Loss Reserve Valuations and Financial Results in Nonlife Insurance

Abstract

Relationships between loss and loss adjustment expense reserve valuations and the reported financial results of 60 nonlife insurers during 1955-67 are examined under different reserve misstatement assumptions. The results of a similar study by R. J. Balcarek are also presented involving the 1953-60 experiences of ten large insurers. Both study results indicate that even minor loss and loss adjustment expense reserve misstatements can have a significant impact upon the earnings reported by nonlife insurers. The paper also presents a method whereby an insurer can measure the amounts of its reserve misstatements at the ends of successive accounting periods in order to reconstruct earnings statements and balance sheets to provide an accurate financial record for management. The uses of the computer in order to trace sources of reserve misstatements to facilitate appropriate adjustments in the reserving system are also discussed. Regulators, policyholders, shareholders, investment analysts, and the general public place importance upon the financial results reported by the nonlife insurance industry, yet it is not generally recognized that an important component of these results, the loss and loss adjustment expense reserve, is not measured accurately. The purpose of this paper is to analyze some theoretical and actual relationships between loss and loss adjustment expense reserve misstatements and the reported results of nonlife insurance companies. For these purposes, the financial result may be viewed as a combination of underwriting and investment results. An inaccurate loss and loss adjustment expense reserve affects the accuracy of the underwriting result. Stephen W. Forbes, Ph.D., is Associate Professor of Finance, University of Illinois. The author gratefully acknowledges the financial assistance of the Graduate Research Board of the University of Illinois. This paper was submitted in July 1971. The Underwriting Result The underwriting result measures the difference between the earned premium and the losses, loss adjustment expenses, and underwriting expenses incurred by the insurer during the accounting period. If the earned premium exceeds these other elements, the insurer reports an underwriting gain for the period. If, on the other hand, the earned premium is less than these elements, the insurer reports an underwriting loss. When analyzing the effect of the accuracy of the loss and loss adjustment expense reserve upon the measurement of the underwriting result the following simplification of the incurred losses and loss adjustment expenses becomes useful: