Faculty and Institute of Actuaries Claims Reserving Manual v.1 09/1997) Section A Section A THE INSURANCE BACKGROUND Preamble Before embarking on the methods and techniques for claims reserving, which make up the greater part of the Manual, it is important to establish the background to the work. Why is claims reserving such a vital topic in General Insurance, and what purposes does it serve in the industry? What are the characteristics of the main classes of business to which the reserving relates? And what is the place of the claims reserve within the technical reserves as a whole? The present section provides answers for these questions, but in summary form only. The Manual is not, and cannot be, a study of the whole of general insurance. The crucial point to establish is that the methods do not operate in a vacuum . In themselves, they are but abstractions. The reserver should take as a starting point the concrete world of business which the methods are intended to serve, and keep such a view in mind. Claims reserving methods are of little value unless they become good practice as well as good theory. Contents A 1 . Purpose of Claims Reserving A 2 . Types of Business — The Primary Market A 3 . Types of Business — Reinsurance & the London Market A 4 . Note on Technical Reserves A 5 . Note on Terminology 09/97 A0
Faculty and Institute of ActuariesClaims Reserving Manual v.1 09/1997)Section A
Section ATHE INSURANCE BACKGROUND
Preamble
Before embarking on the methods and techniques for claims reserving, whichma ke up the greater part of the Ma nual, it is important to establish thebackgroun d to the work. W hy is claims reserving such a vital topic in G eneralInsurance, and wh at purposes does it serve in the industry? W hat are the
characteristics of the main classes of business to which the reserving relates? Andwha t is the place of the claims reserve w ithin the technical reserves as a whole?
The present section provides answers for these questions, but in summaryform only. The M anual is not, and cannot be, a study of the w hole of generalinsurance. The crucial point to establish is that the metho ds do not operate in avacuum . In them selves, they are but abstractions. The reserver should take as astarting point the concrete world of business wh ich the methods are intended toserve, and keep such a view in mind. C laims reserving methods are of little valueunless they become good practice as well as good theory.
Contents
A 1. Purpose of Claims Reserving
A2. Types of Business — The Primary Market
A3. Types of Business — Reinsurance & the London Market
Claim s reserving in G eneral Insurance is an activity w hich is critical to thesuccess of the insurer. Its basic purpose is to estimate the cost of claim sultimately paid out of the business written to date. As such, it is concerned withthe outcom e of future even ts, and must therefore rem ain part art and part sc ience.The co ntribution of the actuarial profession is, and will continue to b e, tostrengthen the scientific part of the analysis to the utmost degree po ssible. To thisend, the present Manual is dedicated. This systematic attempt to improve thereliability of claims estimates in general insurance is both a wo rthwhile task in
terms of the profitability of the industry, and a necessary one in terms of helpingto ensure its continuing solvency.
From such a general statement, one must turn to the particular. W hat are thespecific aspects of the business which are affected by, or indeed founded upon ,the claims reserving figures? A t least five such aspects can be picked out. W hilethey are related, each has its own special significance.
a) Accounting to Shareholders — Annual returns under Companies Act.
b) Acc ounting to the Inland Reven ue — Returns for tax purpo ses.
c) Insurance regulation and solvency control.
d) Ratem aking — Financial basis for writing future business.
e) General Managem ent Control — Claims control, market strategy, etc.
The rem ainder o f this section will be given to expanding the nee ds andrequirements for claims reserving under each of these main headings.
Accoun ting to Shareholders
We are here concerned with the annual returns which every company must m akeunder the C ompa nies Act. The information so disclosed w ill be of vital interest toshareholders, current and prospective, and to stockmarket analysts, investmentmanagers and others. The key questions which they will be seeking to answer
concern essentially the profitability of the company and its future pro spects in theinsurance sector. Its strength vis a vis takeover activity m ay a lso be at issue, andif times are bad its continuing v iability as an indepen dent entity. Th is is not theplace to go into a full discussion of company analysis, however. Suffice to saythat, for a general insurance com pany, the largest single balance sheet item w illvery frequently be the reserve for outstanding claims. Beca use of its size, acomparatively minor variation in the value set upon the reserve may havedisproportionately large c onsequences for the declared profitability of thecompany.
