A claims reserve is an account an insurance company establishes to pay future claims. When it settles a claim, it pays the policyholder from the claims reserve.
To forecast the amount of money they need in claims reserves, insurers use complex methods, relying on data and mathematical calculations. They also employ different types of claims reserves to mitigate the risk of higher-than-expected claims and claims that policyholders have yet to report. The level of funding a provider allocates to a claims reserve can impact policyholder premiums.
Let’s take a closer look at what a claims reserve is and how it’s determined.
Definition and Example of a Claims Reserve
A claims reserve is an account established by an insurance company to pay future claims. Funding a claims reserve is based on a projection of the amount of money needed to pay unsettled claims or unreported claims.
- Alternate name: Outstanding claims provision
Let’s say you have a fender bender and file a claim against your collision coverage. When the insurer approves a settlement, it will pay you from its claims reserve.
How a Claims Reserve Works
To understand how claims reserves work, it’s important to know what “claim” and “reserve” mean. When you file an insurance claim, you’re submitting a demand to receive a monetary settlement from the insurer for a loss covered by a policy. For instance, if a fire destroys your kitchen, you could file a claim against your home insurance coverage.
A reserve is money allocated for a specific intent. A claims reserve is money an insurance company must set aside to pay claims. So, if your carrier approves your homeowners claim following the kitchen fire, it will draw from its claims reserve to pay you.
Providers also maintain loss reserves to cover outstanding losses and loss-adjusted expenses.
A claims reserve is a forecast of the amount of money a carrier estimates it will need to pay future claims. A professional called an insurance actuary, a person who manages and measures risk using mathematics and statistics, produces such forecasts. Typically, actuaries use several methods to forecast how much money a claims reserve needs to cover future claims obligations.
Actuarial Projection Methods
Actuarial projection methods are processes actuaries use to estimate future claims liabilities. These methods include:
Algorithm: Employs a dataset to estimate claim liabilities by applying a model based on the incidences and frequency of claims and the settlement process.
Predictor dataset: Collection of information about claims that includes several data elements. For example, a car insurance dataset might include the number of collision and comprehensive claims, zip codes of where crashes occur, and the types of stolen vehicles.
Intervention points: Judgment calls that need to be made during the actuarial projection process. For instance, an actuary may need to adjust the model’s parameters or override certain data to manually tweak the algorithm.
For life insurance products, most states have adopted principle-based reserving (PBR) methods. The amount of funds held in reserve can affect the cost of insurance policies. High reserves can increase premiums, while low reserves can put an insurer at risk of not having enough money to pay claims.
The PBR method of reserving gives insurance companies the leeway to calculate reserves based on their own experience via a set of fundamental principles. PBR employs simulation models, which actuaries can use to forecast reserve needs based on many economic scenarios. As economic conditions change and companies produce new data, they must regularly recalculate reserve needs.
This new method of reserving produces a more accurate risk assessment. By pinpointing risk, insurers can increase reserves for some life insurance products and decrease reserves for others, as needed.
PBR reserving does not affect life insurance policies already purchased. It only applies to new products issued after a state implements the new method.
An insurance company’s loss ratio is the proportional relationship of incurred losses to premiums expressed as a percentage. So, if a provider collects $1 million in premiums and forecasts $500,000 in claims, it has a 50% loss ratio.
When setting rates and establishing a claims reserve, an actuary must determine the loss ratio. Correct calculations will not lead to losses. However, as actual losses occur, the actuary may need to adjust claims reserve estimates.
Several factors can lead to claims reserve adjustments, including claims volatility and inflation. These adjustments are common, as actual losses paint a clearer picture than the initial estimate.
Types of Claims Reserves
Insurers use three types of claims reserves:
- Outstanding Claims Reserve (OCR): Money set aside to pay unsettled claims that can include only reported claims or all unsettled claims.
- Incurred But Not Enough Reported Reserve Provision (IBNER): Funds reserved to cover potential excess claims as further information becomes known on open claims.
- Incurred But Not Reported Reserve Provision (IBNR): Funds allocated for covered losses not yet reported by policyholder.
- Claims reserves help insurance companies manage risk and ensure they can meet their claims obligations.
- Actuaries determine how much to fund claims reserves by creating forecasts of future claims.
- High reserves can lead to higher premiums.
- Low reserves can put an insurance company at risk of insolvency.