While reviewing a group of professional liability claim files, Ifound it necessary to discuss the nature of the exposure and therelativity of the pending case reserves with a seasoned adjuster.Our conversation included an explanation of the intent of casereserves and the downstream importance to underwriters andactuaries. “No one ever explained it to me like that,” was theresponse from this 22-year adjusting veteran.

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The response caught me off guard, especially coming from someonewith so many years in the business. I immediately thought of howmany organizations I have inherited or reviewed wherein casereserves remained at inappropriate levels until shortly beforepayment of the loss. In fact, I remember one specificorganization's reserving philosophy: No claim will be reservedbefore its time. The result? Last-minute loss and loss adjustmentexpense increases that created surprises and problems for theproduction department as well as re-insurers.

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How can it be that companies spend hundreds of thousands ofdollars on training and development but still wind up in thispredicament? As it turns out, there are a number of reasons.

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Case Reserving Overview

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Case loss reserves represent an insurance company's estimate ofexposure for unpaid claims. The estimate includes claims that havebeen reported and adjusted but not yet paid, and claims reportedbut not yet adjusted. In addition, a number of companies alsoestablish allocated loss adjustment expense case reserves toreflect the anticipated cost of handling. The basic premise here isto establish dollar estimates based on a number of factors,including known facts, interpretation of loss circumstances,historical experience with similar cases, case law, and regulatoryinfluence. Case reserves are based on the experiential estimationof anticipated pay out. As such, there is an element of uncertaintyinherent within the dollar values. While multiple variations ofcorporate reserve philosophies exist, there is, however, oneuniversal common denominator: timeliness.

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Case reserves provide an important economic indicator ofperformance to the enterprise. Think of it as a financial “radar,”an early warning system so companies aren't caught off guard. Partof the fiduciary responsibility of any claim department includesthe timely communication of loss exposures in financial terms todecision makers, such as program managers and pricing actuaries, inorder to provide them with line-of-business loss experiencefeedback.

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Untimely or inappropriate case reserves distort the actual lineof business performance or experience indicators, creating aninaccurate base upon which the actuaries forecast performance andestablish rates. Loss and loss adjustment expenses are the largestcost elements of each premium dollar earned, followed by producercommissions. The rest is profit from the sale. If the price doesnot cover its operating costs, the company will be unable tosustain long-term operations. Pricing changes must be approved bythe state within which the product is sold. The approval processtakes time. In addition, price changes create potential marketplacedisruption. Insurance companies make concerted efforts throughplanning and actuarial analyses to avoid price fluctuations thatcreate marketplace disruptions. It is important, therefore, thatcase reserves accurately reflect the anticipated exposures as soonas practicable in order to assist the actuaries in making timelyand informed decisions relative to product price.

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The importance that timely and accurate case reserves play intimes of economic uncertainty, such as those that currentlyprevail, must also be understood. Property and casualty companiesderive profit from two primary areas: investment portfolio andoperations. When market conditions deteriorate or become uncertain,carriers focus their attentions on the operations side of thebusiness to support overall profitability. If case reserves arelate or do not reflect the appropriate loss exposure, the potentialfor decreased profitability increases. The goal here is for eachside to offset softness or performance deterioration in the other.There is perhaps no worse phrase in the claim lexicon than “adversedevelopment on known losses.” The financial reverberation of thesewords casts a long and unpleasant shadow.

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Establishing Consistency

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Inappropriate case reserves misrepresent the real picture as faras any valid statistical analysis is concerned. If the lossinformation represents fewer dollars being reserved, questionsarise regarding the payouts and how long the company can sustainthis velocity of payment (commonly referred to as the survivalratio).

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A breakdown in underlying profitability caused by understated oroverstated liabilities directly impacts a variety ofconstituencies. Agents are profit driven. In the event elementssuch as late-emerging adverse developments on known losses diminishagency profitability, the relationship between company and agentchanges. New or renewal business may be directed to other marketsthat represent potential for profitability. In addition, loss ofprofitability by an agent creates the potential for adverseselection (questionable risks being directed towards unprofitablemarkets).

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Uncertainty or loss of confidence in management's ability todeliver a consistent return on investment increases the potentialfor loss of investment dollars, a drop in stock price, and apotential rating reduction. Retention and seasoned business may beadversely affected as the result of policyholder dissatisfactionwith erratic rates. Excessive loss reserves reduce an insurancecompany's reported profit, thereby reducing its tax liability.Overstated reserves may cause a depressed stock price. Conversely,understated loss reserves may prompt questions of insolvency. Thepotential for adverse economic consequences as a result of a lackof disciplined reserving is varied and significant.

