Outstanding claims

What Is Outstanding Claims?

Outstanding claims, also known as claims reserves or loss reserves, represent the estimated amount of money an insurance company expects to pay out for claims that have been incurred but not yet settled or paid. These are crucial components within insurance accounting, a specialized field of accounting that governs how insurance companies record their financial transactions. This figure serves as a significant liability on an insurer's balance sheet, reflecting its future obligations to policyholders. The accurate estimation of outstanding claims is vital for an insurer's financial stability and regulatory compliance.

History and Origin

The concept of reserving for future claims has evolved alongside the modern insurance industry itself. As early insurance systems emerged in the 17th century, particularly with the growth of marine and fire insurance, insurers began to recognize the necessity of setting aside funds for claims that were reported but not yet paid, or even those that had occurred but not yet been reported. This practice became more formalized with the development of sophisticated financial reporting and the emergence of actuarial science in the 18th and 19th centuries. Actuaries played an increasing role in developing statistical methods to predict future losses. The professionalization of claims adjustment and the need for consistent financial practices further drove the refinement of estimating outstanding claims.⁸

Key Takeaways

• Outstanding claims are an insurer's estimated future payout obligations for incurred but unsettled claims.
• They are a significant liability on an insurance company's balance sheet.
• Accurate estimation is crucial for financial solvency and regulatory compliance.
• The calculation involves sophisticated actuarial methods due to inherent uncertainties.
• Outstanding claims directly impact an insurer's profitability and capital adequacy.

Formula and Calculation

While there isn't a single, universal "formula" for outstanding claims, their estimation typically involves complex actuarial methodologies that analyze historical claims data, payment patterns, and various other factors. One commonly used approach is the Chain Ladder Method, which projects future payments based on past development factors. The estimation of outstanding claims is often broken down into two main components:

1. Reported But Not Settled (RBNS) Claims: Claims that have been reported to the insurer but have not yet been fully paid or closed.
2. Incurred But Not Reported (IBNR) Claims: Claims that have occurred but have not yet been reported to the insurer.

The general concept can be summarized as:

Actuaries analyze "run-off triangles" which track how claims from different accident years develop and settle over time. These triangles help determine "development factors" to project future payments. The estimation process considers the expected future payments, taking into account factors like the average duration of claim settlement and the expected ultimate loss ratio for a given line of business. The initial premiums collected form the base from which these future obligations must be met.

Interpreting the Outstanding Claims

Interpreting the figure for outstanding claims requires an understanding of its implications for an insurer's financial health. A higher-than-expected amount of outstanding claims can indicate a number of issues, such as an increase in claim severity, a slowdown in the claims settlement process, or a miscalculation in initial reserving. Conversely, an overly conservative estimate might tie up capital unnecessarily, affecting an insurer's ability to take on new underwriting business.

Regulators and analysts scrutinize outstanding claims closely to assess an insurer's solvency. An adequate reserve ensures that the company can meet its obligations to policyholders, even in the face of unexpected events. Insurers strive for an optimal balance, ensuring reserves are neither deficient nor excessive.

Hypothetical Example

Consider "Horizon Auto Insurance," an imaginary company. At the end of its fiscal year, Horizon needs to estimate its outstanding claims.

Let's assume the following:

• Reported But Not Settled (RBNS) Claims: Horizon's claims department reviews all open claims that have been reported. After individual assessments, they estimate that a total of $50 million will be required to settle these claims. These include ongoing lawsuits, claims awaiting final repair estimates, and those pending medical evaluations.
• Incurred But Not Reported (IBNR) Claims: Horizon's actuarial team analyzes historical data. They observe that historically, about 10% of total claims for a given period are typically reported after the accounting period closes but relate to incidents within that period. If total reported claims for the current period amounted to $450 million (excluding the $50 million RBNS), the IBNR estimate would be $450 million * 10% = $45 million.

Therefore, Horizon Auto Insurance's estimated outstanding claims at year-end would be:

This $95 million represents the estimated amount Horizon must set aside to cover future claim payments for incidents that have already occurred. This figure is crucial for Horizon's risk management and financial planning.

