AGN 4
ACTUARIAL GUIDANCE NOTE
AGN 4 OUTSTANDING CLAIMS IN GENERAL INSURANCE NOTE
ON PROFESSIONAL PRACTICE
Application: This guidance note applies to actuaries preparing estimates of the liabilities for outstanding claims of a general insurer or reinsurer in Hong Kong.
Definitions
An insurer’s liabilities for outstanding claims at a given date (the valuation date) are the present value of claim payments, to be made after the valuation date, on claims which, under the terms of its contracts, arose on a before the valuation date plus the present value of the insurer’s internal costs directly related to administering and settling those payments.
Outstanding claims are claims which have arisen or will arise from events which have occurred on or before the valuation date and include claims which have been reported and have not yet been finalised or settled, claims which have been incurred but not yet reported (IBNR), and claims which have been administratively finalised and which may be reopened.
Claim payments refer to payments to or on behalf of the claimant, and any third party costs such as investigation, medical and legal fees associated with each claim.
Incurred But Not Reported (IBNR) may be used to refer to the actual claims, i.e. IBNR claims or the amount set aside in respect of those claims, i.e. IBNR provision.
Incurred But Not Enough Reported (IBNER) refers to the amount set aside in respect of the expected cost of claims in excess of the case estimate held. It is to meet the development on case estimates as further information becomes known on open claims.
Recoveries refer to amounts or expected amounts to be recovered by an insurer in respect of particular claims. A distinction is made between reinsurance recoveries and non-reinsurance recoveries (salvage, subrogation, sharing agreements, etc).
A central estimate of the liabilities is an estimate which is intended to contain no deliberate or conscious over or under estimation. The nature of insurance claims is such that the actual value of the liabilities may not be known for some considerable time and it is usually very difficult to determine the central estimate with reasonable degree of precision. For this reason the inherent uncertainty in the central estimate must also be considered.
An outstanding claims provision is the amount set aside in the insurer’s accounts, to provide for outstanding claim liabilities and includes any separate amounts for IBNR and/or IBNER. In order to deal with uncertainty a distinction is drawn in this document between the ‘provision’ (the amount set arise in the accounts) and the ‘liability’ (the unknown value of the outstanding claims).
A prudential margin refers to the amount by which the provision set aside in the accounts is greater than the actuarial central estimate of the liabilities to reflect the inherent uncertainty in the determination of the actuarial central estimate.
A risk free rate of return refers to the expected rate of return on matched portfolio of investments with minimal risk.
Short tail classes of business refer to those classes of business where the claims are typically settled within one year of the date of occurrence of the events which give rise to them. Long tail classes of business refer to those classes of business where the claims are typically settled more than one year after the date of occurrence of the events which give rise to them.
1. Introduction
The purpose of this note on Professional Practice is to give guidance to any actuary in general insurance who:
- estimates outstanding claims liability; and/or
- advises on outstanding claims provision.
Outstanding claims liability is an insurer’s obligation to make future payments in respect of claims which have already occurred. [see Section 3]
Outstanding claims provision is the amount which an insurer sets aside to meet those liabilities. [see Section 4]
Estimates of outstanding claims liability are used for a variety of purposes, including:
- premium rate setting;
- experience rating adjustments;
- claim management;
- assessment of levies;
- liability transfers;
- assessment of the value of an insurer;
- financial control;
- assessment of premium deficiency reserves;
- assessment of solvency; and
- as a basis for the outstanding claim provisions to be shown in an insurer’s balance sheet.
The last two are of particular importance: the outstanding claims provision is often the largest single item in an insurer’s account and even small percentage differences can have a major impact on the results and the solvency of the insurer. The estimation of outstanding claim liabilities is a field in which there is continuing theoretical development. The suitability of particular methods depends, to a great extend, upon the data. It is, therefore, not appropriate to try to specify how this work should be carried out. Rather, this note is concerned with principles. It describes the role of the actuary and sets out principles which should underlie the technical work. It concludes by establishing reporting guidelines.
Deviations from this guidance note may be acceptable in certain circumstances and in such instances the actuary needs to state the reasons for the variation in the report.
2. The Role of the Actuary
The actuary’s role is that of adviser. Commercial decisions, including the actual level of provisions to be adopted, are matters for the actuary’s employer or client. While an individual actuary may have management responsibilities and may make such decisions, they are not part of the actuary responsibility. This note is concerned with that actuarial responsibility.
As an adviser, the actuary must have a clear agreement with the employer or client as to terms of reference. It is essential that the actuary understand the purpose for which an estimate of outstanding claim liabilities is sought.
The actuary should exercise care at all times but particular care should be taken if:
- a narrowly defined brief is likely to give rise to misleading results;
- the available data is inadequate, inaccurate or cannot be properly checked;
- the estimate provided would not form a suitable basis for the establishment of the outstanding claim provisions; and/or
- there is difficulty in arriving at an appropriate single central estimate of the outstanding claim liabilities. [see 3.4]
The actuary should include reference to any such circumstances in the report. It may also be appropriate to discuss the situation with an experienced actuary. As a last resort, it may be necessary to decline to provide an estimate.
The actuary may be requested:
- to recommend what would be reasonable provisions; or
- to comment upon provisions.
The actual decision on provision, however, remains the responsibility of the actuary’s employer or client.
3. Outstanding Claims Liability
3.1 Liabilities
An insurer’s outstanding claims liability at a given date is the present value of the amounts which it is liable to pay, after that date, for claims which, under the terms of its contracts, arose on or before that date.
Outstanding claims include:
- claims which have been reported and have not yet been finalized or settled;
- claims which have been incurred but not yet reported; and
- claims which have been finalized and which will be reopened.
In addition to payment sot or non behalf of the claimant, claim payments include any third party costs such as investigation, medical and legal fees.