To give an idea of the ma gnitude of the figure, at the end of 1985 the largestinsurers in the UK set their claims reserves in the region of 80- 11 0% of thewritten prem ium income for the year. Their net trading profits over the previousdecade, however, had averaged only approximately 5-10% of the writtenpremiums.
These figures tend to emphasise the intrinsic paradox which und erlies allgeneral insuranc e. To a large extent, the costs of the business lie in the future, andare unknow n in their precise extent. The claims reserve is the main reflection ofsuch future costs, yet in the balance sheet it has of necessity to be stated as aprecise amount. The uncertainty which is the essence of the business cannot bewelcom ed as a formal element in the company 's financial statements toshareholders and others.
What, then, is the solution to the paradox? An accountant's view might bethat the best estimate of the outstanding claims must be made. This might bedefined, perhaps, as the position in which there is a 50% chance that the
estimated amount w ill be exceeded by the actual out-turn. But the course is aninsecure one , since an adverse out-turn could soon push the company towardsinsolvency. M ore satisfactory would be to take as the claims reserve a figuresufficiently large, that is fairly un likely to be exceeded by the actual cost — saywith a chance of 10% only, rather than 50% . Such conservatism w ill dampen theamo unts imm ediately available for distribution to sha reholders, but is likely to bein the better long-term interests of the co mpany.
The question cannot be answ ered with any finality, howe ver. It will dependon the particular circumstances of the evaluation, and on the expert opinionpresent. W hat is important is that there should be conscious consideration. Thematter of the reliability of the claims reserve and the protection to be affordedagainst possible adverse experience should be addressed exp licitly by thoseconcerned.
Accounting to the Inland R evenue
It might be thought that the C ompan ies Act returns (as discussed in a) above)wou ld suffice for tax purposes as w ell. That is not necessarily the case: the InlandReven ue are not concerned w ith profitability or even solvency as such, but ratheras to whether tax requirements as laid down by statute and regulation have be enproperly met. The tax regime controlling the insurance companies is a complexone, and a specialist subject in its own right. For reserving purpose s, it is
sufficient to note that there is no hard and fast right to tax exemption for thewho le of the claims reserve declared in the annual company re turn. What m ayappear as common prudence to the finance director or the policyholder may bedeemed overprovision by the tax inspector.
In contrast with paragraph a) above, the tax authorities may w ish to requirethat allowable reserves be established only with strict regard to the bestestimate principle. Ma rgins to allow for possible adverse circumstances m aywell be ruled out of court, as being a device adopted for the postponeme nt oftaxation properly due. This may seem unfortunate and negative from the insurer'spoint of view , but one should appreciate that a different, legitimate stance can betaken by the tax inspector. The position may w ell need to be developed to itsconclusion by cases at law — there is already some history in this regard.
Insurance regulation and solvency control are important matters which have beenhigh on the agenda since the collapse of the Vehicle & G eneral in the early 1970s.By now , there is a well-established system of regulation, based on the obligatory
provision by the insurers of annual returns to the insurance supervisory authority.These returns require greater detail than that brought out by the Companies Actreturns. In particular, claims reserves have to be shown broken dow n both byclass of business and by ye ar of origin. (This has resulted in the building u p of aconsiderable bank of statistics. Their usefulness for general an alysis, however, ismarred by lack of consistency in the data-class definitions by different insurancecompa nies and by the limited availability to the public at large.)
The supervisory authority is concerned essentially to protect the interests ofth e policyholder. Hen ce its emphasis is not on profitability or tax integrity, but onsolvency itself. It follows that the conservative view of reserves described in a )above is entirely appropriate w hen com piling figures for the returns. The contrast
with the best estimate view required for tax purposes could not be mo re evident— while the supervisory authority is looking for ample reserves to supportsolvency, the Revenue is demanding a paring down of those same reserves so asto maximise taxable income.
The existence of two contradictory requirements on the part of theGovernment apparently poses a dilemma when it comes to reserving. The truththat emerges, how ever, is a highly relevant o ne. It is that there can be no absoluteright value for a claims reserve. The value will depend on the purpose for whichthe reserve is needed, and even then there w ill be room for a ma rgin of error.Probability and uncertainty w ill always be present in an honest appraisal.
