Accrual accounting states that revenues should be recognized when earned, and that expenses should be matched to revenues. Therefore, insurers have to recognize their losses in the same period as they earn their premiums. The tricky part is that insurers often don't pay claims until some future date, requiring them to estimate their losses.
I'm not as think as you drunk I am
Estimating claims losses is kind of like trying to guess how drunk you are after each successive shot of tequila. Because the drunkenness doesn't come until later, you have to make educated guesses based on statistics (such as body weight) and historical experience. Insurers estimate their losses using actuarial estimates and experiences.
If, in the aforementioned situation, you're too conservative, you won't have enough to drink and won't achieve your desired state of intoxication. Similarly, insurers who are overly conservative may allot too much of their capital to reserves and be underleveraged, depressing their investment income.
If you're too aggressive and have too much tequila, then your night may end prematurely due to excessive drunkenness, and you may end up with a hangover, or even alcohol poisoning. Similarly, insurers who are too aggressive with their loss reserves may find that, later on down the road, they have to recognize losses and may even become insolvent.
One thing should be clear: It's better to err on the side of caution. Even if an insurer can get away with aggressive loss reserves in the short term, claims must be paid eventually, and overly aggressive insurers end up paying the piper.
Is you in or is you isn't?
If loss reserves are management estimates, then how do investors get comfortable investing their hard-earned money in an insurance company? Reputation and historical track record are some of the best ways to gauge an insurer's credibility.
If I'm at a golf course with Tiger Woods and my neighbor Billy, and they both tell me they have awesome handicaps, I'd tend to put a little more faith in Tiger. Likewise, some insurance executives have great reputations, mostly due to long track records of conservatively but accurately estimating loss reserves.
As time goes on and claims get paid, loss estimates become much more accurate. Every year, as new information becomes known, the insurer must reestimate historical loss reserves, resulting in a loss adjustment expense (LAE). Overly aggressive insurers, who under-reserve their losses and overstate income, eventually find out their claims are higher than their reserves, and have to make upward loss adjustment expenses.
Insurers report their historical results in cumulative redundancy tables. If loss reserves were too aggressive, then the results show a large deficiency. If they were too conservative, then the results show a large redundancy.
Some insurance companies have demonstrated over many years and underwriting cycles that they have the culture and integrity to adequately and accurately measure loss reserves. Investors would be well-served to stick to management teams that have already proven their mettle. As the famous saying goes, if you don't know the horse, know the jockey. Some insurance companies with rock-solid "jockeys" include Markel, White Mountains, Renaissance Re
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Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates comments, concerns, and complaints. The Motley Fool has a disclosure policy.