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To hold, or not to hold (a reserve margin):
that is the question

Our viewpoint

Of many Warren Buffet’s wise sayings, my favourite is ‘Only when the tide goes out do you discover who's been swimming naked’.

Whether an insurer chooses to hold an explicit margin in their reserves is determined by their risk appetite and how averse to under-reserving they are.

Some carriers choose to reserve at the ‘best estimate’ level but this means that reserves will be inadequate about half of the time.

For some companies that may be fine, but many others choose to have an explicit margin on top of the best estimate reserves.

In practice even a best estimate will include some margin - ask any actuary if their ‘best estimate’ is a TRUE best estimate and watch them squirm uncomfortably!

Which stakeholders are interested in the level of margin held within the reserves?

Ideally, from an auditor’s point of view, any margin should be clearly justified and quantified for each individual issue or uncertainty the margin is held for, to dispel any notion that results are being ‘smoothed’ from year to year. 

As issues resolve themselves, they would expect the margin held for that issue to be released, perhaps to be replaced by a new uncertainty and corresponding margin.

Pricing actuaries will need to compare notes closely with their reserving colleagues as pricing on a prudent reserving loss ratio could lead to losing business due to a lack of competitiveness.

Shareholders and policyholders both gain comfort from margins within the reserves as protection against rainy days.

Generally regulators are also happy to see margins within reserves as they afford policyholders more protection.

Also, Solvency II regulations will drive the transparency over margins within the booked reserves as they need to be stripped out for Technical Provisions.

HMRC will also have an interest in the level of margin in the reserves and require an opinion which states the reserves are ‘not excessive’ but without quantifying what this means.

They will want to be convinced that tax receipts are not being delayed by excessive over-reserving.

Is the cupboard bare?

The insurance market has been soft for a number of years with increasing pressure on profitability from both reducing underwriting margins and increasing costs.

It is clear that, for some at least, releases from margins within reserves have been used to relieve some of the pressure on the bottom line.

But for how much longer can this continue? At what point do we say the cupboard is bare? Last year, one of the regular ‘Dear CEO’ letters from the PRA highlighted their observation that reserve releases were at their highest for 30 years.

Conclusion

So although best estimate reserving is perfectly acceptable, holding a reserve margin affords more protection against adverse deterioration in claims.

One thing is for sure, those with healthy reserve margins are less likely to be embarrassed when the tide goes out.

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