Determining a reasonable range of loss reserves, required

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1 C OVER S TORY By R USTY K UEHN Medical Malpractice Loss Reserves: Risk and Reasonability On March 1 of every calendar year, property/casualty insurance companies file a Statement of Actuarial Opinion (SAO), along with an annual statement, with their domiciliary insurance department. They submit the same statements in every other state where they are licensed. In the SAO, the company s appointed actuary must: 1. State that he or she has evaluated the underlying data for reasonableness and consistency and reconciled that data to Schedule P Part 1 of the company s current Annual Statement. 2. Opine on the reasonableness of the company s carried loss reserves and, if material, unearned premium reserves. 3. Address any relevant issues, such as the risk of material adverse deviation, reinsurance collectibility, and any unusual NAIC IRIS reserve ratio values. Determining a reasonable range of loss reserves, required for item 2, is particularly challenging when reserves are subject to substantial volatility. If, in addition to their inherent volatility, the reserves are relatively large compared with other items on the balance sheet, the risk of Ronald (Rusty) T. Kuehn, FCAS, MAAA, CPCU, ARM, FCA, is a Consulting Actuary with Huggins Actuarial Services, Inc. material adverse deviation (as noted in item 3), will be greater. This article discusses these two important aspects of the SAO, for medical professional liability insurance (MPLI) providers in particular: opining on the reasonableness of loss reserves and commenting on the risk of adverse deviation. MPLI carriers are subject to more adverse development than is the overall industry. Furthermore, the relative magnitude of MPLI reserves makes adverse development singularly important for sustaining company solvency. 18 P H Y S I C I A N I N S U R E R T H I R D Q U A R T E R 2007

2 No explicit definition of material is provided in the actuarial guidelines. Opining on Reasonableness of Loss Reserves Estimating adequate reserves is a challenging task, for many reasons. Ultimate claims costs, which may not be reported for years, or paid for many more years, are influenced by a multitude of factors, both external and internal to the company. External factors include economic changes; judicial decisions; regulatory actions; and political, social, and geographic variations. Claim costs may be influenced by internal factors as well. Many departments in a company can have an impact on loss reserves. They may have a direct effect on losses or, if they adopt new procedures, there may be changes in the statistics actuaries use in estimating loss reserves (See Box, page 22). What Differentiates MPLI? All of the factors cited, both external and internal, contribute to the uncertainty of the ultimate value of settled claims. In addition, the results for an MPLI enterprise are particularly susceptible to some of the key variables in the insurance business. Timing of claims. MPLI coverage entails long time lags between the date of exposure and the settling of a claim. The time lag between the exposure period and the settling of a claim can be broken up into four segments: Date of the underwriting exposure to the date of the first report of an incident Date of the first report of an incident to the date when it becomes a claim Date the claim is filed to the date of settlement Date of settlement to the date when the claim is paid. The longer the time lag, the more the external and internal factors can affect the ultimate settlement value. Reinsurance limits. Even more uncertainty stems from the large limits required by, and sold to, many MPLI providers. Reinsurance mitigates the impact of large claims; but, as limits increase, this effect decreases. Potential for high-severity claims. MPLI coverage is particularly susceptible to the unpredictability of jury verdicts: Claims frequently pertain to complex cases associated with severe damages. The mere occurrence of a few high-dollar awards can induce extreme volatility in reserves. The combined impact of such large claims can mask, or sometimes reverse, otherwise predictable trends in aggregate claims experience. Despite these challenges, the company must book a loss reserve, and the appointed actuary must explicitly identify, in the opinion section of the SAO, which one of these five categories applies to the stated reserve amount: 1. Reasonable Provision the stated reserves fall within the actuary s range of reasonable reserve estimates. 2. Inadequate Provision the stated reserves are less than the minimum amount that the actuary believes is reasonable. 3. Redundant Provision the stated reserves are greater than the maximum amount that the actuary believes is reasonable. 4. Qualified Opinion the reserves for a certain item or items are in question and these items are likely to be material. 5. No Opinion no conclusion can be reached, because there are deficiencies or limitations in the data, analyses, assumptions, or related information. Addressing the Risk of Material Adverse Deviation The SAO is a tool used in solvency regulation. Therefore, the selected materiality standard is oriented toward the potential impact that a misstatement of reserves would have on surplus levels. The company s carried reserves are a point estimate. But the total amount required for settlement of claims may not be known for many years, and the required reserve may be higher or lower than this carried amount. If the appointed actuary identifies some risk of material adverse deviation from the amount in the carried reserves, this risk needs to be explicitly addressed in the SAO. The NAIC 2006 Annual Statement Loss Reserve Opinion Instructions state: The Appointed Actuary must provide specific RELEVANT COM- MENT paragraphs to address the risk of material adverse deviation. The actuary must identify the materiality standard and the basis for establishing the standard. The materiality standard must be disclosed in $US T H I R D Q U A R T E R 2007 P H Y S I C I A N I N S U R E R 19

