Estimates of Loss Reserves in P&C
Insurance in Israel Insurance CompaniesAccounting and Regulatory Aspects
Yoram Eden
Arie Ovadia
Ben-ami Zuckerman
The College of Management, Israel
1
The Accounting Process of Profit
Recognition in P&C Insurance
• Insurance policies are usually issued for
one year.
• By the end of the insurance period, the
premiums are fully collected (usually
during the underwriting calendar year).
• The premium income is reported in the
underwriting year’s financial statements
(after deduction of unearned premium
allowance and prepaid income).
2
The Accounting Process of Profit
Recognition in P&C Insurance
(Cont.)
• The estimation of outstanding claims
(including INBR) is done on an actuarial
basis (mainly chain-ladder and
Bornhuetter-Ferguson methods).
• Estimating the outstanding claims is
particularly difficult in the “long tail” lines
(e.g., Motor Act, third party liability).
3
The Long Tail Liability Lines
• By the end of the underwriting year the
accumulated payments out of recognized
claims in these lines is only 3%-4%. By the
end of the next year this ratio is still only
15% - 17%.
• The premium income which is generated
in the long tail lines is about 33.6% of the
total premium income of the P&C
insurance industry of Israel.
4
Premiums from Long Tail Liability Lines out
of Total Premiums from P&C in the Israeli
Insurance Industry
FY 2006
FY 2005
Motor Act
21.5%
22.3%
Third Party
3.0%
3.1%
Employers’
Liability
Other
1.8%
1.8%
7.3%
6.4%
33.6%
33.6%
5
The Profit Recognition Criteria in
the “Long Tail” Lines
• According to the rules imposed by the
Commissioner of Insurance in Israel, the
calculated profit from liability lines is added
to the Loss Reserve (and not immediately
recognized in the income statement), and
stays there, in most cases for 3 years.
• Only at the end of a period of 3 years it is
released to the current year’s income
statement.
6
The Profit Recognition Criteria in the
“Long Tail” Liability Lines (Cont.)
• For example, the insurance profit for the
underwriting year 2003 is included in the
Profit and Loss account of the FY 2006.
• Few Insurance Companies release the
deferred insurance profits only after a
period of 5 years!! (I.e., the insurance
profit for the underwriting year 2001 is
included in the Profit and Loss account of
the FY 2006).
7
The Implications of Profit
Accumulation in the Liability Lines
• The financial statements of insurance
companies in Israel actually include a
“hidden reserve”.
• As Demonstrated on Tables 1&2 that
“hidden reserve” (after tax) is on average
about 7.7% (10.9% of the FY 2005) of the
reported net equity of Israeli insurance
companies, and about 10.5% (14.9% of
the FY 2005) of the required STAT equity.
8
The Implications of Profit Accumulation
in the Liability Lines (Cont.)
• On December 31, 2006, the after-tax hidden
reserve amounted to 24% of the STAT equity
reported by “small” companies, and only 5% of
the STAT equity of the “Big 5” insurance groups.
• This accounting policy enables the insurers to
postpone corporate tax payments but limits their
ability to allocate cash dividends.
• Hence, this profit accumulation is used as an
effective regulatory mean to ascertain the capital
adequacy of the Israeli insurance companies.
9
Deviation Between the Underwriting Year
and the Reported Financial Year
• In the liability lines there is actually a gap
between the underwriting results of the reported
year, and the profit from those lines included in
the Profit and Loss Account.
• Note also that the deferred income is increased
by the investment gains of 3 years.
• This deviation may deteriorate the meaning of
the financial statements in periods of material
fluctuations in the insurance profitability of the
liability lines.
10
Deviation Between the Underwriting Year
and the Reported Financial Year (Cont.)
• It is not possible to learn from the financial
statements about the real Loss Ratio (and
the Combined Ratio) of that year in the
liability lines.
• Unfortunately, in many instances, analysts
use wrong data.
• The Management of most Insurance
companies overlook this issue in their
yearly MDAs.
11
STAT VS. GAAP (IFRS)
• From the point of view of shareholders and
the investors in general, all financial
statements, including those of insurance
companies should adopt GAAP.
• However, the commissioner would prefer a
more conservative accounting policy, in
order to ascertain the financial strength of
the insurance companies.
12
The Key Question
• Are the reported estimates of the
outstanding claims in the liability lines
accurate enough to allow a yearly profit
recognition?
