Techniques For Handling Med-Mal Reserves

"We're part of the solution [because] when rates are grossly inadequate, the actuaries are waving their hands [calling] for 30 percent or 40 percent more rate."

"Unfortunately, nobody is listening," he added, suggesting that a few years back actuaries "lost a little bit of credibility by overstating the situation" concerning surging claims.

Explaining this, he went through a detailed example showing the "rearview mirror" approaches that actuaries use in loss reserving in times of severity surges.

Analyzing history to predict the future, Mr. Mize said, can overstate projections, which in turn can amplify market swings.

His example, using data for a large multistate hospital system with an occurrence policy and a large retention, revealed actuarial estimates that overestimated actual losses by $10-to-$20 million for some accident years.

Going through the example, he displayed a series of slides that graphically illustrated loss development patterns. With each curve on the graph representing an accident year, points plotted on the curves were losses initially reported and those reported over time, at each subsequent stage of development (6 months, 12 months, 18 months, etc.)

On the first slide, which depicted how losses looked in April 2001, the curves for the earliest years–1996 through 1998–increasing through 12 and 24 months, tended to flatten at about 36-48 months of development. This would indicate to an actuary that the client had a good handle on what its claims were worth after three or four years of development–and the actuary would assume that subsequent years would flatten in a like manner.

But on other slides, Mr. Mize showed that in April 2002 and April 2003, the early accident years started to depart from the expected flat pattern, with some years "going through the roof" after that three- or four-year development stage.

While the client initially explained that a few unusual claims were driving the departures and were under control, he said that when upward patterns persisted through April 2004 across multiple years, actuaries had no choice but to respond by assuming upward development in projections for later years.

"Even if we tried to convince ourselves that things weren't that bad, auditors [would] question…optimistic assumptions," he explained.

Presenting still more graphs, Mr. Mize showed that in 2005 and 2006, the loss development patterns for each accident year reverted back to the flat patterns that had been observed historically–prior to the surge in severity and the hard market.

In dollar terms, the differences between assuming flat development and escalating development patterns were in the tens of millions for each accident year, with a $40 million difference arising from selecting a different pattern for the 2004 accident year alone.

Still, Mr. Mize noted that experienced actuaries learn over time that "when things are really bad they tend to get better, and when things are really good they tend to get worse." So they wouldn't want to take the number down by the full $40 million after only two years of development.

But in the age of Sarbanes-Oxley, a reserving actuary would be under pressure from auditors to take the numbers down to whatever the current patterns indicate, rather than perhaps averaging the indication based on the current pattern with one based on more conservative patterns of the recent past.

Mr. Mize suggested that a tendency by auditors to rely on mechanical approaches would prevent actuaries from using judgment in selecting development factors that aren't in line with current indications–one potential remedy to the problem of amplifying market swings.

Another clear obstacle to taking a judgmental approach, he said, is that "if you as an actuary bet the shop that the severity surge is over, and it's not over, then you can grossly underestimate the ultimate losses."

He suggested that another potential way to rectify the situation is for actuaries to use inflation-adjusted actuarial methods rather than methods that rely on history. He noted that such methods, which aren't used extensively in the U.S., are used in countries that have very high and variable levels of inflation.

Giving a final recommendation, Mr. Mize advised health care facilities, doctors groups and medical malpractice insurers to request results of sensitivity tests from their actuaries that quantify the dollar impacts of selecting different development patterns and severity trends.

Moderator Stephan Farr, national practice leader for Gallagher Healthcare Insurance Services in Nashville, Tenn., noted that the lengthening development of claims happened to coincide with the height of the last hard market.

He asked panelist Robert Francis, the chief operating officer of The Doctors Company of Napa, Calif., to provide some insights on drivers of market change.

Mr. Francis said that large jury verdicts were one main driver.

Large verdicts, he said, drive claims departments to adopt conservative philosophies and to set higher reserves. "Some of that was justifiable," he said. "Not all of it was."

He also noted that while long-term severity trends average 5-7 percent, taking them apart reveals that there may be five-year periods of 20 percent severity jumps each year, and other periods where severity drops 2 percent each year.

When severity can swing so dramatically, he said, "sometimes you recognize it appropriately and sometimes you overreact," Mr. Francis said.