Reserve Adequacy on a Growing Commercial Auto Line
You are the appointed actuary for a specialty carrier writing commercial auto liability. Written premium grew from $80 million to $140 million over three years, driven by new large-fleet accounts. Reported loss ratios have improved from 72% to 64% over the same period, and management cites this as evidence of underwriting improvement. However, the case reserve adequacy review shows that average case reserves on open claims have fallen from $18,000 to $13,000 while average paid severity has risen 9% annually. The claims department attributes the lower case reserves to faster payments and better triage. Your actuarial team's development factor analysis shows that the three-year average chain-ladder factors are 1.42 for the most recent year, but the most recent two years show factors of 1.55 and 1.61. The CFO is preparing the statutory annual statement and wants to know whether the carried reserves are adequate and how to set the loss reserve opinion.
1. Evaluate whether the improving loss ratio reflects genuine underwriting improvement or a reserving artifact.
Read the worked answer
The evidence points strongly toward a reserving artifact rather than genuine improvement. First, written premium grew 75% in three years, so the book is heavily weighted toward recent accident years with immature development. A lower reported loss ratio in immature years is expected because incurred losses are understated when case reserves are set too low. Second, average case reserves fell 28% while paid severity rose 9% annually, a combination that is internally inconsistent unless the carrier is settling small claims quickly and leaving large claims under-reserved. Third, the chain-ladder factors are rising, from 1.42 to 1.55 to 1.61, which is the classic signature of reserve strengthening emerging in the most recent years. Fourth, faster payments and better triage would reduce the time to payment, not the ultimate cost of large claims. The apparent improvement is likely the result of inadequate case reserves on a growing book, and the true accident-year loss ratios are probably deteriorating, not improving.
2. Recommend how to set the carried reserves and what to disclose in the statement of actuarial opinion.
Read the worked answer
The actuary should not rely on the reported loss ratios or the three-year average development factors. Instead, the analysis should use the most recent and more credible development factors, select 1.55 to 1.61 for the recent accident years, and apply them with judgment rather than mechanical averaging. The actuary should also perform a Bornhuetter-Ferguson or expected-loss-ratio method for the immature years, using an a priori loss ratio based on pricing and exposure rather than on the distorted reported experience. A case reserve adequacy test should compare the $13,000 average case reserve to the expected ultimate severity implied by the 9% trend, which suggests a shortfall. The actuary should quantify the indicated deficiency, recommend strengthening, and document the change. In the statement of actuarial opinion, the actuary should state whether reserves are reasonable in the aggregate, identify the material change in methods or assumptions, and disclose the reserve strengthening and its effect. If management resists the strengthening, the actuary must consider whether a qualified or adverse opinion is warranted and should document the disagreement.