Why Insurers Fail: The Dynamics of Property and Casualty Insurance Insolvency in Canada.” This FSA study analyzed failed insurers across life and non-life sectors within fifteen countries of the European Union and concluded that over 60 percent of the failed insurers “showed poor underwriting or reserving as a contributing factor” to their failure. Further, in their investigation of the 35 P&C insurance companies that had become insolvent in the Canadian insurance market between 1960 and 2005, Leadbetter and Dibra determined that “inadequate pricing and deficient loss reserves are the leading cause of insurer insolvency.”

Our Take: Concentration of L&LAE Reserves Renders Industry Analysis Interesting But Not Meaningful

Our analysis of the L&LAE reported and recorded by Property and Casualty (P&C) insurers focused on the 2,1371 insurers reporting financial information to the NAIC that reported their loss and loss adjustment expenses reserves at year-end 2013 were greater than zero. We excluded 559 carriers with reported L&LAE of zero or less.

Our analysis considered L&LAE reserves on a net basis, by carrier. We did not review P&C L&LAE reserves by group, holding company, family of companies or other basis. Projections of L&LAE reserves, actuarial or otherwise, were outside the scope of the study.

As you will observe, had we reviewed loss and loss adjustment expense reserves on a net basis by group or family of insurers, the concentration of L&LAE reserves might have been interpreted differently. We chose a carrier level basis of review because we believe that each carrier exists within a group or family of carriers to play a unique role.2

Of the 2,137 active P&C insurers comprising the P&C industry, seven insurers recorded and reported 20% of industry L&LAE reserves. That is, seven companies reported $119,240,160,000 of the $596,700,000,000 that was described as “industry loss and loss adjustment expense reserves.”

Breaking down the numbers further, we find that:

Ten carriers, the seven above plus three others, reported 25% of the industry’s L&LAE reserves.

Less than one-half of one percent of the 2,137 carriers reporting net L&LAE reserves carried ?25% of industry L&LAE reserves.

Thirty two carriers, one and one-half percent of the reporting entities, recorded 50% of industry L&LAE reserves.

One hundred and fourteen carriers, about five percent of the carriers, recorded 75% of industry L&LAE reserves.

This concentration indicates to Demotech that a relatively small percentage of the carriers comprising the P&C industry constituted a significant component of “industry loss and loss adjustment expense reserves.” As shown in the table and pie chart below, the L&LAE reserves reported by the largest single carrier exceeded the combined L&LAE reserves reported by the 1,605 smallest carriers in terms of L&LAE reserves. These 1,605 carriers comprised 75% of the industry by count.

We think this bears repeating: 1,605 of the 2,137 insurers reviewed held loss and loss adjustment expense reserves that if combined, were less than the dollar amount reported solely by State Farm Mutual Automobile Insurance Company.

In an industry that has this distribution of L&LAE reserves, does a high level analysis of “industry L&LAE reserves” create value? Or is the term “industry loss and loss adjustment expense reserves” a misnomer due to the concentration of L&LAE reserves in a relatively small number of insurers?

Demotech believes that the concentration of loss and loss adjustment expense reserves in a small number of companies reduces analyses and studies of industry L&LAE reserves to a level that is interesting but can hardly be considered informative or indicative of the situation of any specific individual carrier.

The Impact of Adverse L&LAE Reserve Development on Reported Income

Loss and LAE reserving and reported income are but two components of a thorough, all-encompassing rating agency analysis of an insurer. Today, more than ever before, there appears to be a move toward qualitative areas of analysis, such as general financial and operational management with a focus on corporate governance and Enterprise Risk Management (ERM). The adequacy of capital, business profile, current or historical financial metrics are viewed as the output of a corporate governance process as much as they are the reported dollar amount in a statutory financial statement.

If this is the direction in which regulators, rating agencies, reinsurers, Wall Street analysts and other third parties are heading, the discussion of reported financial results is as much about how the results were achieved or calculated, i.e., “process,” as it is about “what was recorded in the reported financial statements.” In this environment, governance, managerial processes and execution of the business model are now as important, perhaps even more important, than reported operating results.