Ratemaking
Every com pany m ust establish and maintain a sound financial basis for writingfuture busin ess, by sound underwriting and by setting premiums at an appropriatecommercial level having regard to the three major elements of estimated claimscosts, expenses and investment inc om e. If premium rates are set and kept too low ,then eventual insolvency will follow. If they are too high, then mark et share w illbe consistently lost to more aggressive compe titors. The information tha t willallow a realistic setting of the rates comes from past and present exp erience. T helevel of the market as a whole need s to be looked at, in conjunction with theparticular experience of the com pany. For the most recent view of the latter, theclaims reserve on each past tranche of business will be needed. T his, takentogether with the claims already pa id out, will provide an e stimate of the incurredclaims costs so that any inadequacy or oversufficiency in the prem ium rate will bedetected at the earliest opportunity. The c laims reserve is thus an essential part ofthe control mec hanism which ev ery efficient insurer requires.
What sort of estimate w ill be appropriate in this case? S hould it beconservative in nature, or use the be st estimate principle? The latter is more likelyto be correct, since we are here considering the company very much as a goingconcern. In general, it cannot afford to be over-cautious in its ratemaking , or itwill lose mark et share. Of course , the prevailing con ditions of the market m ustalso be taken into account. In a hard market, comfortable m argins can be built in,whereas in a soft m arket they will be pared to the bone, with som e policy lines
even becoming effective loss-leaders. Thus, reserve estimates do not ab solutelydetermine prem ium rates, but they are a vital input. As such , their realisticassessment is a key task.
General Management Control
Apart from the ratem aking proc ess, claims reserving is vital to many other aspectsof management control. An essential matter will be to monitor the company'spremium writing capacity in relation to its free reserves after providing forexpected claim s and other costs. Other problem s to be tackled will be those ofclaims con trol, market strategy and the identification of the relative profitabilityof different lines of business. As w ith ratemaking, it will be right to take reserveson a best estimate rather than a conservative basis. The matter of discounting willalso be an important one to face. Although it has not been cu stomary in theindustry to discount estimates of outstanding claims, the evidence suggests thatfor purposes of ma nagem ent control it is a very desirable practice. The reason isthat unless discounting is applied the pattern of future financial flows will bedistorted, and give a different view of the relative profit and loss on given lines ofbusiness.
Another po int at issue will be the subdivision of the data from the va riousclasses of business. Modern data systems should allow the insurance manager toobtain finer detail concerning the lines under their control, and perhaps to isolatesubclass characteristics which m ay enhance profit or loss. But there will be a limitto the process, in that statistical estimation of the reserves for very small classesbecom es unreliable. (The ma tter is taken further in B 2, dealing with the groupingof data.)
General insurance embraces a wide variety of contracts and covers. For practicalreserving purposes it may be prudent to be aware of the effects of thesevariations, but the present discussion is confined to the chief types of busin essand their main characteristics, and how the reserving process may be affected bythem . To begin w ith, it is useful to have a general classification of the field. Thecategories specified for solvency returns, in respect of all companies (primary andreinsurance) other than Lloy d's, mak e a good starting point. They are:
1) Acciden t & Health2) Motor Vehicle
3) Aircraft
4) Shipping
5) Good s in Transit
6) Property Dam age
7) General Liability
8) Pecuniary Loss
9) Non -proportional Treaty Reinsurance
10) Proportional Treaty Reinsurance
Classes 2) 3) & 4) include both physical damage and liability aspects. Classes 9)& 10) apply specifically to treaty reinsurance business. Facultative reinsuran ce isplaced in with the direct business in Classes 1) - 8).
In general, the main classes w ill not be homog eneous in the range of risksthey cover, although this w ill vary with the particular business m ix of thecompany in question. An impo rtant issue with all classes, therefore, is whether itis necessary to subdivide for reserving purpose s, and if so how the subdivisionshould be mad e. In some respects the returns require the main categories to b esubdivided into risk groups.
Other dimensions are also important, which cut across the above
classification. Thu s, it is useful to separate personal and comm ercial lines; and todistinguish the prima ry, or direct, market from reinsurance written at Llo yd's(which is subject to special treatment under the returns) or on the London M arket.In this section, we shall consider briefly the ma in primary classes listed abo ve,with reference to the direct insurers. The next section (§A3) then looks atreinsurance and the London Market.
