If you’re a numbers person and read your business results in terms of annual revenue and costs, you’re probably looking at your insurance program in much the same way.
Ultimately, a numbers person is looking for value, some measure of “return” on your annual insurance “investment,” usually perceived as the difference between what you paid in insurance premiums and how much your insurer paid out in claims in a given year.
As easy as that seems, it’s just not the way it works.
Just because your insurance policy is handled annually, it doesn’t mean that all your claims are settled within those same 12 months. There’s a huge difference between a paid, closed claim and an open “reserved” claim. A closed claim is settled. An open reserved file is just the insurer’s best estimate – based on information at hand at that time – as to the ultimate cost of that claim down the road.
Let’s take a step back. When you report a loss or claim, your insurance company does two things: First, it conducts an investigation to learn the facts of the claim; second, the insurer sets aside money it believes it will pay out to cover the final cost of that claim. This second activity is called claims reserving.
Some claims are easier to estimate or “reserve” than others. If a truck rolls over on a quiet road, injuring no one, it’s pretty easy to reserve the claim and it will not take long to close. It’s basically the cost to repair the truck and the value of any damaged cargo.
But what about when someone is injured? Let’s say your truck jack-knifes and hits a passenger vehicle, causing serious injuries to the car’s three occupants. Determining the cost of the car, your truck and the cargo is relatively simple. But the ultimate costs to compensate the injured (immediate and ongoing medical costs, rehabilitation, lost wages) and defend you in a lawsuit and trial will likely not be known for years. Someone who is injured today in an accident can take a turn for the worse, something impossible to predict, driving up the cost of the claim. The reserve at the end of 12 months on these types of open claims is usually far below what will ultimately be paid out. The difference between the two is called “reserve development.”
The problem is that it’s virtually impossible to tell which injured people on which open claims are going to eventually take a turn for the worse, and which juries are going to return ridiculous verdicts.
Insurers must therefore set up additional bulk reserves to cover the inevitable development of open claims files. As it’s impossible to tell which claims will develop and how far, these bulk reserves can’t be allocated to specific claims files, which means they can’t show up on your individual loss run.
So when you look at your loss run for the year, you’re only getting a potentially small part of the picture. All you’re seeing are the closed claims files and the current estimate of open files based on information known at that time, not the final cost of your claims.
Insurance is risky business
Remember all those eager trucking insurance companies over the years, who ended up disappearing? The single biggest reason for these trucking insurer failures is under-estimating the cost of open claims – paying far more in claims than what you collect in premiums is not a formula for success.
Let’s look at a trucking company that pays $100,000 in insurance premiums, and had $30,000 of estimated reserved losses at the end of 12 months. In that $30,000 estimate is a bodily injury claim that hasn’t yet closed.
If that claim ultimately settles for $5 million (something all too common these days), the true cost of this one claim to the insurance company wouldn’t be covered by the carrier’s next 50 years of insurance premiums. Although your numbers person only sees $30,000 in losses after 12 months, your insurance company sees – and ultimately pays – a very different number.
All of a sudden, things look more favourable for the trucking carrier. The numbers person now sees an excellent return on the $100,000 premium: by the time the claims are all closed on that year, the carrier has received over $5 million in value.
Insurance is not an annual business. Many “good” years from a particular carrier client won’t come close to paying for one “bad” year. And the bad years always come for carriers – it’s just a question of when.
Insurance is one of the only businesses where you sell your product today, but don’t know your final costs for years to come – a responsibility that your numbers person would probably (and gladly) hand over to someone else.
– Mark J. Ram is president and CEO of Markel Insurance Company of Canada. Please send your questions, feedback and commentary about this column to firstname.lastname@example.org. For more information about Markel visit www.markel.ca.