Legacy Liabilities and Modeling

By Steve Streff
Streff Insurance Services

Most insurance companies carry reserves for lines or coverages that have been inactive for many years. Sometimes these reserves relate to old assumed reinsurance treaties. Other times they’re for coverages that were not excluded in policy language because no one imagined that such risks were insurable. Asbestos liabilities have gained new life in recent years and are one of the few dark clouds over a healthy insurance industry.

Legacy liabilities are notoriously difficult to quantify. They test the full range of an actuary’s reserving skills. Schedule P offers little help, as the prior-year line consolidates the reserve and payment development for all years beyond ten years. Record keeping on old claims can be dicey. A 1964 policy and subsequent claim written by a subsidiary company acquired three mergers ago, probably got lost in the shuffle.

Although it may be difficult to evaluate old reserves, creative methods can help quantify and corral the most stubborn liabilities. Here are three tools for legacy liabilities arranged from least to most effective.

Survival Rate Method

Asbestos and environmental reserves are often evaluated with survival rates, which estimate the number of years until a company’s carried reserves will be exhausted. If an insurer averages annual payments of $2 million and is carrying reserves of $30 million, its survival rate is 15 years. That number by itself doesn’t mean much, until you compare it to industry standards. A survival rate of five years would be considered weak and could raise a red flag. This method is over-simplistic.

Standard Projection Methods

Legacy liabilities earned their reputation by defying traditional actuarial methods. The typical “data triangles” that work so well for property and medium-tail lines such as homeowners and auto liability, break down when one tries to quantify the impact of new coverage classes and the whims of the legal system. These reserves tend to ebb and flow with economic and tort cycles. Standard projection methods can’t handle the environment well.

Simulation Modeling

Recent years have seen advances in the use of modeling for sticky reserve situations. Modeling gives the analyst the flexibility to incorporate and adjust a wide variety of assumptions and inputs. Simulation software can compile virtually all possible outcomes and create a range of possibilities around an expected value.

For example, last year, my company helped a client estimate its legacy liabilities. The company was beset by an initial wave of claims for a coverage that was later specifically excluded from such policies. These liabilities seemed to be headed for closure until a group of lawyers roused up a new batch of willing plaintiffs and a fresh wave of claims was upon the company.

Our model used simulation techniques built around frequency and severity curves. While the client booked reserves just slightly above our midpoint, the upper end of the range helped establish a “worst case scenario.” Going forward, we can monitor the key assumptions and update the model as needed.

About the Author: Streff Insurance Services is located in Red Wing, Minn., and can be visited online at www.streffinsurance.com. E-mail Steve Streff at steve@streffinsurance.com. Reprinted with permission from Focus, Spring 2006.

Posted: Friday, May 19, 2006 12:00:00 AM. Modified: Friday, May 19, 2006 3:32:43 PM.

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