Form erly designated Personal Acc ident in the statutory classification, this isessentially a personal rather than comm ercial type of insurance. Typical exam plesin the class would include holidayma kers taking ou t travel insurance, or fam ilies
buying cover for private medical treatment. From the statistical point of view,personal lines have useful charac teristics — i.e. a large numbe r of policies areissued on relatively similar risks, which gives homogeneity to the class. H owev er,as with life a ssurance the pattern of claims can be upset by atypical individualpolicies for particularly large sums insured.
2) Motor Vehicle
In spite of its ready familiarity, m otor insurance is not a simple type. Thu s, a UKcomprehensive policy will cover property damage, third party liability, andpossibly consequ ential loss as well. If homo geneity of data is the aim, the reserver
may wish to analyse comprehensive business separately from third party only.They m ay also wish to isolate the physical dama ge from the liability element inthe comp rehensive class. Such refinements are not always possible in practice,how ever, and it is more important to ma ke the most of the available data than tochase theoretical perfection.
Ano ther source of heterogeneity in motor insurance is the difference betwe enprivate cars and comm ercial vehicles. This is of great importance, and it wou ld beusual to analyse the two groups separately. Again, there is the wide range in thevehicle types which can be covered, from motor scooters through private salooncars to buses and heavy duty goods wagons. Such categories as motor cycles(private or commercial) and car or lorry fleets (comm ercial) may well need
separate treatment.
In general, motor business is amena ble to statistical treatment, with a largenumb er of similar policies entering the reckoning. As such, it make s a good testground for the development of systematic reserving methods.
3)-5 ) Aircraft/Shipping/Goods in Transit
Like motor, these classes of insurance are hybrid types, comprising both physicaldama ge and general liability. They are particularly (though not exclusively)associated with Lloyd's and the London M arket. Since there are key differences in
procedu re, e.g. the slip system tends to be used, and accou nts are drawn up on a3-year rather than a 1-year basis, the group is better left until the next section(§A3).
6) Property Damage
This is a major class of insurance, in which the central cover is given aga instdam age by fire. But the cover will normally b e extended to many other perils,such as explosion, storm, flood, theft and riot. The im portant characteristic from areserving point of view is that the run off of claims w ill be relatively brief inelapsed time . Thus, within 24 mon ths of the accident year end one would expect
the great majority of the outstanding c laims to have been settled. The reason is
that property dam age is very evident in its nature, and relatively straightforwardto assess. Classes of business with such a short run-off period are co mm onlydescribed as short tail lines.
W ithin property dama ge, it will be necessary to separate out the pe rsonal
from the comm ercial business, as the two types have very differentcharacteristics. Once again, the personal business, mainly householders' policies,will consist of a large numbe r of relatively similar units. These will be am enableto statistical treatment. The comm ercial side, however, m ay be more difficult toencom pass, since the buildings and plant insured are likely to make a veryheterogeneous collection. Reserving is most likely to be based on individualestimates for the various claims in question, as at the accounting date. Such c aseestimates will be made by expert assessors, either company employees or externalloss adjusters.
How ever, this does not me an that statistical methods are ruled out forcommercial property reserving. In the first place, the case estimates may need to
be adjusted for bias. Second, an ana lysis of the claim size distribution and itsdevelopment over time may give added insight about the incidence of largeclaims.
7) General Liability
For the reserver, it is in the liability class that the most profound problem s arelikely to arise. If property dam age is taken as the typical short tail line, thengeneral liability exem plifies the long tail side. Now adays it is not uncommon tofind liability run-offs extending for 15, 20 or even 25 years and more. Th e mo stnotorious exam ple is that of industrial disease claims resulting from exposure to
asbestos. At the time that muc h of the insurance was written, the danger w asunknown. But the subsequent claims have been upheld at law, particularly in theUS A, and have resulted in a serious drain on the free reserve s of the insurersconcerned.
