Understanding reserve risk

The 2016 edition of Aon’s Global Insurance Market Opportunities looks at the current risk environment, in addition to the ability and willingness of insurers and capital providers to address the risks that the market faces today.

The Aon report points out that in 2015 the US property casualty industry experienced its 10th consecutive year of loss reserve releases, with $7.3 billion in favourable development booked. On the surface this headline may sound like “more of the same,” but as Aon points out the story is more nuanced.

According to the report: “This is the smallest reserve release for the industry since 2006, and the percentage of companies experiencing adverse development is increasing. Might these be signals that insurers’ financial positions are substantially weakening? And might this herald the long-awaited conclusion to the current soft market? Let us take a deeper look.

“We can form an independent opinion about the adequacy of statutory reserves using the high quality, uniform data at the legal entity available through the National Association of Insurance Commissioners Schedule P in statutory accounts. The accounts provide US regulators with a clear view into insurance companies and are part of a very effective system of solvency regulation based on consistent and transparent reporting.”

The report reveals that Aon Benfield started publicly tracking the reported reserve adequacy of US companies seven years ago and that each year the company analyses the aggregated net loss development data by Schedule P line of business.

Aon says that working at an aggregate level allows its actuaries to use different methods and to weigh the results in different ways compared to those working with smaller and less stable datasets. Compared to public studies, Aon’s reports have called for continued reserve releases by the industry—predictions that the report claims have been borne out by subsequent facts.

A look at the data

Table 1 summarises the analysis of the year-end 2015 data. The overall industry redundancy position decreased to $4.8 billion at year end 2015—equivalent to only 0.8 percent of total booked reserves. This compares to a $6.3 billion total industry redundancy position at year end 2014. Commercial lines continued to show an aggregate reserve deficiency of nearly $2 billion, but the biggest move in the aggregate reserve adequacy position was in personal lines where the projected redundancy dropped to $6.5 billion at year-end 2015 from $8.3 billion.

With reduced equity in reserves going forward, mistakes made by insurers in underwriting, rate monitoring, and primary pricing will no longer be masked by a reserve cushion. As Aon has claimed in past editions of this study, understanding reserve risk is critical for effectively modelling company solvency and monitoring the phases of the underwriting cycle.

“Looking back through history,” Aon claims, “A graph (Figure 1) of the US property casualty premium relative to gross domestic product (GDP) is a quick visual demonstration of the underwriting cycle. Since 1968, the industry has had three major hard market turns of significant premium increases, across multiple calendar years.

“All three steep increases in the premium-to-GDP line have been led by significant loss-to-GDP increases. Since Schedule P was introduced in the mid-1980s, we have detailed information regarding the movement in prior year loss reserves for the last two hard market turns in the underwriting cycle, highlighted in grey.

“In both of these instances, loss to GDP increased substantially over a three to four-year period, preceding the premium to GDP movement each time by one year. By contrast, a single year of large cat losses does not cause a hard market—we note the absence of hard market conditions following hurricanes Andrew in 1992 and Katrina in 2005.”

Evaluating the information more granularly, the report claims to see the link even more clearly. Looking at the commercial auto liability line, Figure 2 shows the difference between accident year ultimate loss ratio picks at the initial estimate (gold line) and the final estimate 10 years later (blue line).

Accident years that were initially under-reserved show a difference between the two lines in red and accident years that were initially conservatively reserved show up as the green differences between lines. As shown, sequential initial accident year underestimation of ultimate losses and reserves leads to future calendar year adverse development. This calendar year reserve development can then align with corresponding premium growth.

The percentage change in market premium levels is highly correlated to the changes in reserve development, and in particular, the large increases in premiums associated with the hard market align with the large increases in calendar year loss development.

Three points

According to the Aon report this illustration highlights three key points:

Accident year reserve inadequacy is a leading indicator for an underwriting cycle turn to a hard market.

A single year view of reserve risk understates the cumulative impact of volatility. The movement in reserves across time is clearly correlated.

Premium will increase at the same time reserves will be increasing.

Aon claims that if a company tries to maintain market share across time, then at the turn of an underwriting cycle it will see reserve increases erode surplus at the same time that premiums will be increasing. Given that both risk-based capital and rating agency solvency models are factor-based models driven by reserve and premium balances, the company will then see its required capital increase at the same time that its surplus is decreasing.

The report goes on: “The commercial auto liability line has entered the adverse reserve development portion of the cycle, and in the past, the risk of adverse development has emerged first in commercial auto before emerging in other casualty lines. As companies look to enhance the robustness of their own risk solvency assessment process, creating a realistic, multi-year underwriting cycle scenario, understanding both their individual exposure as well as their relative exposure to the macro market dynamics is critical to assess capital adequacy across a multi-year time horizon.

“Aon Benfield Analytics has developed effective models of industry loss drivers, as well as a realistic underwriting cycle stress scenario based on line of business movements across the last two hard market turns. While in the current environment insurers have been focused on growth and innovation, it is always important for companies to manage their overall financial position with an understanding of the potential risks of a turn in the market.

“Only with that understanding can the growth and innovation agendas be placed on solid footing and executed successfully,” the report concludes.