This said, the influence of inadequate L&LAE reserves on the integrity of an insurer’s balance sheet has been discussed in numerous articles and research papers with a focus on the correlation between inadequate L&LAE reserves and the failure rate of insurers. However, it is Demotech’s observation that the impact of inadequate L&LAE reserves, overreporting of pretax profit or underreporting of pretax loss, has not received the explicit discussion that it deserves as regards solvent carriers.

Every dollar of adverse one-year L&LAE reserve development reported in calendar year 2013 was a dollar of overstatement in pretax operating income in calendar year 2012. Similarly, a carrier that reported favorable L&LAE reserve development in the year subsequent had understated its pretax operating income in the prior calendar year. The integrity of earnings is higher when a carrier overestimates L&LAE and reports favorable reserve development.

To initiate a preliminary discussion, Demotech reviewed the statutory financial statements of thousands of insurers to identify those that had:

Received an unqualified statement of actuarial opinion as regards its year-end L&LAE reserves for five consecutive years;
Received an unqualified year-end audit from its auditors for five consecutive years;

Self-reported at least five consecutive years of adverse L&LAE reserve development.

Our thought process is this: If reported L&LAE reserves are adequate, the integrity of earnings is high. If adequately reserved carriers are assigned ratings at an A level or above, then reported operating results, in and of itself, may be sufficient to address the requirements of rating services.

Conversely, if the reported results associated with L&LAE reserves do not appear to favorably impact the ratings assigned by rating services, then it seems reasonable to believe that operational, managerial or governance related procedures and processes are more important, or more heavily weighted, than one of the most fundamental objectives of an insurance enterprise: estimating its L&LAE reserves adequately.

We identified 28 insurers with ratings at an A level or above that self-reported at least five consecutive years of adverse one year L&LAE development at year-end 2013. As such, each prior period’s pretax operating income may have been overstated by the subsequently reported amount of adverse reserve development.

For this group of 28, the average annual reduction in the group’s reported pretax operating income would have been more than $2.7 billion. Annual figures for the group are summarized in the table below. Refer to Appendices 1, 2 and 3 for details by company of each of the 28 companies in each of the five years studied.

Demotech then reviewed the same database of statutory financial statements to identify insurers that had:

Received an unqualified statement of actuarial opinion as regards its year-end L&LAE reserves for five consecutive years;
Received an unqualified year-end audit from its auditors for five consecutive years;
Self-reported at least five consecutive years of favorable L&LAE reserve development.

We identified 49 carriers that were assigned ratings below an A level despite self-reported favorable L&LAE reserve development in each of the latest five calendar year reporting periods. As such, the integrity of their pretax operating income was fully intact. Refer to Appendices 4, 5 and 6.

Although Demotech did not prepare a statistical analysis of the two groups, a scan of the names of the companies in each group indicates that the first group – those self-reporting adverse reserve development and therefore having reported pretax operating income with less integrity – tended to be larger, publicly traded stock companies. Among them are eight members of American International Group, six members of QBE Group, Fireman’s Fund, which is affiliated with Allianz, and Continental Insurance Company in CNA Group. The only large company on this list that is not affiliated with a publicly traded company is Auto Owners, a mutual.

In contrast, those that reported favorable L&LAE reserve development over the same five calendar years and thereby demonstrated greater integrity in their initial report of pretax operating income than their below-A ratings might suggest, tended to be smaller, mutual companies or risk retention groups.

That’s not to say that big companies are in trouble or small insurers are all overestimating reserves. For the A-rated companies that underreported reserves, the dollar amount of the adverse L&LAE reserve development, whether measured as a percentage of reported L&LAE, admitted assets, earned premium or surplus, did not appear to be material for the larger, publicly traded carriers. It impacted the integrity of reported income but could in no way be considered a threat to the solvency of the reporting entity.

In this type of environment, it seems reasonable to assume that rating agencies, regulators and Wall Street analysts have focused on governance, operational management and qualitative considerations, including the implementation and execution of enterprise risk management procedures, to differentiate the stronger carriers.

However, Demotech is unwilling to concede bigger is always better. It appears to us that as the conversation of a regulatory focus or a rating agency review turns to capital adequacy, business model, execution, financial and managerial operations, including ERM, as opposed to balance sheet fundamentals, L&LAE reserve adequacy or integrity of reported earnings, some insurers will be downgraded solely due to the change in the rating agency review processes. This transition may disproportionally impact smaller, privately held or mutual insurers which have consistently practiced conservative loss reserving but may not have the resources or the interest to garner the highest ERM and governance scores from rating agencies.

We are also concerned that users of ratings may believe that the ratings assigned by rating agencies are more focused on L&LAE reserve adequacy and other balance sheet fundamentals than may be the case. If, or maybe as, downgrades may be based on subjective qualitative criteria, users of ratings should be made aware of this.

Putting it All Together

We began our research with two questions:

Is the term “industry loss and loss adjustment expense ?reserves” a meaningful one?
Why hasn’t the relationship between underreporting of ?L&LAE and the concomitant overreporting of income been ?thoroughly discussed?

Our review of 2,137 companies found that the term “industry loss and loss adjustment expense reserves” is interesting yet meaningless because less than 10 percent of the insurers comprising the industry account for 85 percent of the industry’s L&LAE reserves. Given this level of concentration, “industry loss and loss adjustment expense reserves” would appear to be the L&LAE reserves of a small number of larger carriers.

As to underreporting of L&LAE reserves and the overreporting of pretax operating income, we believe three interesting observations emerged from our preliminary research:

Industry research and studies have focused on underreserving and its impact on carrier insolvency. Our analysis of this research shows that explicit acknowledgements of underreserving as an overstatement of income were negligible. This phenomenon is not restricted to insolvent carriers.
Chronic underreserving at a level that overstates reported pretax operating income does not appear to adversely impact the ability of larger, publicly traded stock insurers to be assigned A level ratings or above. Concurrently, a conscious effort to report adequate L&LAE reserves appeared insufficient to enhance the ratings assigned to smaller, privately held carriers, smaller mutual insurers or risk retention groups.
Rating agency review and analysis techniques and procedures appear to heavily consider criteria other than L&LAE reserve adequacy, such as capital adequacy, business model, financial and operational management and corporate governance.

Initiating a Dialogue

Demotech undertook this research to initiate a dialogue between insurers, regulators and other informed third parties about the utility of L&LAE reserves on an industry basis and the relationship between the relative level of L&LAE reserves carried by an insurer and the concomitant impact on its reported pretax income.

Some of the questions that we suggest are:

Should L&LAE reserve adequacy and its concomitant impact ?on the integrity of earnings be more heavily weighted in the ?ratings assignment process?
Are the observations, summarized in Appendices 1 through ?6, sufficient to conclude that L&LAE reserve development is not the singularly critical criterion in the assignment of ratings?
Were you aware that larger, well known, respected carriers could sustain high ratings despite self-reporting of L&LAE reserve inadequacy?
Were you aware that carriers with a long history of L&LAE reserve adequacy could be assigned ratings below an A level?

Your thoughts, comments, perspectives and opinions are both welcomed and encouraged.

Disclaimers

This study is not intended to be, and should not be construed to be, a statement of actuarial opinion regarding loss and loss adjustment expense reserves or any other type of statement of actuarial opinion.

This study was compiled from sources that Demotech, Inc. believes to be reliable. However, Demotech makes no representations or warranties as to the accuracy, reliability or completeness of such information, and the information should not be relied upon in making business, investment or similar decisions.

Demotech did not independently verify the accuracy or reliability of the information.

This analysis was based upon financial statements promulgated using statutory insurance accounting principles as prescribed or permitted by the National Association of Insurance Commissioners. An analysis of financial statements based upon generally accepted accounting principles may have other implications.

The statutory insurance accounting information underlying our analysis was created, compiled and self-reported by the carriers. As part of this analysis, Demotech did not review or seek to draw conclusions about the sizes or ownership structures of:

The 28 companies with ratings of A or above that self-reported favorable L&LAE reserve development in each of the latest five calendar year reporting periods;
The 49 companies with ratings below A that self-reported adverse reserve development in each of the latest five calendar year reporting periods.

Is the term “industry loss and loss adjustment expense reserves” a meaningful one?

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