SIGMA Spectrum Vol. 1, No. 2

An insurance program analysis includes a calculation of outstanding liabilities for all incurred claims. These liabilities are a key component of the costs associated with funding the program. The outstanding liabilities almost always exceed the reserves found on a loss run. The reserves are an estimate of future payments for each individual claim. The sum of the reserves do not equal outstanding liabilities because this sum excludes the impact of IBNR.

IBNR includes development on known claims as well as a provision for claims that have occurred but not been reported as of a certain evaluation date. An IBNR analysis is typically prepared to meet regulatory or financial reporting criteria and is often required by external auditors as part of the audit process. The analysis is most frequently prepared for a self-insured trust, a captive insurance company, a corporation that uses a loss sensitive cash-flow plan or as part of the due diligence process for mergers/acquisitions or divestitures.

Basic Methodology

The calculation of IBNR includes the following:

Ultimate losses are calculated for each policy period using one or more actuarial techniques.
The estimates from each technique are compared and a selection of ultimate loss is made.
Paid losses and case reserves are subtracted from the estimated ultimate incurred losses to calculate the IBNR.

SIGMA provides actuarial services to government entities, associations, self insureds and commercial insureds in a wide variety of health, retail, service and manufacturing industries.
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For more information, you can also e-mail
Al Rhodes, ACAS, MAAA, president of SIGMA, or contact him at 615-352-3944.

Gathering and Analyzing the Data

An IBNR analysis requires three major steps:

1. Gather the necessary data. Required data includes incurred losses and paid losses summarized by policy period. The losses should be limited to per occurrence and aggregate limitations. A current loss run of all claims has all the information you need to summarize the losses.

2. Adjust the limited losses to an ultimate cost level. The most common technique is to use loss development factors (see "Sources of Loss Development Factors" at right). These factors quantify the late developing aspects of certain losses. They also account for losses that occurred during a period but are not reported until a later date.

The expected ultimate losses for each period are estimated by multiplying the development factors by the reported losses for each period. If you are using both incurred and paid losses, then you will have to select a weighted average of the two estimates of ultimate loss for each period. As shown in the sample below, estimated ultimate incurred losses are defined as the amount needed to provide for the cost of claims relating to events that occurred during each period.

Sources of Loss Development Factors

There are a number of sources of loss development factor data - actuaries, brokers, insurance companies and risk management consultants all gather this information. But the information received from an external source may not be appropriate for every situation. If historical data is available, then calculate unique loss development factors. Unique factors allow for a more accurate reflection of specific loss development patterns. Theoretically, the use of unique factors, as opposed to industry averages, produces a more accurate projection of ultimate incurred losses.

The development factors applied to reported losses are selected based on the time that has passed between the beginning of a loss period and the evaluation date of the loss. In most cases, the closer the evaluation date is to the period effective date, the larger the loss development factor needed. Conversely, as the period matures, the loss development factor approaches 1.000.

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Estimated Required Reserves

	Estimated
	Ultimate	Reported	Estimated
	Incurred	Paid	Required	Case
Period	Losses	Losses	Reserves	Reserves	IBNR

xx	$185,849	$185,849	$0	$0	$0
xx + 1	190,000	146,976	43,024	20,000	23,024
xx + 2	270,000	175,130	94,870	61,000	33,870
xx + 3	300,000	203,060	96,940	44,927	52,013
xx + 4	750,000	342,255	407,745	236,669	171,076
xx + 5	680,000	142,993	537,007	218,059	318,948

Total	$2,375,849	$1,196,263	$1,179,586	$580,655	$598,931

A convenient way to show the impact of IBNR is to show the various components of the
estimated ultimate incurred losses for the insurance program, as illustrated in the above chart.

3. Subtract paid losses from the selected ultimate losses to arrive at the estimated required reserves, which is the amount that will be required for future payments on (1) claims that have been reported and (2) claims that have occurred but have not been reported as of the evaluation date. The estimated required reserves can then be segregated into case reserves and IBNR. Case reserves are calculated as reported losses minus paid losses. IBNR includes development on known claims as well as a provision for claims that have occurred but not been reported as of the evaluation date.

Summary

The key to a credible analysis of IBNR is to gather as much data as possible that is unique to the insurance program. A current loss run allows the calculation of ultimate losses without relying on industry severities and frequencies. Prior yearly evaluation of losses will allow the calculation of unique development factors. An understanding of all per occurrence and aggregate limitations will allow the correct amount of each claim to be included in the calculation.