13
Motivation for this Research
• The FY 2004 was the first year in which data on
the run-off of claims in previous years, and data
of the accumulation of insurance profit in the
Loss Reserve were partially disclosed.
• That data enables us to learn about the level of
accuracy of estimates of Loss Reserves in the
underwriting years 2004 and 2005 in the Motor
Act line (using 2006 data).
14
The Data
The data included:
• The “Big 5” insurance groups (which
generate about 68% of the premiums in
P&C insurance in Israel).
• The 4 next medium-size companies.
As demonstrated on tables 1&2, these 9
companies represent more than 90% of
the P&C market in Israel.
15
The Data (Cont.)
• The financial statements of these 9
companies include data about the run-off
of the claims in the Motor Act and in the
third party liability lines, starting in the
underwriting year of 2001.
• Since the financial statements of I.D.L (the
9th company in Israel) have been restated,
we have omitted it from most of our
calculations.
16
Methodology
• We have compared the loss reserve estimates that were
recorded in the financial statements of the FY 2004 to
the discounted estimates of the loss reserve (for the
same underwriting years) that were recorded in the
financial statements of the years 2005 and 2006.
• For each of the 8 companies, and for each year (2005,
2006), we have estimated a specific company’s discount
rate reflecting the company’s average rate of return on
the investments of the P&C reserves.
(Note that the data of the sums accumulated in loss
reserve is disclosed only on the MDA and not directly in
the financial statements).
17
Methodology (Cont.)
• An added result of the research is an ability to
compare the rate of claims’ payments between
the Motor Act line and the third party liability line.
• This comparison enables us to examine whether
the No-Fault regime in the Motor Act insurance
does actually result in shortening the gap
between the end of the underwriting year and
the actual date of payment of claims.
18
Main Results (Tables 3&4)
• The loss reserves estimates in the Motor Act
Line recorded in the financial statements of the
FY 2005 and 2006 were overstated.
(This data may indicate an unexpected
improvement in the insurance profitability of this
line).
• There is a substantial variance among the
insurance companies in the level of the accuracy
of the loss reserve estimations.
19
Main Results (Cont.)
• This variance among the insurance companies
may be explained by differences in the actuarial
work. It may also indicate that some companies
use loss reserve estimations as a tool for
“smoothing earnings”.
Noteworthy, Gaver and Paterson (JAE 2004)
reported that insurance firms manage loss
reserves to avoid violating the IRIS ratios.
20
Main Results (Cont.)
• There is no sufficient data to make an
estimate of the level of accuracy of the
claims reserve in the other liability lines
(including third party liability insurance).
• However, as demonstrated on Table 5a
and 5b there is a material underestimation
(of 9.12% and 6.37% ) in the reserve for
third party liability insurance included in
the FY 2004 and 2005 balance sheets.
21
Main Results (Cont.)
• This underestimation is partially explained
by a change in the legal status of
outstanding claims, caused by a
revolutionary judicial decision, concerning
the claims for loss of future income of
accident’s victims.
22
Does the Motor Act shorten the Length of
time of the Legal Process Related to Claims’
settlement?
• Comparison of the length of time it takes
to settle a claim in the third party liability
line to the length of time in the Motor Act
line, shows unequivocally that in the Motor
Act line the rate of payment is faster.
(66% of total claims reserve for the
underwriting year 2001 was already
settled by the end of FY 2006, as against
only 48% in the Third Party Liability Line).
23
Does the Motor Act shorten the Length of
time of the Legal Process Related to Claims’
settlement (Cont.)
• One explanation is that under the Motor
Act No-Fault regime, there are
“institutional” agreements with hospitals,
and down-payments settlements to the
victims, which fasten the claim settlement
(before the final judicial decision is made).
24
Conclusion
• The accounting profession has adopted the
principle of “Fair Value”.
• IFRS 4, “Insurance Contracts”, exempts an
insurer temporarily (during phase 1 of this
project) from some requirements of other IFRSs.
• However, it will not be possible to continue in the
future (under IFRS 4 phase 2) with the
accounting policy of the deferment of insurance
profit for a period of 3 years.
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Conclusion (Cont.)
• It is our conclusion that there was no
justification, from accounting point of view, to the
delay in the recognition of the profit generated in
the underwriting years of 2001 and 2002.
• The Commissioner should adopt alternative
means for ascertaining the financial strength of
insurance companies.
• A better fair disclosure in the financial
statements of Israeli insurance companies,
which will enable analysts (among others), to
measure the Loss Ratio in every line of P&C
Insurance is called for.
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