Future claim payments may well be greater, as a result of inflation or other economic or environment causes, than payments at current levels on similar claims. Any such claim escalation is a part of the outstanding claims liability and should, where relevant, be taken into account.
The insurer will also have to meet its own administrative costs in settling claims.
3.2 Estimates
Often, the insurer will not know, until well after the given date, exactly how much each claim is going to cost or when the payments will be made. It is, therefore, necessary to estimate what payments are to be expected, on the basis of the available information, particularly the past behaviour of similar claims.
It is usually the actuary’s responsibility to provide a central estimate of the value of the liabilities for outstanding claims [see 3.4]. Such an estimate should be expressed as a single figure, being the aggregate of the discounted values of the estimated future payments. For some purposes, a cash flow or some other representation of the liabilities may be more appropriate.
Depending on the purpose of the investigation, it may be appropriate to:
- ignore the costs of claim administration;
- include them as part of the outstanding claims liability to be estimated; or
- make separate estimates of the costs of outstanding claims administration.
The actuary should make it clear which of these courses has been followed.
The experience should normally be analysed on a gross basis. Analysis of the reinsurance and other recovery experience should be appropriate to the circumstances. In some situations it may be more appropriate to analyse the experience net of reinsurance and/or other recoveries. Separate estimates of the recovery amounts may still have to be made. In making such judgments, the actuary should be aware that the net valuation result will usually be the most important.
The actuary should describe the methods and assumptions used to allow for reinsurance and non-reinsurance recoveries.
3.3 Discounting
In arriving at an appropriate discount rate assumption the actuary should consider matters including current investment yields, the risk free rate, the assets held by the insurer and the insurer’s investment policy.
The risk free rate of return should normally be the starting point for determining the appropriate discount rate. The actuary should, where appropriate, explain the reasons for adopting a higher or lower rate than the risk free rate.
For short tail classes, the actuary may choose, on the grounds of materiality, not to make specific allowance for discounting.
For Insurance Companies Ordinance accounting purposes, the discounting of claims is not allowed, except with the prior approval of the Insurance Authority. Hence, in general for these purposes the provision for outstanding claims would represent the total ultimate cost of settling outstanding claims including claims handling expenses. Accordingly the provision allows for increases in claims costs between the date at which the financial statements are prepared and the date of the actual settlement but does not anticipate the future income from any funds held pending the settlement of claims.
If an actuary is providing advice for the purposes of establishing a provision for outstanding claims under the Insurance Company Ordinance and is furnishing an estimate that allows for discounting, the actuary has a duty to check that the relevant approval has been obtained.
Where claims provisions are not discounted then this can be taken into account when advising on the need for a contingency margin in accordance with 3.4 below.
It is noted that for Companies Ordinance accounting purposes, the Hong Kong Society of Accountants’ Industry Accounting Guideline Statement 2.301 “Accounting for general insurance business” does permit discounting on long-tail business where there is a reasonable basis for so doing.
3.4 Uncertainty
Outstanding claim liabilities are often hard to estimate. The extend of the liabilities depends on future economic and environmental factors outside the control of the insurer as well as on past events and the insurer’s own actions. This difficulty and uncertainty is often the reason why the actuary has been given the job of estimation. It is part of the actuary’s task to respond to uncertainty, both as a technical matter and in the presentation of results.
- the model(s) chosen for the analysis and projection will never exactly match the actual claim settlement process;
- past fluctuations in the claims settlement patterns will result in uncertainty in estimating the parameters of the model, even if a perfect model could be found;
- undetected errors in the data may result in errors in estimating the parameters of the model;
- future economic and environmental conditions are not known and may be very different from those experienced in the past. (e.g. latent claims);
- future claim fluctuations will result in uncertainty in the projected payments, even if the true parameter values could be found for a perfect model.
The assessment of uncertainty will generally require use of one or more of:
- statistical analysis;
- sensitivity analysis - making changes to the model parameters and/or the models themselves;
- analysis of different scenarios; and
- judgment.
In many cases, the range of reasonable uncertainty will be very large. The conclusions which may be drawn at different ends of this range may be totally different (e.g. large profits vs insolvency). While it may be technically difficult to do so, it is usually the actuary’s responsibility to provide the client with a single central estimate of the liabilities. A central estimate is intended to contain no deliberate bias toward either over-estimation or under-estimation. However if in the actuary’s opinion it is inappropriate to make a central estimate, the reasons should be explained and the nature of the estimate(s) described.
It is also important that the Principal understand the practical consequences of the uncertainty of this estimate. Depending on the purpose(s) for which the estimates are required and on other considerations, it may be appropriate for the actuary to:
- advise on a contingency margin (or different margins for different purposes); and/or
- describe the uncertainty in statistical terms; and/or
- try to convey an understanding of the uncertainty by other means.
3.5 Methodology
The choice of method for the estimation of claim reserves depends on the class or nature of the business and the form and quality of the data. It is for the actuary to select the method(s) appropriate in the circumstances. Particular points to consider include:
(i) lack of homogeneity or changes in the mix of the data;
(ii) the effect of large claims, including catastrophe claims and aggregations from a single event;
(iii) cyclical characteristics or temporal trends, including the effect of inflation;
(iv) patterns of claims paid or settled; and
(v) the effect of reinsurance.
The steps which an actuary should take when advising on outstanding claim liabilities are similar to those for other actuarial investigations.
(a) determine what is required by the Principal;
(b) collect and check the necessary data;
(c) analyse the experience;
(d) select a projection model;
(e) select the model parameters;
(f) do the projection calculations;
(g) reconcile the results since the previous investigation;
(h) analyse variability and sensitivity;
(i) reach conclusions and determine recommendations;