Introduction
Insurance companies accept premiums in exchange for assuming the risk of loss from events taking place in the future.1 Policyholders trade cash up front for protection against losses that, in many cases, would be financially ruinous in the absence of coverage. Insurers hope to underwrite profitably over their entire risk pool by earning premiums that, in aggregate, exceed loss payouts and expenses associated with running their insurance operations. In addition to underwriting profits, insurers generate income from investing funds that will eventually be used to pay claims.
It is no exaggeration to say that insurers are selling a promise to policyholders when they accept premiums. The customer receives nothing more than a piece of paper indicating coverage for a period of time. This is an alluring business model but the downside is that the insurer does not have certain knowledge of its ultimate exposure until sometime after a policy expires.2 As a result, insurers must devote much careful attention toward estimating the reserves required to pay anticipated future losses.
Maintaining accurate loss reserving practices is one of the most crucial functions for any insurance company. An insurer that does not have a good track record of loss estimation cannot have confidence that it is pricing new and renewal policies at a level that will produce acceptable levels of profitability. In addition, loss reserves are recorded as a liability on the balance sheet. A chronic failure to accurately estimate loss reserves could make it more difficult to invest policyholder funds appropriately.3
Investor confidence will inevitably suffer if reserves prove to be inadequate. Investors often value insurers based on a multiple of book value. Inadequate reserves have the effect of inflating reported book value. Insurance companies with a history of adverse reserve development are likely to trade at a lower multiple of book value compared to insurers with a history of adequate reserving or favorable reserve development.4
Owners of public companies have a limited view of how management operates the business. Executives are reluctant to speak to shareholders due to fears of violating selective disclosure regulations. Disclosures in the form of press releases and SEC filings are typically less than fully illuminating and quarterly earnings calls normally focus more on short-term drivers of profitability than long-term strategic topics.
The opaque nature of investing in public companies is not an insurmountable challenge. Investors can focus on simple businesses where there is little need for estimation in financial results. When it comes to insurers, investors can opt to focus on companies engaged in short-tail lines where loss reserving problems will show up relatively quickly. For example, inadequate loss reserving is going to show up far more quickly for a property insurer than for a reinsurer specializing in asbestos liabilities.
Automobile coverage is a good example of short-tail insurance. When auto-related losses occur, they are likely to be reported very quickly. The cost of repairing vehicles is usually known within weeks or months at the most. While it can take longer for claims related to bodily injury to be finalized, the overall nature of auto insurance provides relatively quick feedback related to loss reserve adequacy.
Progressive focuses primarily on short-tail auto insurance and management provides more data to the public compared to most publicly traded insurers. In addition to annual and quarterly reports, Progressive publishes monthly results with useful data. Management also publishes a detailed loss reserve report every two years. I have found Progressive’s disclosures to be far more illuminating than the industry norm.
In early August, Progressive held a conference call (webcast, slides, transcript) to explain how loss reserving works in quite a bit of detail. I have followed the insurance industry for a long time, but always from the perspective of an individual investor without access to the nuts and bolts of how the reserving process works at the claims level and rolls up to the aggregate figures we see on financial statements.
It was interesting to listen to Progressive’s actuary discuss how reserves are set and adjusted. Following the actuary’s presentation, there was a valuable discussion about cohort pricing. The profit profile of a policyholder varies over the lifetime of the relationship and the distribution channel. Readers with a serious interest in the insurance industry will want to listen to the webcast or read the slides and transcript.
In this article, I briefly discuss Progressive’s recent reserving results following by highlights from the presentation that I found interesting. The goal of this article isn’t so much to analyze Progressive’s recent results as it is to walk through how the management of a successful insurer thinks about loss reserving and cohort pricing.
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- The typical insurance business model accepts premiums in exchange for taking on future risks. However, there are specialized types of insurance that accept premiums in exchange for accepting risks that have taken place in the past but are of indeterminate magnitude. Title insurance and retroactive reinsurance are two examples of insurance covering adverse events that have taken place in the past. [↩]
- Insurers are responsible for covered losses during a period of time defined in the policy. There is often a delay between the time of a loss and when the policyholder notifies the insurer. In some cases, notice of a loss incurred during the policy term could arrive after the end of a policy term. Insurers maintain a reserve for claims that have occurred but have not been reported. This is known as Incurred But Not Recorded (IBNR) reserves. [↩]
- For example, some insurers aim to invest policyholder float in fixed-maturity investments with the duration of the investments matching the duration of expected liabilities while investing shareholders’ equity in stocks. Underestimating loss reserves will lead management to underestimate the amount of funds that will be necessary to pay out claims and to overestimate the amount of shareholders equity available for investment in stocks. A sudden demand to pay out additional claims could result in a situation where stocks would need to be liquidated at a loss to cover unexpected claims. Underestimating loss reserves could also lead management to return more capital to shareholders than would be prudent, ultimately leaving the insurer undercapitalized from a business and regulatory perspective. [↩]
- Insurers conduct periodic actuarial reviews of loss reserves. If a review indicates that loss reserves for a prior accounting period were not adequate, the insurer must record adverse loss development during the current accounting period. Conversely, if reserves for a prior accounting period were more than adequate (also referred to as redundant), the insurer records favorable loss development during the current accounting period. The goal of a well-run insurer is to minimize occasions where adverse loss development must be recorded. [↩]