What is loss development?
The evolution of losses is the difference between the final losses recorded by an insurer and what the insurer initially recorded. The evolution of losses aims to take into account the fact that some insurance claims take a long time to settle and that the estimates of the total loss that an insurer will suffer will adjust as the claims are finalized.
Key points to remember
- The evolution of losses is the difference between what the insurer initially records for liabilities compared to the final level of claims.
- A claims development factor allows insurers to adjust claims to their projected final levels.
- One of the most important factors for insurers when determining potential losses is the time it will take to process a claim.
How Loss Development Works
Insurance companies use loss evolution factors in pricing and reserves to adjust claims to their final expected level. Insurers must take a number of factors into account when determining, if any, the losses they may incur as a result of the insurance policies they purchase.
One of the most important factors is the time it takes to process a claim. Although claims can be reported, processed and closed during a given insurance period, they can also be reported during subsequent insurance periods and may not be settled for a long time. This can make reporting complicated and at best based on an approximation of the loss that the insurer will ultimately suffer.
Insurance claims in long tail lines, such as liability insurance, are often not paid immediately. Insurance adjusters establish initial reserves for claims; however, it is often impossible to accurately predict the final amount of an insurance claim for various reasons. Claims development factors are used by actuaries, underwriters and other insurance professionals to “develop” claim amounts to their estimated final value. The ultimate loss amounts are necessary to determine the deferred reserves of an insurance company. They are also useful in determining the appropriate insurance premiums, when loss experience is used as a rating factor.
Loss development factor
A loss development factor (FDL) is used to adjust losses to account for the increase in claims. The FDL is a number which aims to adjust the complaints to their ultimate projected level. For example, an LDF of 2.0 means that for every dollar of claim, the final payment will be $ 2. If an insurer had $ 100,000 in outstanding claims, the final payment would be $ 200,000 with an FDL of 2.0.
Loss amounts are essential for pricing insurance premiums and determining deferred reserves.
Loss development requirements
Insurers use a loss trend triangle when assessing loss trends. The triangle compares the evolution of losses for a specific insurance period over a long period. For example, an insurer can examine the evolution of losses for the 2020 insurance period at twelve-month intervals over a five-year period. This means that it will examine the evolution of losses from 2020 to 2020, 2019, 2020, 2021 and 2022.
Insurers are required to report their financial condition to state regulatory authorities who use these reports to determine whether an insurer is in good financial health or if there is a risk of insolvency. Regulators can use a claims development triangle to compare the percentage change from one period to the next and use that percentage when making estimates of their claims experience for a particular insurer in future periods . If the rate of change fluctuates considerably over time, the regulator can contact the insurer to find out why its claims estimates are irrelevant.