An insurer collects premiums today for losses that will be reported and paid later. Reserves are the estimated liability for those future payments, and their accuracy determines whether reported profit is real.
Two kinds of unpaid claim exist
Case reserves are estimates for claims already reported, set by adjusters based on the specific facts. Each open file carries its own number, revised as information arrives.
A second reserve covers losses that have occurred but not yet been reported to the insurer. Nobody knows the individual claims, so the amount is estimated statistically from past patterns.
Together they form the loss reserve, typically the largest liability on a property and casualty insurer's balance sheet.
Estimation relies on development patterns
Actuaries examine how claims from earlier periods evolved from initial estimate to final payment, building patterns for how reported amounts develop over time.
Those patterns are applied to current periods to project ultimate losses. Lines that settle quickly, such as automobile physical damage, develop over months; liability lines can take many years.
Long-tail lines are therefore where estimation error accumulates, because more time passes before actual outcomes replace assumptions.
Reserve changes flow straight through earnings
If actual claim costs exceed prior estimates, the insurer strengthens reserves, recording an expense in the current period for losses from earlier ones.
If prior estimates proved too high, releasing reserves adds to current earnings. Both movements are reported and are scrutinized by analysts as an indicator of estimation discipline.
Repeated strengthening suggests optimistic assumptions; persistent releases suggest conservative ones. Neither pattern is neutral information about the company.
Inflation reaches reserves through claim costs
Reserves are estimates of future payments, so rising costs for vehicle repair, construction materials or medical care raise the ultimate amount owed on claims already incurred.
Social inflation, the term used for rising settlement and jury award severity in liability lines, has a similar effect and is harder to project from historical patterns.
Both explain why an insurer can be surprised by the cost of business it wrote years earlier.
Regulators supervise reserve adequacy
State insurance regulators require annual statements including a qualified actuary's opinion that reserves are reasonable. Solvency oversight is built around that certification.
Capital requirements scale with the risks an insurer carries, including reserve risk, so an insurer with volatile long-tail exposure must hold more capital against it.
The system exists because the product is a promise to pay later, and supervision of the estimate is the only way to test the promise before it comes due.