Apart from the emergence of previously unknown causes, other influencesconsistently work to extend the liability tail. Thus, the litigation required toestablish liability in disputed cases may b e a long drawn out process. Again , itmay take yea rs for the effects of bodily impairme nt or disease to become fullyapparent. Until the ultimate co ndition of the injured pa rty is known, damag escannot be properly assessed. During this time, the insurer must keep anappropriate reserve on the books. A case estimate, based on the most recent
information, can be used. But given the timescales involved, a more realisticassessment is likely to come from combining the case estimate data withtechniques of statistical projection.
Mo ving to the subdivision of liability bu siness, employe rs' liability is likelyto be analysed separately. Then the remaining aspects such as public and productliability will be taken together, in what has to be adm itted is a very heterogen eoussubclass. Professional indemn ity, if such cover is given, will need to be treated asa further separate category for reserving purpose s.
TYPES OF BUSINESS — REINSURANC E THE LONDON MARKE T
Coming to reinsurance as opposed to direct writing, commercial operations arefocused on the London M arket. This is a distinct market from that of the directinsurers, but the separation is not absolute. At its centre, the London M arket h asthe unique institution of Lloyd's. The brok ing, underwriting and accountingsystem which has evolved at Lloyd's gives the market its modus operandi, anddistinguishes it clearly from th e practices of the m ain direct writing offices. ButLloyd's itself should no t be equated with the London Market, of which it is only apart. Institutions other than Lloyd's w hich typically participate in the market ar e:
Specialist reinsurance com panies, both UK and foreign
Reinsurance subsidiaries of large broking firms
Hom e foreign departments of the large direct writing com panies
Overseas branches and subsidiaries of foreign companies
A simple but incom plete definition of the London M arket might be that itcomprises all business which com es to be placed through the agency of L loyd'sbrokers, using the Lloyd's slip system. This wo uld be fine except that it does notallow for the considerable amount of business placed directly betwe en reinsure rsand other companies, without the agency of a broker.
Another po int is that though the Londo n Market is particularly associatedwith reinsurance, it also underwrites an appreciable am ount of direct busines s.Direct marine and aviation insurance, com prising hull, cargo and liability cov ersare typically placed at Lloyd's, or with other Lon don market firms. Lloyd'ssyndicates write a good deal of motor b usiness, and indeed may take on directrisks in any of the other main insurance categories already described.
With these provisos, we may look at reinsurance, and its main type s astransacted in the London M arket. Three levels of classification are n eeded:
c) Non-P roportional Treaty (Excess of Loss/Stop Loss)
III) Length of Claims Run-off
a) Short Tail
b) All Other (including M edium and Long Tail)
The three classification levels are discussed very briefly below. For a fullexposition of reinsurance on the London M arket and the system by which it iswritten, the reader is referred to Craighead's papers and Kiln's book (detailsin §0).
I) Type of Primary Business requiring Reinsurance
Unfortunately, it is difficult to generalise about the sub-types under this he ading.The m ix of business w ill vary a great deal between different syndicates andreinsurance firms, and each w ill develop its own groupings for analysis. The threemain subheads of Marine, Aviation and Non-Marine are essential in that theymus t be distinguished under the system of Lloyd 's Audit Codes. That is thetraditional division of the mark et, with different unde rwriters work ing in eacharea.
II) Type of Reinsurance Cover
The basic technical types of reinsurance are com plex. Thus , facultativereinsurance can itself be proportional, or relate to an excess layer of loss on agiven risk. It can comprise fleet covers (in aircraft, shipping or motor) as well asindividual risks. Proportional treaties can be for quota share on a full portfolio, oron designated lines of business only. They ca n be in favour of a direct office, orof another reinsurer. Non-p roportional treaties can be for excess of loss protec tionon given classes of business, and written in a number of distinct layers. They canbe applied as a further safeguard to existing proportional treaties, and can alsotake the form of Stop Loss contracts on a who le portfolio. The po sition is thus an
elaborate one, and the following is probably a minimu m classification for theLloyd's syndicate or London Market reinsurer:
a) Direct written business
b) Facultative reinsurance
c) Proportional treaties
d) Excess of loss/Stop loss treaties
Individual excess of loss risks are perhaps better taken as b), facultative business,than under d). In addition, Craighead (1979) recommends that excess of loss
TYPES OF BUSINESS — REINSURANCE & THE LONDON MARK ET
treaties should be split according to their origin, i.e. whe ther from the Lon donMarket or from the direct writing companies.