Practical Applications

Outstanding claims figures are fundamental in several aspects of the insurance industry:

• Financial Reporting and Compliance: Insurers are legally required to report their outstanding claims to regulatory bodies, such as state insurance departments in the U.S. and the National Association of Insurance Commissioners (NAIC). These figures are a significant part of the NAIC Annual Statement, a detailed financial report.⁷,⁶
• Capital Adequacy Assessment: Regulators use outstanding claims estimates to determine if an insurer holds sufficient capital to meet its future obligations, influencing regulatory capital requirements.
• Pricing Insurance Products: Accurate outstanding claims estimates allow insurers to price new insurance policy products appropriately, ensuring that future cash flow from premiums adequately covers expected losses.
• Reinsurance Decisions: Insurers use outstanding claims data to manage their underwriting risk by determining how much risk to transfer to reinsurers. The collectibility of ceded reinsurance amounts also factors into the overall reserve assessment.⁵
• Performance Evaluation: Analysts and investors assess an insurer's financial performance by evaluating the accuracy of its outstanding claims estimates and any subsequent adjustments.

Limitations and Criticisms

Estimating outstanding claims is inherently challenging and subject to limitations due to the uncertain nature of future events. Critics and challenges in the prediction of insurance reserves are well-documented in academic research.⁴ Key limitations include:

• Estimation Uncertainty: Outstanding claims are estimates, not precise figures. Factors like inflation, changes in legal environments, and evolving medical costs can significantly impact the ultimate payout amount, leading to potential inaccuracies in initial estimates.
• Data Quality and Sufficiency: The accuracy of actuarial models relies heavily on robust historical data. Gaps or inconsistencies in past claims data can lead to skewed projections.
• Methodological Complexity: While methods like the Chain Ladder are widely used, they can be sensitive to assumptions and may not always capture complex claim development patterns, especially for "long-tail" lines of business where claims take many years to settle.
• Regulatory Scrutiny: Actuarial estimates supporting outstanding claims are subject to rigorous review by regulatory bodies and external auditors. The Actuarial Standards Board (ASB) provides guidance to actuaries in forming opinions on these reserves.³,²
• Difference in Accounting Standards: Insurers often maintain reserves based on both Statutory Accounting Principles (SAP) for regulatory reporting and Generally Accepted Accounting Principles (GAAP) for public financial statements. These differing objectives (solvency vs. profitability) can lead to variations in reserve figures and potential confusion.¹

Outstanding Claims vs. Claim History

While both terms relate to past insurance events, outstanding claims and claim history refer to distinct concepts. Outstanding claims specifically represent the unpaid future obligations for claims that have already occurred. It is a forward-looking estimate of funds needed to settle current and future liabilities arising from past events. Conversely, claim history refers to a comprehensive record of all claims previously filed by a policyholder or against a specific property, including those that have already been settled and closed. An insurer's claim history is used to assess past risk behavior and determine future premium rates or eligibility for coverage, whereas outstanding claims are a measure of the insurer's current financial commitment to its policyholders.

FAQs

What happens if an insurer underestimates outstanding claims?

If an insurer underestimates outstanding claims, it may find itself with insufficient funds to pay future claims, which can lead to financial distress, regulatory penalties, and even insolvency. This underestimation would result in a restatement of earnings and a reduction in surplus.

How often are outstanding claims estimates updated?

Insurance companies typically review and update their outstanding claims estimates at least annually, often more frequently (e.g., quarterly), as new information becomes available and claims develop over time. This continuous process ensures the reserves remain as accurate as possible.

Do all types of insurance policies have outstanding claims?

Yes, outstanding claims apply to most forms of insurance, including property and casualty, health, and some life insurance products. Any insurance policy that covers future potential losses for past or ongoing incidents will require an estimation of outstanding claims.

Who is responsible for estimating outstanding claims?

Actuaries are primarily responsible for estimating outstanding claims. They use their specialized knowledge of statistical analysis and financial modeling to project future payouts based on historical data and industry trends.

Can outstanding claims affect an insurance company's stock price?

Yes, significant changes or inaccuracies in an insurance company's outstanding claims can impact its reported earnings and financial strength, which can, in turn, influence investor confidence and the company's stock price.