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By DAVE OTTO, director at EMB USA

To what extent is the senior management team driving your reserving agenda or taking an active interest, other than in a balance-sheet number and what this means for capital requirements? Don't worry if your answer is: "Not much." You are not alone.

THE REGULATORY CASE

Big changes are afoot in the wider accounting treatment of reserves. Amendments to both International Financial Reporting Standards (IFRS) and the arrival of the European Solvency II Directive will significantly alter insurance company balance sheets over the next three to five years. The principal change is that organizations will have to discount reserves to take into account risk margins and the time value of money.

On first examination, it would be easy to regard the work involved as another imposition upon insurance companies. However, it can help to kick-start some positive changes. Many companies are missing out on the opportunity to extract more value out of reserving. They are failing to align technical reserves with what the business does. With the enforced changes that lie ahead, now is a perfect time to remedy that.

What is more, there are additional benefits from getting your reserving practices into shape for the evolving regulatory environment.

In many ways, the current accounting treatment of reserves does insurers a disservice because it provides no indication of when liabilities need to be paid, nor the associated risk. Consequently, it creates uncertainty for investors about the true cash flows and returns of the business. If implemented well, the changes to reserving will enable investors to understand insurers' true liabilities better and to make more direct comparisons with investment opportunities from other sectors.

GETTING COMMUNICATION RIGHT

Numbers aside, the other major effect of the new regulations is to make the information that needs to be available to stakeholders more explicit.

How can this communications challenge be met? A good starting point is a reserving approach that is set at a high level by the board and reflects the business's risk profile and appetite. All the involved parties also need to communicate using appropriate language and levels of detail for the target audience. After all, effective communication is reliant on understanding, not just transmission.

Drill further down into the organization, and the practice of better communication and its benefits become more apparent.

Reserving and claims teams are natural allies. Analysis of claims experience and data is the core part of the reserving process. But claims teams and reserving actuaries have valuable information and insight to share over and above a set of numbers.

Reserving relies on patterns of data in which the claims team will be best able to explain any distortions. Similarly, claims specialists can contribute their knowledge of underlying or emerging patterns.

In today's market, this would extend to fraudulent claims. Although the reserving actuary might be able to apply some industry averages to the evolving claims pattern, a far better measure would take account of the relative fraud risk of the lines of business being written, the claims team's own experience and the feedback on success of preventative strategies.

HIGHER-LEVEL BENEFITS

The benefits of closer communication are far from one-way. One objective of a claims department, for example, might be to settle claims faster. It might become apparent to the actuary, though, that this strategy is more costly in the long term because it leads to more claims being reopened. Also, subtle inflationary trends such as increases in repair costs, which claims staff will not necessarily notice because they are immersed in the day-to-day detail, can be picked up by reserving.

The aim of closer cooperation is to pick up higher-level trends and promote a better understanding of the underlying business.

The pricing function will certainly also benefit in that potentially profitable and more risky lines of business can be identified. Another way in which pricing can feed off reserving work is when the best estimates generated are incorporated in the claims assumptions used for pricing. Furthermore, more accurate estimates of inflation are available straight from the reserving exercise and could be incorporated into pricing work.

Logically, the ultimate collection point for information within an insurance business is the capital model. There are potentially lots of outputs and work that is done naturally as part of a reserving exercise that can and should be incorporated into the model.

Where there are two different teams working on modeling and reserving, senior managers need to clarify the expectation for how the teams interact. It is not generally that the two are averse to working together; it is just that responsibilities need to be clear.

Forging clearer lines of communication between reserving and modeling and the rest of the business is not just a matter of improving operational risk management (although it will) or placating regulators. Real potential financial benefits are at stake here: better pricing for risk, lower claims costs and reduced capital requirements. These are all factors that command attention in any insurance company.

September 1, 2010

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