Financial Implications of Over-Reserving in Nonlife Insurance Companies

Abstract

A recent study of the loss reserving practices of nonlife insurance companies indicated a fairly consistent tendency toward over-reserving. This paper reports the results of a study of the economic incentives for and financial implications of this practice. The study was made using a computer model to explore the effects of different levels of over-reserving given various company growth rates and mixes of insurance policies sold. The results indicate that while there may be some direct economic gain derived from the practice, especially where high loss reserve lines and/or high growth rates predominate, reported underwriting gain and thus policyholder's surplus levels may be significantly reduced. The paper concludes by pointing out the possible implications of over-reserving for the policies of insurance firms, regulatory agencies and the Internal Revenue Service. In a recent study of loss reserving behavior of 36 nonlife companies during the period 1955-64, Dan R. Anderson reported that (i) loss reserves of the sample companies were for the most part overvalued during this period; (ii) the degree of error in the loss reserve estimates was significant, i.e., the estimates for the most part, did not fall within the actuarial five percent range of reasonable error; (iii) there was a distinct tendency for the sample companies to move from a heavily over-reserved position in the early years of the study to a less over-reserved or even under-reserved position in the later years of the study; (iv) the sample companies tended to exhibit a stable reservJohn J. Anderson, Ph.D., C.P.A., is Assistant Professor of Business in the University of Wis-