How Does an Insurance Company Set Reserves?

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Reserves reflect an insurance company’s ability to pay claims on the claim's closing date. All types of insurance, including life, health and auto, have reserve requirements. State insurance departments set minimum reserve requirements in the state's insurance code. These typically amount to about 10 percent to 12 percent of an insurance company’s annual revenue, according to Fineweb.com.

Factors in State-Mandated Minimum Reserve Requirements

  • State insurance departments consider similar basic factors in calculating minimum reserve requirements. These include the number of policyholders in the state, the total dollar amount of potential benefits and the total amount of revenue generated. A complex reserve calculation formula determines the minimum percentage of total revenue that insurance companies must keep in reserve. However, this doesn’t mean individual insurance companies comply with state insurance code standards simply by maintaining minimum reserves. Instead, actual reserve requirements are often much higher than the minimum.

Data Organization

  • The key to setting accurate reserves lies in gathering and organizing the right type and amount of predictive data. Underwriters typically start by grouping claims that are similar to each other, both in characteristics and in size. However, claim groups must be large enough to produce the amount of data required to ensure that calculations -- and resulting loss development patterns -- are statistically reliable. To accomplish this, underwriters might organize data according to line of business, such as auto insurance, and the type of coverage, such as physical damage. Another option is to organize data according to claim size, such as grouping claims according to whether they are under or over a specific dollar amount.

Tabular Estimations

  • Underwriters often use age and probability tables to calculate accident, health and workers’ compensation insurance reserves. Tabular reserve calculations typically apply to all claims in a specific category. For example, an underwriter might base a workers’ compensation insurance reserve for accidental death claims on the number of policies issued, as well as tabular information such as the benefit level, the probability a surviving spouse will remarry, and the ages of a surviving spouse and any minor children.

Average Value Method

  • The average value method considers all claims in a specific category still open at the end of the current fiscal year to set a per policy reserve for the upcoming fiscal year. For example, assume 10 auto insurance liability cases from 2013 are still open at the end of the fiscal year -- three averaging $5,000 each, three averaging $8,000 each and four averaging $10,000 each -- and a $10,000 carryover case from 2012 is still open. Underwriters would set an auto insurance liability per policy reserve of $8,090, or $89,000 divided by 11, for the 2014 fiscal year.

References

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