Basics of Loss Development Triangles

Wooden orange and blue triangles

John M. Foehl | April 25, 2024 |

Wooden orange and blue triangles

Congratulations on your appointment to the board of a captive insurance company or a risk retention group (RRG). While you may be an expert in your field, serving on an insurance board requires you to uphold fiduciary responsibilities for financial stability. This article, the second in our series (see the first: "Key Concepts for New Captive Board Members"), aims to demystify loss development triangles and "Schedule P" reserves.

Understanding financial basics is just the beginning; continuous learning is crucial. This article assumes your captive or RRG is operational, not just in formation. Future articles will delve into feasibility study essentials.

In our first article, we explored understanding the actuarial opinion statement. Loss development triangles are central to this process. If you're new to captive boards, understanding these triangles might be unfamiliar. They can be complex, even for industry professionals, yet crucial for gauging your captive insurance company's performance.

You'll want to know if your captive files a full or modified National Association of Insurance Commissioners (NAIC) annual statement, especially Schedule P, which comprises loss development triangles.

Loss development triangles are a tool created by actuaries to monitor changes in both known and unknown claims over time. In insurance, unlike many other industries, the cost of the product—losses from claims—isn't known when pricing is set. Insurance policies typically cover losses over a specific period, often annually, though this can vary. For some types of insurance, injuries or damages might occur during the policy period but not be reported until later. This reporting delay varies based on the policy's coverage type. Terms like "short-tail" and "long-tail" describe how quickly a claim is reported and settled.

Property claims are considered "short-tail" because they are typically reported promptly. For example, if your business's building catches fire, you immediately inform the insurance company. In contrast, liability and workers compensation claims are categorized as "long-tail" because they may take time before being reported to the captive insurance company. Incurred losses that the insurer lacks information on are termed "incurred but not reported" (IBNR) losses.

Whether a loss is short-tail (like property) or long-tail (such as liability or workers compensation), the estimated payout for settling the claim is likely to evolve over time. For instance, consider a car accident where no injuries occur, but your vehicle sustains significant damage. You promptly report this to your insurance company, which assesses the initial damage and sets an opening reserve based on that estimate. However, upon inspection at the body shop, more extensive damage to the frame or components is discovered. This increases the settlement cost, illustrating how losses can evolve or "develop" over time.

While we provided a straightforward example, the estimates for liability and workers compensation claims evolve over time as new information emerges. Loss development triangles organize and track these changes. Typically evaluated annually, these triangles are based on either the policy or accident year. Below is an example of a loss development triangle.

 Loss Development Triangles 2-20-17

Organizing the data in this manner allows for clear visualization of how estimated losses evolve over time. Losses typically change for two main reasons. First, as previously mentioned, some losses from a specific accident year may not be reported until later, termed as IBNR (Incurred But Not Reported) losses. Second, case reserves, the amounts established by claims examiners for the captive insurer, need adjustment as more information about the claim emerges. Additionally, claims believed to be settled or closed may require reopening due to unexpected developments.

Schedule P includes triangles for paid, incurred, and IBNR losses. These triangles offer insights into claim trends. For instance, the triangle might show declining annual reported losses, prompting questions about risk control, underwriting, or claims management changes.

Understanding loss development triangles equips board members to assess their captive's financial health more comprehensively. It empowers you to ask strategic questions about pricing, claims, and loss reserves—key concepts for effective governance.

John M. Foehl | April 25, 2024