An important feature that distinguishes insurance from other sectors of the economy is the timing of the exchange of considerations. In manufacturing, payments for goods are typically made at the time of a transaction. In contrast, for insurance, money received from a customer occurs in advance of benefits or services; these are rendered at a later date. This leads to the need to hold a reservoir of wealth to meet future obligations in respect to obligations made. The size of this reservoir of wealth, and the importance of ensuring its adequacy in regard to liabilities already assumed, is a major concern for the insurance industry.
Setting aside money for unpaid claims is known as loss reserving; in some jurisdictions, reserves are also known as technical provisions. We saw in Figure 1.1 how future obligations arise naturally at a specific (valuation) date; a company must estimate these outstanding liabilities when determining its financial strength. Accurately determining loss reserves is important to insurers for many reasons.
- Loss reserves represent a loan that the insurer owes its customers. Under-reserving may result in a failure to meet claim liabilities. Conversely, an insurer with excessive reserves may present a weaker financial position than it truly has and lose market share.
- Reserves provide an estimate for the unpaid cost of insurance that can be used for pricing contracts.
- Loss reserving is required by laws and regulations. The public has a strong interest in the financial strength of insurers.
- In addition to the insurance company management and regulators, other stakeholders such as investors and customers make decisions that depend on company loss reserves.
Loss reserving is a topic where there are substantive differences between life and general (also known as property and casualty, or non-life), insurance. In life insurance, the severity (amount of loss) is often not a source of concern as payouts are specified in the contract. The frequency, driven by mortality of the insured, is a concern. However, because of the length of time for settlement of life insurance contracts, the time value of money uncertainty as measured from issue to date of death can dominate frequency concerns. For example, for an insured who purchases a life contract at age 20, it would not be unusual for the contract to still be open in 60 years time. See, for example, Bowers et al. (1986) or Dickson et al. (1986), for introductions to reserving for life insurance.