A Mediator’s Guide to Claims Reserves in the Insurance Industry
Mediators may encounter a reluctance to settle by one or both parties during the course of a mediation session, but understanding the underlying realities of each party’s position may help break logjams. All stakeholders must understand all the factors that might pose either an opportunity for or an impediment to settlement.
Plaintiffs may overestimate the value of their claims and/or the defendants’ liability exposure. Correspondingly, defendants may undervalue the claim and/or their exposure. Due to many courts being closed during the pandemic, plaintiffs and defendants alike may believe that it will take years for their case to reach a jury. The backlog of criminal cases, along with the substantial backlog of civil cases already set for trial but continued for the past year or more, is compelling evidence that civil jury trials may be significantly delayed. Plaintiffs’ counsel may believe that defendants want to delay, and the pandemic is serving to facilitate this obstruction to settlement.
To understand this mindset, it is important for the neutral, and for counsel as well, to ascertain what can facilitate settlement. One example is the function of reserve accounts on the claims side of liability insurance. Broadly speaking, liability insurance provides protection against claims resulting from injuries and damage to people and/or property. It also covers legal costs and payouts for which the insured party is liable. Among the various types of liability insurance, general liability insurance helps cover costly claims that can arise during normal business operations.
An example of a costly claim is third-party bodily injury: If a customer gets hurt after slipping and falling in a store, he or she can sue the business. An insurance policy generally includes bodily injury liability coverage to help pay for medical bills. Third-party property damage coverage may help cover repair or replacement costs if a business damages someone else’s chattel/personal property. Similarly, in the motor vehicle accident context, liability coverage may cover the cost of bodily injury and/or property damage that an insured causes to others when the insured is at fault. Uninsured and underinsured motorist coverage provides first-party coverage to the insured for bodily injury as well. In any case, insurance carriers are required to maintain a reserve of money, often called a “claims reserve,” to account for claims asserted against their insureds.
Generally, a claims reserve is money that is set aside for the future payment of incurred claims that have not yet been settled. These requirements apply to first- and third-party claims. A claims reserve is earmarked for policyholders who have filed or are expected to file legitimate claims on their policies; this includes third-party claims made against insureds that fall within the various policy coverages. Typically, insurance companies process claims that are filed against the policies that they sell. For example, an auto insurance policyholder who has an accident will usually file a claim with his or her insurance provider to pay for any damage to his or her car. Some claims, such as property losses due to fire, may be easily estimated and quickly settled. Others, such as product liability claims, complex automobile accident claims or construction defect claims, may be settled long after the policy has expired.
Here are some facts about claims reserves:
- An outstanding claims reserve is an actuarial estimate because the amount liable on any given claim is not known until settlement or final judgment.
- A claims reserve is generated from a portion of a policyholder’s premium payments over the course of the insurance contract.
- Any outstanding claims reserve is recorded as a liability on a company’s balance sheet.
A balance sheet reserve is a liability. Upon entering an insurance contract with a customer, an insurance company accepts any liability in the event that an adverse occurrence damages the item that is insured. Accepting liability means making a payment to the insured person when he or she files a legitimate first-party claim (e.g., an auto insurance policyholder’s claim for medical coverage after an accident or a homeowner’s claim for damage caused by a covered loss) or paying a settlement in a third-party case, such as an injured driver seeking to recover for damages caused by an auto accident.
As stated previously, a claims reserve is money set aside by the insurer for a claim that has been reported but not yet settled or incurred but not reported. An insurance company will assign a claims reserve to each file that fits one of those descriptions, reflecting its best estimate of the eventual settlement amount. The claims adjuster is responsible for estimating the payable amount. Defense counsel often assist in evaluating the case; as discovery progresses, the case’s value may be adjusted, along with the reserve. The monetary amount of the claims reserve can be calculated subjectively, using the claims handler's judgment, or statistically, by evaluating past data to project future losses. Actuarial estimates of the amounts that will be paid on outstanding claims must be evaluated so that the insurer can calculate its profits.
Again, an outstanding claims reserve is an accounting provision that is recorded as a liability on a company’s balance sheet. It is classified as a liability because it must be settled at a future date (e.g., settlement or final judgment). In other words, it is a potential financial obligation. Insurance companies have to be prudent not to over-reserve. This can have an adverse impact on a company's profitability, as it then will have fewer resources available to deploy on investments. Conversely, under-reserving can free up more funds with which to invest. However, regulators monitor insurance companies' reserves to ensure that they are adequate. Carriers have an incentive to get those liabilities off their balance sheets and free up these monies for other, more lucrative purposes. The mediator, as well as counsel, can use that incentive to push for settlement, even when there is a perceived countervailing incentive to delay resolution of a claim.
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