Property/casualty insurers and reinsurers have released redundant liability reserves into their earnings for the past eight years as a result of favorable loss development. This practice has worked well to compensate for low investment yields and soft market prices.

But have carriers gone too far, now entering a new “danger phase” when reserves are being released faster than accident year experience would dictate?

David Flandro, JLT Re’s global head of Analytics, and Ed Hochberg, JLT Re’s CEO North America, cautioned that reserving problems are looming.

JLT Re conducted an empirical analysis of reserve development since 1998 for the top 30 global insurance and reinsurance companies, which revealed they have released the lion’s share of redundant reserves built up between 2003 and 2007.

Flandro and Hochberg met with reporters at this week’s reinsurance Rendez-Vous de Septembre in Monaco to discuss the results of their analysis in a new JLT Re report titled “Enough in Reserve?”

The problem with reserving, is that it’s an inexact science as “it relies on human judgment to estimate claims that are likely to be paid out in [the] future,” said the report.

JLT Re’s report said deficient reserves arguably have been “the biggest catastrophes ever to have pummeled the [insurance and reinsurance] sector.”

“In fact, it was the liability crisis of 2001-2005 which most recently came closest to pushing the insurance sector over the brink,” the report said, noting that deficient loss reserves from soft market pricing was the primary cause of P/C insurer impairments between 1969 and 2014.

Flandro said reserving is the sector’s biggest liability. Putting the numbers in context, Flandro noted that Hurricane Katrina in inflation adjusted dollars probably cost the insurance and reinsurance sectors around $55 billion to $60 billion, while the liability crisis cost just the insurance sector around $300 billion.

“In one quarter in 2003, 6 percent of the sector’s entire capital was wiped out by reserve moments and we had several quarters like that,” Flandro told reporters during a press briefing. As the size of the insurance sector is in the trillions of dollars, 6 percent equates to hundreds of billions, he affirmed.

When companies start to realize that, rather than being over-capitalized, they are actually facing reserve deficiencies, that is when the market starts to change, he indicated.

When reserves “go upside down,” it frightens boards of directors, management teams and rating agencies because nobody really knows where the reserving bottom is, said Hochberg. “If you strengthen reserves, the next question is, did you strengthen them enough?”

The situation in today’s market “is eerily similar to, if less pronounced, than the comparable phase of 1998 to 2000, with the sector coming off several years of favorable underwriting results and low loss inflation and frequency,” the JLT Re report said.

“Our analysis shows calendar year reserve movements by quarter have generally been slow to respond to cyclical trends. For example, carriers, on average, released reserves for eight consecutive quarters in 1999 and 2000 even though accident years 1998 and 1999 were, by 2000 developing unfavorably,” said Flandro in a statement accompanying the release of the report.

“The sector experienced an extreme ‘danger phase’ during the late 1990s and the result was a period of strengthening in the early 2000s,” he added.

“Our research shows that this ongoing lack of alignment between market cycles and reserving patterns could create a new danger phase as carriers are continuing to release large amounts of reserves even though accident year experience indicates that redundancies are fast diminishing.”

Product Possibilities

Given that reserve inadequacies could lead to capital exiting the market and a tightening of prices, Flandro and Hochberg recommended that now is the time for insurers to buy adverse development cover or loss portfolio transfers.

“We’re not saying we’re going to have another liability crisis like we did in the late 1990s, early 2000s, but we are saying that the level of redundancies is diminishing in the sector,” said Flandro.

“We learned last time around that it was so much more efficient to buy cover before the cycle turns,” he added. “If you buy cover before the reserving cycle turns, you will be able to optimize your balance sheet much better than you would if you were to try to do so after the cycle turns.”