Mercury Insurance 2015 Annual Report Download - page 45

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C. Critical Accounting Policies and Estimates
Losses and loss adjustment expenses reserves ("loss reserves")
Preparation of the Company’s consolidated financial statements requires management’s judgment and estimates. The most
significant is the estimate of loss reserves. Estimating loss reserves is a difficult process as many factors can ultimately affect the
final settlement of a claim and, therefore, the loss reserve that is required. A key assumption in estimating loss reserves is the
degree to which the historical data used to analyze reserves will be predictive of ultimate claim costs on incurred claims. Changes
in the regulatory and legal environments, results of litigation, medical costs, the cost of repair materials, and labor rates, among
other factors, can impact this assumption. In addition, time can be a critical part of reserving determinations since the longer the
span between the incidence of a loss and the payment or settlement of a claim, the more variable the ultimate settlement amount
could be. Accordingly, short-tail liability claims, such as property damage claims, tend to be more reasonably predictable than
long-tail liability claims.
The Company calculates a loss reserve point estimate rather than a range. There is inherent uncertainty with estimates and
this is particularly true with loss reserve estimates. This uncertainty comes from many factors which may include changes in claims
reporting and settlement patterns, changes in the regulatory and legal environments, uncertainty over inflation rates, and uncertainty
for unknown items. The Company does not make specific provisions for these uncertainties, rather it considers them in establishing
its loss reserve by looking at historical patterns and trends and projecting these out to current loss reserves. The underlying factors
and assumptions that serve as the basis for preparing the loss reserve estimate include paid and incurred loss development factors,
expected average costs per claim, inflation trends, expected loss ratios, industry data, and other relevant information.
The Company also engages independent actuarial consultants to review the Company’s loss reserves and to provide the
annual actuarial opinions required under state statutory accounting requirements. The Company analyzes loss reserves quarterly
primarily using the incurred loss, paid loss, claim count development, and average severity methods described below. When
deciding among methods to use, the Company evaluates the credibility of each method based on the maturity of the data available
and the claims settlement practices for each particular line of insurance business or coverage within a line of insurance business.
The Company may also evaluate qualitative factors such as known changes in laws or legal rulings that could affect claims handling
or other external environmental factors or internal factors that could affect the settlement of claims. When establishing the loss
reserve, the Company will generally analyze the results from all of the methods used rather than relying on a single method. While
these methods are designed to determine the ultimate losses on claims under the Company’s policies, there is inherent uncertainty
in all actuarial models since they use historical data to project outcomes. The Company believes that the techniques it uses provide
a reasonable basis in estimating loss reserves.
• The incurred loss development method analyzes historical incurred case loss (case reserves plus paid losses)
development to estimate ultimate losses. The Company applies development factors against current case incurred losses
by accident period to calculate ultimate expected losses. The Company believes that the incurred loss development
method provides a reasonable basis for evaluating ultimate losses, particularly in the Company’s larger, more established
lines of insurance business which have a long operating history.
• The average severity method analyzes historical loss payments and/or incurred losses divided by closed claims and/
or total claims to calculate an estimated average cost per claim. From this, the expected ultimate average cost per claim
can be estimated. The average severity method coupled with the claim count development method provide meaningful
information regarding inflation and frequency trends that the Company believes is useful in establishing loss reserves.
The claim count development method analyzes historical claim count development to estimate future incurred claim
count development for current claims. The Company applies these development factors against current claim counts
by accident period to calculate ultimate expected claim counts.
• The paid loss development method analyzes historical payment patterns to estimate the amount of losses yet to be paid.
The Company uses this method for losses and loss adjustment expenses.
The Company analyzes catastrophe losses separately from non-catastrophe losses. For catastrophe losses, the Company
determines claim counts based on claims reported and development expectations from previous catastrophes and applies an average
expected loss per claim based on loss reserves established by adjusters and average losses on previous similar catastrophes.
There are many factors that can cause variability between the ultimate expected loss and the actual developed loss. While
there are certainly other factors, the Company believes that the following three items tend to create the most variability between
expected losses and actual losses.