Posted by James Financial Services Inc

How Insurance Companies Calculate their Reserve: Expected Loss Ratio Method

How Insurance Companies Calculate their Reserve: Expected Loss Ratio Method

One of the ways insurance companies estimate their reserve is via the expected loss ratio method. This is a technique they use to estimate the earned premiums. Whenever the insurer does not have the required claims data to make available due to changes in product. Also, when there is not enough data for product lines in long-tail.

Calculating Expected Loss Ratio

In calculating expected loss ratio, one will have to multiply earned premiums and the expected loss ratio together. From the result, one will subtract paid losses.

Implications of the Expected Loss Ratio Method 

A part of the premiums that will be set aside from underwriting policies will help pay for future claims. This loss ratio helps determine what they will set aside. Also, it is critical to note that how solid the claim is plays a vital role. There are forecasting methods that help determine claims reserve.

In some cases, like the line of business, the expected loss ratio method is the major way to estimate the appropriate level of loss reserves that they need. Another use of the expected loss ratio approach is to classify the loss reserve for specific business lines and policy periods. 

You can estimate the ultimate loss which could be paid or incurred by multiplying the earned premium figure by the expected loss ratio. There are, however, some businesses in which the regulations determine the maximum level of loss reserves they need. 

Using Expected Loss Ratio: An example 

Another use for the expected loss ratio is to calculate the total reserve and incurred but not reported reserve (IBNR). The expected loss ratio is a ratio of ultimate loss to the earned premiums. We calculate the ultimate loss by multiplying the expected loss ratio by the earned premium. You can get the total reserve by removing the ultimate loss minus paid losses. 

The incurred but not reported reserve (IBNR) is the total reserve minus the allowed cash reserve. The following example sheds light on the concept. 

For example, let us assume there is an insurer with premiums amounting to $15,000,000. She also has a loss ratio of 0.65. over the year, there is a loss of $650,000 with cash reserves of $950,000. 

The total reserves for the insurer would be $9,100,000 ($15,000,000 * 0.65 - $650,000). Also, the value of the incurred but not reported reserve (IBNR) would be $8,150,000 ($9,100,000 - $950,000)

Chain Ladder Method and Expected Loss Ratio Approach

In estimating claim reserves, both the expected loss ratio approach and chain ladder method can be used. The Chain ladder approach uses previous data to predict future occurrence. The expected loss ratio on the other hand comes in handy in the shortage of past data. 

Many lines of businesses find the expected loss ratio approach helpful

Limitations of the Expected Loss Ratio Approach 

The forecasting methods alongside the actuarial models determine the amount of claims reserves that an insurer can put aside. Also, the amount and quality of data available provides the perfect ground to use the expected loss ratio approach. 

It comes in handy in the early days of forecasting since actual paid losses are excluded. In the latter part, however, the absence of responsiveness to changes makes it less accurate to change which serves as a major limitation.



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