III) Len gth of Claims Run -offOf major imp ortance for reinsurance reserving is the length of the claims run-off.Wh ether the business is marine , aviation or non-marine, and irrespective of itstechnical form, it is likely to contain both property and liability eleme nts. Thegeneral rule is that property damag e will lead to a short tail in the run-off andliability to a medium or long tail. Thus, given a particular reinsurance c ontract, itwill always be useful to estimate the split of the risk between the short tail and thelong tail elements. The claim amounts which actually emerge can then, ifpossible, be monitored over time to test their adherence to the original long/shortestimate.
(It should be no ted that reinsurance, of its nature , will lead to longer run-offs
for all classes than w ill the w riting of direct business. The reason is simply thatthere are more steps in the chain to be completed before acc ounts can be finallysettled. Delays in the original reporting of claims, in the comm unications betwe enbroker and underwriter, and in the completion of complicated settlements acrossinternational boundaries, all add to the effect.)
Taking all the above classifications together there will be a number ofseparate reserving categories for each portfolio. O ther distinguishing factors, forexample currency, may increase the number of categories. However, practicallimitations may make it necessary or justifiable to amalgamate some of thecategories.
W hile the subject of the M anual is Claims Reserv ing, other kinds of technicalreserve will be encountered in General Insurance. Som e of these are effectivelyspecial aspects of the main c laims reserve, e.g. the IBN R reserve , and as such fallwithin the scope of the M anual. O thers, howev er, in particular the unearnedprem ium rese rve, are outside its ambit. For convenience, this note brieflydistinguishes the various types of technical reserve.
Reserve for known outstanding claims
At any given accounting d ate, there will be a number of claims on the bookswhich have not yet been settled, or at least not finally settled. The insurer'sestimated liability in respect of such c laims may be referred to as the reserve forknow n outstanding claims. It forms part of the overall claims reserve. (See alsonote on p. A5.1).
IBNR Reserve
IBNR stands for Incurred but not reported. It refers to claims whose date of
occurrence lies in the period on or before the accounting date, but which for somereason have not yet reached the insurer's books. Dam age and liability can taketime to becom e manifest, and there will be delays in the reporting and rec ordingof claims even under the best of circumstance s. Hence the need for the IBN Rreserve, which relates to the claims which are effectively hidden from view . Apartfrom outstanding claims, IBN R forms the other main portion of the overall claimsreserve.
Unearned Premium Reserve
At the accounting date, for each policy which rem ains open on the insurer'sboo ks, a part only of the contracted risk period is likely to have elapsed. If aprem ium was payable, say, on 1 October for one year's cover, then nine m onthswill remain when the accounts are drawn up on 31 December. A proportionatepart of the premium must be retained as a reserve to cover the period of risk from1 January onward. (In this case, ignoring inflation, the portion would be 75 % , lesssome allowan ce for initial expense.)
Such a reserve, for risk periods subsequent to the accounting date is kno wnas the unearned premium reserve (UPR).
The UPR, being based on the premium, may be inadequate if the premium itselfis insufficient to cover the cost of the risk and expenses. Hence an upw ardadjustment m ay be needed , and this increment is known a s the unexpired risk
reserve.
Catastrophe Reserve
With an event such as a severe earthquake or hurricane, a large number ofconnected claims for personal accident, property damage, consequential loss andgeneral liability w ill inevitably arise. In such cases, the norm al provision forfuture c laims, based on the concept of independent events, may be entirelyinadequate. Henc e, where the type or geography of the risks written indicates theinsurer's susceptibility to catastrophe loss, an additional cushioning of thereserves may be considered.
Fluctuation Reserve
It is in the nature of things that a n insurer's claims experience w ill fluctuate fromyear to year. Even w ithout the occurrence of an identifiable catastrophe, rand omvariation may thro w up on e, or even a series, of lean years. For protection againstsuch an out-turn, the insurer may w ish to establish a fluctuation reserve. Inpractice there may be little conceptual difference betwe en a fluctuation reserveand a catastrophe reserve; and it is unusual for comp anies to show them explicitlyin the UK w here they are not allowable for tax purposes.