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Sound and consistent case reserves require adherence tofundamental or core technical skills. Timely coverage verificationis critical. Coverage should be verified or potential coverageissues identified the same day of assignment to the claim handler.Coverage issues such as loss location, policy effective dates,primary/excess, and contractual or additional insured statusrequire prompt verification. Resolution of coverage issues shouldbe pursued aggressively. In standard lines of business, 14 calendardays from date of receipt by the claim handler is appropriate.Specialty losses such as environmental, construction defect, andasbestos often require more time to validate coverage. However, adue date should be established and monitored in order to maintaintimeliness of coverage verification.

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Liability is the pivotal determinant in establishing a reserve.Fact-gathering must be performed in an aggressive manner (generallywithin 30 days, depending on the line of business and whetherlitigation is involved) in order to make timely, informed exposuredecisions. Influencing factors, such as contributory or comparativenegligence and joint and several liability, should be clearlydocumented in the claim file to support the values established.

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Verification and analysis of damages should commence as soon aspracticable. Estimates should be secured, injuries verified, andlost-income claims documented. Documentation of the extent of theclaimant's injuries and distinguishing actual treatment fromdiagnostic procedures establishes a more accurate injury value. Thepotential for adverse development on known losses increasessignificantly when claim departments deviate from thoroughlyperforming these fundamental adjusting skills.

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Having reviewed a number of case reserve inventories, includingpersonal, commercial, and specialty lines of business, I found abroader-than-expected variance in case loss reserves, indicatinglack of awareness on the part of the claim staff of the purpose andcorporate importance of prompt, accurate case reserving. Beyondloss reserves, a wider degree of variance was noted in the area ofallocated loss expense reserves. Quite often, expense reserves donot reflect the likely or probable anticipated costs necessary tohandle the case. A majority of you will be familiar with thepay-as-you-go expense reserving technique (often referred to as“stair-stepping”) found most often in this category. Laterecognition of exposures and last-minute increases to coverimminent payments have a direct impact on corporate profitability.By delaying or failing to recognize loss or expense exposures,claim professionals waste the potential benefit of advancecommunication to aid corporate economic forecasting andplanning.

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Learn the Language

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Communication of potential exposures and case reserveappropriateness requires the collective effort of both the claimand actuary departments to ensure timely and accurate exchange ofeconomic information. Claim management must establish and maintaina close working relationship with the actuarial department toobtain maximum benefit from the reserving process. Beyondcase-specific evaluation, claim handlers, supervisors, andfrontline managers need a working knowledge of the fundamentals ofactuarial science, including trend lines and development patterns,in order to manage case reserves more effectively and avertfinancial difficulties caused by inappropriate evaluations.Understanding how certain lines of business should develop andmaking certain that case reserves reflect the appropriate levels ofexposure must be a key claim management priority.

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The claim department also has the ability to advise actuaries onthe technical and legal elements that make each case reserveunique. This ongoing dialogue between the claim and actuarydepartments develops the intellectual capital necessary toeffectively manage the company's financial resources. Without it,the company's ability to make necessary adjustments relative toproduct development, pricing, and market participation islimited.

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Prompt, accurate, and consistent case reserving is a disciplinethat must be cultivated and maintained in order to support thecharge of fiduciary responsibility that is the claim departments'task alone. The property and casualty industry has made a concertedeffort to educate its technical and managerial claim personnelconcerning the function and purpose of case reserving. However, agrowing percentage of the industry's most experienced techniciansand managers are reaching the end point of their careers. Coupledwith reductions in force and shrinking training budgets, thisknowledge base is being depleted, creating the potential forcontinuing erosion of this important core skill.

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Faced with challenging caseloads, legal and regulatoryrequirements, and high-pressure customer service demands, companiesare allowing the global corporate importance of timely andappropriate case reserving to become obscured. It is for thisreason that persistent case reserve assessments by claim managementmust be established early on and frequently reinforced in order todevelop a discipline that supports timely and accurate casereserving in the claim organization. This, in turn, will ensurecorporate financial strength.

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Paul Swank is president of Swank Consulting Services, a firmthat provides claim solutions to the property and casualtyindustry. He may be reached atwww.swankconsultingservices.com.

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