FOR MORE THAN THREE DECADES, reserve adequacy for the property and
casualty (P/C) insurance industry has been highly cyclical, alternating between
periods of adverse and favorable reserve development.
Figure 1 offers a dramatic picture of just how widely reserve
adequacy has varied between 1989 and 2011, based on industry
aggregate Schedule P data. The bars rising above the $0 line
represent adverse reserve development, while bars below show
favorable development. Development is measured on a statement-year basis, meaning the reserve development in Figure 1
represents the aggregate of all reserve development (through
Dec. 31, 2012) subsequent to the booking of reserves for the given annual statement date.
No one knows for certain what factor or factors cause these
swings. It’s commonly thought that internal industry influences—such as claims department practices, changes in pricing,
or management decisions—are potential sources. Although we
expect these elements do play a role, there’s no evidence to suggest they are the primary reason for the reserving cycle.
What few have considered, on the other hand, is the possibility that common methods used by actuaries to determine
appropriate reserves may themselves be an important contributing factor to movements in the reserving cycle.
We decided to assess the potentially cyclical behavior of
various actuarial reserving methods, including the paid and
incurred (i.e., paid plus case) chain ladders and the Berquist-
Sherman and Munich Chain Ladder methods, along with 47
others (including variants of different methods). As the general
pattern we observed was consistent across all of the methods
that we examined, we will focus principally on the paid and in-
curred chain ladder methods most commonly used by actuaries.
We found that a material portion of the industry’s historical
deficiencies and redundancies can be attributed to the results
of actuarial methods and that the deficiencies and redundancies
that result from using these methods appear to be highly cor-
related with the economic cycle.
As others have observed, we also saw a strong relationship
between the underwriting cycle and carried reserve adequacy,
although from the data available it can’t be determined whether
pricing was affecting the reserving cycle or vice versa.
It’s difficult to consider that the methods we actuaries
have been using daily for decades may be subject to some bias,
potentially exacerbating movement in the reserving cycle.
Nevertheless, there appears to be a relationship—at least on an
industry aggregate level—between the development indicated
by actuarial methods and the development that ultimately manifests, as shown by carried reserves over time.
Similar research conducted by British actuaries in 2003 also
concluded that a reserving cycle does exist (in that case, in the
United Kingdom) and that standard actuarial methods are probably a contributory cause. That study, however, did not examine
the relationship between the reserving and economic cycles. To
the best of our knowledge, that relationship has not been considered previously by anyone in the field.
FIGURE 1 Reserve Development by Statement Year (in billions)
1989 1990 1991 992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 003 2004 2005 2006 2007 2008 2009 2010 2011