3 M EDICAL M ALPRACTICE L OSS R ESERVES in Exhibit B: Disclosures [of the SAO]. The actuary should explicitly state whether or not he or she reasonably believes that there are significant risks and uncertainties that could result in material adverse deviation. The volatility of MPLI claims, even in the aggregate, may lead to a greater range of reasonable reserve estimates, compared with the general P/C industry particularly at the higher end. Also, the risk of material adverse deviation will be more significant than it is for the typical P/C line of business, because of the volatility of MPLI. Figure 1 Reserve Adequacy Ratio All P&C Lines of Business Ratio of Original Held to Mature Evaluation Why Is MPLI Risk Higher? Several elements, integral to MPLI coverage, can explain why there is a greater risk of material deviation for this coverage than in the P/C industry as a whole. Reserve adequacy. We can observe the increased volatility and greater risk of material adverse deviation for MPLI by examining historical adverse loss development. We can measure reserve adequacy for a line of business retrospectively, by comparing the reserves held at 12 months of age, by accident or report year, with a mature evaluation of those claims. Figure 1 shows industry data from A.M. Best for all P/C lines of business for accident years 1996 through For each year, the ratio of original held reserves as of 12 months to reserves held at December 31, 2005, is shown. A ratio above 100% (the green bars in the graph) means that the original loss reserve estimates were redundant, compared with the more mature evaluation. A ratio below 100% (shown in red) indicates that the original loss reserve estimates were inadequate, compared with the more mature evaluation. A ratio of 100% (also, green) means the original estimate was adequate. For the P/C industry, Figure 1 shows that the original held reserves for accident years 1996 and 1997 (green) were greater than 100% (or redundant), while reserves for accidents years 1998 to 2001 (red) were less than 100% (or inadequate). More recent accident years (2002 to 2004) show that the reserves that were originally held were near-adequate or redundant, although the immaturity of the results in these years makes them less credible than results for the earlier years. Figure 2 uses the same color code as Figure 1 and shows the reserve adequacy for MPLI (claims-made and occurrence policies combined). The MPLI data follows a similar, but much more pronounced, trend than does the overall industry for this same nine-year period. Here, accident year 1996 (green) shows a redundancy, while accident years 1997 through 2002 (red) show an inadequacy. The more recent years (2003 to 2004) are indicated in green, but, like the results in Figure 1, results for these years are still immature and must be viewed as having limited credibility. Figure 3 compares the loss reserve adequacy (as defined above) of MPLI providers, as compared with that of the overall P/C industry, Figure 4 Highly Leveraged Property & Casualty Companies Figure 5 Unleveraged Property & Casualty Companies (in Millions) (in Millions) 20 P H Y S I C I A N I N S U R E R T H I R D Q U A R T E R 2007

