Tracking estimated required reserve changes for captives

The modern captive insurance landscape encompasses a wide array of risks, ranging from traditional, well-understood coverages to emerging perils with limited historical information. No matter what risks are placed into a captive, however, it will at some point be faced with actual loss experience.

Understanding how this loss experience impacts the captive’s financial viability from year to year is a crucial piece of the strategic decision-making process and can provide guidance on what the future might hold for the captive. One of the most efficient ways of reviewing and conveying the continual impact of a captive’s losses is through an actuarial exhibit referred to as a “reconciliation of required reserves”.

Generally, these types of exhibits isolate each of the major changes which brought a captive’s estimate of required reserves from a prior evaluation to the current evaluation. For the purposes of this discussion, estimated required reserves comprise case reserves (from a loss run) and incurred but not reported (IBNR) claims (from an actuarial estimate).

One of the main benefits of a reconciliation exhibit is its brevity. A captive’s board members may not have the time or desire to walk through each minor detail of an actuarial analysis, but they can easily digest what is typically a one-page document summarising the main components of change. This potentially underutilised exhibit can help ensure each of the captive’s key decision-makers is aware of the high-level loss activity within the captive itself and, thus, inform what steps should be taken in the immediate future.

It can also help its audience know what topics require additional investigation and where to drill down for further information. A supplementary exhibit known as a “roll-forward” may help guide this process and will be described in more detail below.

What exactly is a reconciliation exhibit, and where might it be found? Because of its usefulness in portraying large-scale changes, it is generally located somewhere within the executive summary of a captive’s actuarial report, meaning it should be found within the first few pages.

Depending on the complexity of the involved risk(s) and loss activity, lengthier versions of this exhibit might be used, but it can contain as few as five key numbers:

By stepping the reserve estimate forward from the previous evaluation and breaking it down at such a high level, the reconciliation exhibit condenses potentially complex actuarial calculations into an easy-to-understand formula suitable for any audience. Crucially, it also serves to highlight the key drivers of how the reserve estimate might have changed over time.

If, for example, the current reserve estimate is higher than expected, the reconciliation exhibit could show that this was due to a low volume of payments, deterioration in historical claims, or an increased exposure in the current policy period.

It’s also important to understand that increases in reserves do not necessarily equate to deteriorating loss experience. In many captive scenarios, such as after one is newly formed, an increase to the reserve estimate could be expected. Showing that an actual reserve increase is lower than the anticipated increase could indicate improved loss experience, despite the increased reserve estimate.

Use of a reconciliation exhibit

To highlight how one might use a reconciliation exhibit, let’s consider a situation in which Captive XYZ’s owners are trying to determine what is driving an unexpected reserve increase in their most recent actuarial analysis. As a first step, they locate the reconciliation exhibit in the report and review the calculations shown in Table 1.

As shown in Table 1, the payments made since the prior evaluation have fully offset the accrued liabilities in the current period, meaning the increased reserve estimate is due entirely to increased estimated ultimate losses in historical periods (deterioration in loss experience). This information becomes immediately useful, as it drives the discussion toward claim activity occurring in older periods. Captive XYZ’s owners might then review the underlying cause of such movement and whether any changes in strategy are needed.

These exhibits can be expanded to provide greater detail on specific areas. The exhibit provided in XYZ’s actuarial report might be shown as in Table 2.

If XYZ’s actuary were to simply expand one line of the calculation, Captive XYZ’s owners can even more easily identify the root cause of this unexpected increase. As indicated in lines 2A and 2B of Table 2, claim movement in periods prior to 2010 is the primary driver of growth in the reserve estimate, likely as a result of deterioration on a single or a handful of older claims. Once identified, relevant parties can be tasked with investigating further details on this claim (or claims) and determining what next steps should be taken.

Another useful exhibit for this type of review is the “roll-forward” table, which creates an estimate of what the required reserves might be at some point in the future based on anticipated payments patterns and expected loss experience. Comparing the prior year’s roll-forward exhibit with the current year’s reconciliation exhibit allows one to determine how actual loss experience compares to expectations. The two exhibits cover movement over the same period of time, but one is estimated in advance, and the other is calculated after the time period is complete.

The examples covered above also highlight how reconciliation exhibits can easily be expanded or condensed as needed. If, for example, it became necessary for XYZ’s owners to monitor loss experience from a newly acquired entity or run-off segment of the business, the reconciliation exhibits provided in their actuarial report can home in on those specific changes and explain how any potential movement impacts the business as a whole.

Since these exhibits primarily focus on reserve estimates, they can provide significant value when examining another key concern for captives: collateral requirements. Through the consistent use and review of reconciliation and roll-forward tables, captive decision-makers can more readily plan for future collateral indications and get ahead of any potential adjustments. This information can also inform the approach used for collateral negotiations, as it provides clear, concise guidance on what direction the reserve estimate might be heading and why that may be the case.

Reserve estimate changes rely on too many factors, such as exposure growth and payment speed, to always be easily attributed to a single issue. Incorporating reconciliation and roll-forward exhibits into these discussions can shift the ensuing dialogue toward the primary drivers of these changes without bogging down the audience with unnecessary detail.

These exhibits can provide immense value in evaluating and maintaining a captive’s long-term financial viability.

Enoch Starnes is an actuarial consultant at Sigma Actuarial Consulting Group. He can be contacted at:  es@sigmaactuary.com

L. Michelle Bradle is a consulting actuary at Sigma Actuarial Consulting Group. She can be contacted at:  mb@sigmaactuary.com