Under-reserving
Insufficient estimate of the amounts an insurer will have to pay for events that have already occurred, which blinds it to its own position; it is the leading cause of US property and casualty insurer failures in AM Best's studies.
HIH, Australia's second-largest non-life insurer, collapsed in March 2001, and the royal commission that investigated until 2003 found inadequate reserves first. Under-reserving is the mechanism by which an insurer blinds itself to its own position. An insufficient reserve overstates the result and pays out profits that do not exist. It also overstates own funds, and so the apparent underwriting capacity. Above all, it distorts the claims experience on which the following year's rates are set: under-pricing and under-reserving then validate each other in a closed loop. The drift is slow, and each estimate stays within the defensible range. Accumulated over a decade, it opens a considerable shortfall that is recognized all at once, most often on a change of management or an external review.
A board spots the drift by asking how the estimates on earlier generations have moved since they were set. The year's reserve, taken alone, stays defensible.
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