4 Figure 2 Reserve Adequacy Ratio Medical Malpractice Ratio of Original Held to Mature Evaluation Figure 3 Comparison of Reserve Adequacy Medical Malpractice Reserve Adequacy to Industry Reserve Adequacy for the years 1996 to Here, the red areas indicate that the estimates of loss reserves made by MPLI providers were more inadequate than the estimates used by P/C insurers overall. In every single year during the nine-year period, MPLI loss reserves have consistently been 5% to 10% less adequately reserved than their P/C counterparts, and therefore show greater potential for material adverse deviation. Leverage The impact of reserve inadequacy is amplified by the extent to which an insurer is financially leveraged. Insurance leverage arises because an insurer s liabilities are deferred; leverage is frequently measured as the ratio of reserves to surplus or reserves to assets. Highly leveraged companies have less of a financial buffer in their surplus to weather Figure 6 Ratios of Loss & LAE Reserves and Surplus to Total Assets (as of 12/31/2005) adverse events such as catastrophic losses, adverse loss development, and economic downturns. Figure 4 shows the aggregated loss reserves and surplus from the December 31, 2005 annual statement of several highly leveraged P/C companies. The result shows that loss reserves are 360% of surplus ($180 million to $50 million) for these insurers. For these same insurers, the premium was aggregated and compared with surplus, to provide a measure of exposure. Figure 4 shows that the aggregate premium-to-surplus ratio of these highly leveraged companies is 124% ($62 million to $50 million). Figure 5 depicts aggregated loss reserves and surplus from the December 31, 2005 annual statements of several unleveraged P/C companies. The result shows that loss reserves are 56% of surplus ($28 million to $50 million). Their aggregated premium-to-surplus ratio is 72% ($36 million to $50 million). The medical malpractice industry is more highly leveraged than the overall P/C insurance business. Based on A.M. Best data as of December 31, 2005 (Figure 6), the P/C industry s undiscounted loss and LAE reserves accounted for 38% of total assets, whereas the undiscounted loss and LAE reserves for MPLI accounted for 61% of total assets in its sector. Likewise, P/C all-lines surplus accounted for 31% of total assets, whereas MPLI surplus accounted for only 21% of total assets for the sector. Profitability Ratios Another measure of volatility can be seen by examining profitability ratios. The combined ratio, a measure of losses and expenses compared with premium, reflects the underwriting results for a given line of business. The operating ratio reflects the underwriting results, but it also reflects any investment gain. An operating ratio of 100% is breakeven. Figure 7 shows the overall operating ratios for all P/C lines of business and for MPLI, for the ten-year period 1996 to The all-lines T H I R D Q U A R T E R 2007 P H Y S I C I A N I N S U R E R 21

5 M EDICAL M ALPRACTICE L OSS R ESERVES operating ratio is 100% or less in 8 years, and has remained within a 16-point range, from 91% in 1997 to 107% in Over the same tenyear period, the MPLI operating ratio is 100% or less in only 5 years, and has fluctuated by 60 points: from 76% in 1996 to 136% in 2001! Thus, MPLI operating results have been much more volatile and indicative of lower profitability than results for the overall P/C industry. One component of the operating ratio is investment gain. Figure 8 shows the investment-gain ratio for all P/C lines of business, and for MPLI, over the same ten-year period. Investment income has a much greater impact on the profitability of MPLI than on the P/C industry as a whole. So investment gain is another source of volatility in MPLI operating results. Placement in the Range of Reserve Estimates As we have seen, the risk of material adverse deviation is more significant for MPLI than for the overall industry. However, no explicit definition of material is provided in the actuarial guidelines. The actuary may use different criteria to determine what represents material reserve development, depending on the particular company, the specific lines of business, and any other unique aspects underlying the SAO to determine the dollar value of the materiality standard. Affecting the risk of material adverse deviation is the placement of the stated reserves relative to the appointed actuary s range of reasonable estimates. If the stated reserves are near the high end of the range of reasonable estimates, then the materiality standard that would represent the actual reserves exceeding the top of the range is smaller than if the stated reserves were set at the low end of the range. Conclusion The appointed actuary stating an opinion on MPLI reserves will observe that there is more uncertainty in the reserve estimates, compared with other P/C companies. The actuary will also discover that Within the Company: Impact on Loss Reserves Quality Assurance/Loss Control professionals instill practices to prevent or mitigate losses. Claims professionals may modify their claims management practices, and the new business rules alter the historical parameters used by actuaries in making reserve estimates. Underwriting professionals may adjust their riskacceptance and risk-retention decisions over time. As a result, the risk structure of the business may be inconsistent with what the actuary has assumed in the historical analysis used in estimating reserves. Executive management may make important changes that affect the key statistics actuaries use in estimating loss reserves. These changes might include: buying or selling significant blocks of business, rearranging reinsurance for key segments of the book whether prospectively or retrospectively or making sweeping changes in staffing or procedures. the risk of material adverse deviation has more consequences for MPLI than it does for other lines of business. Any reader of the SAO for a MPLI carrier should pay particular attention not only to the Opinion section, but also to the Relevant Comments section that accompanies it, where the risk of material adverse deviation and the contributing factors to it is addressed. PIAA For related information, see www. hugginsactuarial.com Figure 7 Comparison of Profitability: Overall Operating Ratios Medical Malpractice vs. Property & Casualty Industry Figure 8 Comparison of Profitability: Investment Gain Ratios Medical Malpractice vs. Property & Casualty Industry 22 P H Y S I C I A N I N S U R E R T H I R D Q U A R T E R 2007