The Reserve Adequacy Review and Solvency Position
A non-life insurer writes predominantly commercial property and liability business. At year-end its gross outstanding claims reserve is £120 million, of which £45 million relates to liability claims with an average settlement delay of six years. The actuarial team reports that the liability reserves were set three years ago and have not been revalued, and that inflation on bodily injury awards has run at 7% annually. The insurer's solvency capital requirement is £80 million and its eligible own funds are £95 million. The board is considering a dividend of £10 million. The regulator has asked for an explanation of reserve adequacy and the dividend.
1. Assess the adequacy of the liability reserves and the effect on the insurer's solvency position.
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The liability reserves are stale: set three years ago and not revalued, they ignore three years of claims inflation at 7% and any change in settlement patterns. A rough indication: £45 million inflated at 7% for three years is £45m × 1.07³ ≈ £55.1 million, an increase of about £10 million before allowing for new claims and adverse development. The insurer should commission a full actuarial review using incurred-but-not-reported estimates, development factors and discounting assumptions appropriate to a six-year settlement tail.
If the reserve shortfall is around £10 million, own funds fall from £95 million to about £85 million, still above the £80 million requirement but with a thin buffer. The dividend of £10 million would reduce own funds to about £75 million, below the requirement. The board must therefore treat the dividend as conditional on the reserve review. The exam answer should show the arithmetic, explain why long-tail liability reserves are especially sensitive to inflation and discounting, and connect reserve adequacy to solvency capital.
2. Advise the board on the dividend and on what it should tell the regulator.
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The board should not declare the £10 million dividend until the reserve review is complete. On the indicative figures, paying it would take own funds below the solvency capital requirement, which would breach regulatory expectations and could trigger supervisory intervention. The board should either suspend the dividend, reduce it, or make it conditional on the review confirming no shortfall. It should also consider whether the capital requirement itself needs recalculation given the changed reserve position.
The regulator should receive a candid explanation: the reserves are under review, the likely shortfall is around £10 million, the dividend is suspended pending the outcome, and a remediation plan with timescales is in place. Concealing the issue or paying the dividend first would be a serious governance and conduct failure. The model answer should emphasise that reserve adequacy, capital and distributions are linked, that the board must act on actuarial advice rather than hope, and that transparency with the regulator is both a legal and an ethical obligation.