Claims Equalisation Reserve
For certain defined categories of business, UK insurance com panies have fromthe end of 1996 been required to hold a fluctuation reserve, know s as a claimsequalisation reserve (C ER ). The maximum amount of the CER, and the amountsto be transferred to and from the C ER, are specified by statute. A transfer to CERis treated as a deduction from p re-tax profits, while a transfer from CER is treatedas part of the taxable incom e of the comp any in the year in which it is mad e.
Rather unfortunately, there are several terms of central importance in claim sreserving wh ich can be given quite different mean ings by different u sers. It isimportant to be aware of the am biguities, and to be sure of the mea ning intendedin a given context. The chief problem s arise with the term s Outstanding Claims,IBNR, Incurred Loss and Chain Ladder Method, and are described below. (Thelist is not supposed to b e exhaustive.)
Outstanding Claims
The term h as often been used to refer to claims on the insurer's books by theaccounting date, but not by then settled — in other word s, to the know noutstanding claims. W hen this practice is adopted, IBNR claims are specificallyexcluded. The totality of claims for which reserves must be held then consists ofOutstanding Claims plus IBNR Claims, although since the term OutstandingClaims is often used to refer to this totality there is obviously scope for confusion.
Unfortunately there is no universally agreed nome nclature. In the M anual w ewill use the following terminology —
a) Open Claims means claims which have been reported to the insurer andwhich are not yet settled.
b) IBNR Claims means claims which have been incurred but not yet reported tothe insurer in question (see next paragraph).
c) Outstanding Claims m eans the total of a) and b).
IBNR
A further am biguity arises with the term IBNR itself. It is often used as such torefer to the reserve as well as to the group of IBNR claims. Tha t in itself is noproblem : at the accounting date one has a set of open claims and an open claimsreserve, plus a set of hidden claims and an IBNR reserve. But the ambiguity arisesonce one begins to consider the progress of claim settlements subsequent to theaccounting day. Taking the group of open claims, the actual payments will notprecisely match the reserve previously set — there will be a development, whichmay be upward or down. One definition of IBNR is such as to ignore thisdevelopm ent, and it is the sense that will usually be taken in the Man ual. The
alternative definition of IBNR, however, deliberately includes any development inthe open claims. In other w ords , the mean ing of the IBNR reserve becomes:
IBNR = Estimated ultimate loss on all outstanding claims
less Reserve at accounting date for open claims
This seem s less natural than the first definition, but it has real point in somecircumstanc es. It is used in this sense in the Londo n M arket with particularreference to reinsurances. The M anual will specify where app ropriate the sense inwhich the term IBNR is being used in the particular context.
Incurred Loss
There are two distinct definitions of the term Incurred Loss depen ding upon thecontext. The first arises when o ne is considering the insurer's portfolio of
business as a who le, or perhaps a given class within the portfolio. Interest lies inthe progress of the portfolio or the class over the course of the acco unting year,and Incurred Loss is defined as:
Incurred Loss = Claim s paid during course of year
less Claim s reserve held at 1 January
plus Claims reserve established at 31 December
The second use arises equally naturally w hen one looks at a particular tranche ofbusiness wh ich has its origin in a given policy year or a group of claimsoriginating in a given accident year (normally referred to in actuarial w ork as a
cohort . It is interesting to follow the progress of the cohort, and at eac hsubsequent accounting date to assess the losses attaching to it. The estimate ,omitting the IBNR element, is again called the Incurred Loss. It is:
Incurred Loss = Am ounts paid to date on settled or partly settled claims
plus Reserve held for open claims
In the Manual, Incurred Loss will be used exclusively in this second sense. Thatis because the reserving me thods discussed are very generally app lied on a cohortby cohort basis. The overall picture for the portfolio or class is later found byadding up the parts, and is less comm only in q uestion.
Chain Ladder Method
The term is a very familiar one to claim s reserving practitioners. The proble m isthat it is sometimes used in a particular sense, and at other times very generally.In the latter case, it describes a wide range of reserving method s, which o peratethrough com paring the claims develop ment of cohorts of different years of origin,and which tend to employ triangular arrays of data. This usage leaves somethingto be desired. It obscures the important question as to wha t data are actually beingused — m any different po ssibilities exist. Also, it tends to suggest:
