Under Pressure

The company's claims may be managed by its insurer's claim department, a third-party administrator (TPA), or may be administered by the company's own claim organization if it is self-insured. It is vital that all of these claim management organizations focus on the practices that lead to reasonable case reserve estimates, which, in turn, contribute to reasonable aggregate reserves for financial reporting purposes.

Learning from the Past

In some of the previous insurance market cycles, some companies either intentionally or unintentionally reduced their claim reserves, relying in some cases on investment earnings or rapid revenue growth to protect them from this understatement. This led to financial ruin when investment returns soured and the economy declined, and those companies were suddenly faced with a combination of poor loss ratios, understated reserves, and falling investment portfolios. The current economic climate does not provide a forgiving environment, so companies should place increased emphasis on accurate reserve estimates on their claims.

Corporations must be careful that the messages they convey to their insurers or TPAs does not adversely impact claim handlers' reserve estimates. Some corporate representatives may depress reserves by:

• Selecting TPAs that have agreed to or demonstrated a willingness to establish reserves based on "best-case" scenarios rather than estimates on the final ultimate value of claims. It is highly unlikely that all claims will be resolved in a "best-case" light, so the reserves in the aggregate may be understated.
• Directing or pressuring insurers or TPAs to reduce reserves through quarter-end or year-end reviews and argumentative tactics.
• Requiring TPAs to get the company's approval before reserve increases can be made, which tends to limit reserve increases.

Other companies try to reduce reserve stair-stepping by implementing programs for reserve analysis and review. However, this often creates the opposite effect that is desired. For example, a company might require that reserve increases made 90 or 180 days after a claim is received must be submitted to senior management with a report on the status of the claim and an explanation as to why the reserve was increased. While the intent of this may have been to reinforce the need for accurate reserves at this predetermined point and avoid stair-stepping, the result may be that the adjuster over-estimates initially, and then resists later increases that might be required. Also, claims that are transferred from one adjuster to another, or from one TPA to another, may also result in delayed reserve accuracy since new adjusters managing a claim will take some time to "get up to speed" on the claim.

All of these issues point to the need for companies to be vigilant in their reserving procedures and practices in order to maintain reasonable levels.

Claim to Shame?

Claim handlers who feel they are receiving directions or pressure to reduce case reserves should tread carefully. If a client company faces financial problems due in part to its inadequate reserves, the TPA may face errors-and-omissions claims in the future. The TPAs, as the experts in claim administration and therefore in case reserving, must maintain complete integrity in its reserving programs, ensuring that its claim procedures include:

• Prompt and thorough claim management to ensure that sufficient information is obtained and evaluated for reasonable reserve estimates.
• A well-documented reserving process, which requires adjusters to assess reserves at specific mileposts in the claim lifecycle, as well as the use of reserve-analysis worksheets to lead the adjuster through the reserving process.
• Evidence of supervisory direction and control over the investigation, evaluation, and reserving practices, especially of bodily injury liability claims or workers' compensation lost-time claims that exceed predetermined values.
• Alignment with independent and disciplined casualty actuaries who will provide an objective assessment of the aggregate values based on the underlying case reserves and claim management practices.

Self-insured companies with self-administered programs are especially vulnerable to the temptations to reduce case reserves to reduce long-term liabilities. Corporate insurance or risk management programs often report to the CFO or controller, and the company's own claim management program may lack the documented procedures, objectivity, independence, and discipline to identify and combat perceived or directed instructions that aggregate reserves should be lower.

Another matter that may face self-administered claim programs is reduction in the company's claim-handling personnel. The functions, duties, and importance of self-administered program employees are often misunderstood and underestimated by corporate leaders, leading to a tendency to under-staff these programs, or to quickly reduce the size of the claim staff when financial times get tough. Claim personnel who are burdened by unreasonable workloads will necessarily spend reduced time on each claim, leading to issues such as those shown in the Figure 1.

These and other "short cuts" taken by the adjuster will adversely impact the ultimate value of the claim. The lack of time and preparation spent on various important aspects of the claim will likely result in inadequate estimation of case reserves that, when combined with the greater closing values, will create an even larger potential gap. It also may lead a casualty actuary to underestimate the liabilities or provide a greater estimate range if there is a change in the reserving patterns due, in large part, to understaffing.

The same issues that apply to corporations also apply to insurers, which must not only manage the claims for which they bear the risk but must also be responsible to their policyholders for the quality of their claim administration services, which includes the estimation of case reserves. Insurers need to ensure that claims are managed in accordance with appropriate industry standards, and must document their activities to protect themselves against charges of inadequate claim management that may have a negative impact on the policyholder.

There have been numerous suits filed against insurers for failure to properly manage claims in accordance with the contract and/or for failure to reasonably estimate the financial liabilities associated with the company's claims. There are also premium issues that arise out of incurred loss retro policies when periodic reviews are conducted that result in greater-than-expected premium adjustments. Insurers must ensure that their claim organizations are adequately staffed, that the claim management activities are properly documented, and that management and supervision is adequate.

Power to the Procedures

All of these issues point to the need for an insurer, TPA, or a self-administered program to have strong claim management controls and to document the appropriate procedures for adjusters. Some claim organizations state that they prefer to not document their procedures, since claim files are sometimes discoverable and a failure to adhere to documented procedures may be additional fodder for an unfair-claim-practices lawsuit. I argue, however, that a claim organization is more likely to have inappropriately managed claims and a lack of claim management consistency if they do not have well-documented procedures. Claim organizations without these well-documented procedures and controls face a greater likelihood of having adjusters who fall short of the mark, resulting in higher claim costs and expenses, and a greater tendency toward inappropriate claim practices.

Furthermore, the presence of well-documented procedures along with performance that is consistent with those procedures lends more credence to reserve estimates and provides a sound foundation for reserve adequacy discussions. Also, TPAs that manage claims in states where the state periodically reviews or audits the claim files and reserving adequacy will be able to see the reasonableness of the case reserves and will call for fewer reserve adjustments and fewer penalties.

Role of Casualty Actuaries

Casualty actuaries can work closely with the corporation and the claim organization to establish aggregate case reserves for financial reporting purposes that rely more on payment patterns than reserving patterns. A casualty actuary may rely more on paid-loss data rather than incurred loss data if:

• There is uncertainty about the reasonableness of case reserves.
• The corporation representatives state that significant changes have occurred in the program that may affect reserves.
• There has been a TPA change that may reflect different philosophies, direction, or execution.
• Reserving patterns, in general, are not consistent.

This will mitigate the potential that discrepancies in reserve estimation will have an inappropriate impact on financial reporting.

It is vital that insurers, TPAs, and corporations place great importance on the accuracy and reasonableness of case reserves to provide reasonable estimates for financial reporting purposes. These entities, through proactive and disciplined management of their claim programs can develop an assurance that the estimated reserves are within reasonable ranges, given the information available at the time of estimation. Additionally, they can intelligently and confidently discuss the status of their claims with their clients, and provide well-documented proof as to the case reserves — and the related aggregate reserves — that have been established.