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Loss Development What it is How it Works

Loss Development What it is How it Works

Loss Development: What it is, How it Works

Ariel Courage is an experienced editor, researcher, and former fact-checker. She has performed editing and fact-checking work for several leading finance publications, including The Motley Fool andPassport to Wall Street.

What Is Loss Development?

Loss development is the difference between the final losses recorded by an insurer and what the insurer originally recorded. It seeks to account for the fact that some insurance claims take a long time to settle, and that estimates of the total loss an insurer will experience will adjust as claims are finalized.

Key Takeaways

  • Loss development is the difference between what an insurer initially records for liabilities versus the final level of claims.
  • A loss 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 development factors in insurance pricing and reserving to adjust claims from their initial estimate to the final amount paid out after a successful claim. Insurers have to consider various factors when determining the potential losses they may face from the insurance policies they underwrite.

One crucial factor is the time it takes to process a claim. While claims may be reported, processed, and closed during a particular policy period, they may also be reported in later policy periods and may not be settled for a long period of time. This can make reporting complicated and, at best, based on an approximation of the insurer’s ultimate loss.

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Reported but not settled (RBNS) losses are those reported to an insurance company but not settled by the end of the policy period. RBNS losses are initially calculated using an estimation of the severity of the loss based on available information. Incurred But Not Reported (IBNR) is another type of reserve used in the insurance industry as a provision for claims and/or events that have transpired but have not yet been reported. In IBNR situations, an actuary will estimate potential damages, and the insurance company may decide to set up reserves to allocate funds for expected losses.

Loss Development Factor

Insurance claims in long-tailed lines, such as liability insurance, are often not paid immediately. Claims adjusters set initial case reserves; however, it is often impossible to accurately predict the final amount of an insurance claim for various reasons. Actuaries, underwriters, and other insurance professionals use loss development factors to "develop" claim amounts to their estimated final value. Ultimate loss amounts are necessary for determining an insurance company’s carried reserves and for setting adequate insurance premiums based on loss experience.

A loss development factor (LDF) is used to adjust losses to account for claim increases. The LDF is a number used to adjust claims to their ultimate projected level. For example, an LDF of 2.0 means that for every $1 in claims, the ultimate payout will be $2. If an insurer had $100,000 in current claims, the ultimate payout would be $200,000 with an LDF of 2.0.

Loss amounts are crucial for pricing insurance premiums and determining carried reserves.

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Requirements for Loss Development

Insurers must report their financial position to state regulators who use these reports to determine the insurer’s financial health or if there is a risk of insolvency. Regulators may use a loss development triangle to compare the percentage change across time periods and make estimates of loss development for a particular insurer in upcoming periods. If the rate of change fluctuates substantially over time, the regulator may contact the insurer to determine why its loss estimates are off.

Insurers must report their financial position to state regulators who use these reports to determine the insurer’s financial health or if there is a risk of insolvency. Regulators may use a loss development triangle to compare the percentage change across time periods and make estimates of loss development for a particular insurer in upcoming periods. If the rate of change fluctuates substantially over time, the regulator may contact the insurer to determine why its loss estimates are off.

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