Reserving practice has come under scrutiny recently as a result of company collapses and the growing trend for compensation culture. Kathryn McCarthy looks at existing practice and what can be done to improve it.

Doubts about the strength of insurance companies reserves have hit the headlines many times in recent months. The high-profile collapses of Independent and Australian insurer HIH, the rise in the number of asbestos claims and the current compensation culture have all helped put reserving practice under the spotlight.

Reserves are amounts set aside by insurers to cover liabilities assumed to exist at the accounting date. An actuary calculates reserves using risk factors obtained from experience tables. These tables are based on both the company's historical claims data and other industry and general statistical data.

"Reserves are estimates and no single number is the right answer," says Costas Miranthis, principal of Tillinghast-Towers Perrin, one of the largest actuarial consulting firms. "There is a reasonable range and companies have different attitudes towards what a reasonable range is." Miranthis says there are commonly accepted reserving methodologies and principles, each appropriate in different situations.

"In the UK, most firms take some sort of actuarial advice before setting their reserves."

St Paul International actuary Simon Sheaf says because St Paul covers long-term liability risks, such as employers' liability and professional indemnity, it is important to establish adequate levels of reserves for both claims that have yet to be reported (IBNR) and for claims where the full ultimate cost has yet to be realised (IBNER).

Sheaf says: "The IBNER, which is normally integrated within the IBNR, is necessary because of the long time-lag on liability cases between the initial notification of the claims and the time when claims handlers have enough information to enable them to accurately assess liability and quantum. It is certainly not unusual for a claim reserve to increase significantly between the time of the initial reserve and the time of settlement."

Each company has its own approach and philosophy on reserving, says Allianz Cornhill claims manager Harry Rule. "It is useful to use average cost factors where you can. For high-volume, low-value claims, which is most private car and household claims, you can set average values. They have to have a relatively short life, up to three months for household and six months for motor. Above this, each one has to be case-reserved, which is down to individual judgment. Every claim has to be reviewed and re-estimated every 90 days." Rule adds there are many reviews, with larger estimates confirmed by more senior staff. "You need the right expertise, depending on the claim type, and you must always estimate from day one. We are required to account for our outstanding liabilities and we can't have a claim registered to our system without an estimate."

There is no statutory requirement for UK general insurers to use actuaries to sign off their reserves, although many do, and Lloyd's syndicates have their own regulations making the practice compulsory.

In the present loss climate, greater scrutiny of reserves is inevitable. Thanks to recent changes to the Damages Act, insurers may have to go back up to six years to re-estimate their personal injury case reserves.

Asbestos claims are pouring into the market thick and fast. As well as causing reserving problems at Equitas and aiding the collapse of Chester Street, asbestos is a serious problem. On top of this, the World Trade Centre disaster will have hit insurers hard, at a time when they can ill afford extra expense.

"In a profitable period, people have higher reserves," says Lis Gibson, partner at leading actuarial consultancy B&W Deloitte. "We have been in a soft market and it follows that people's reserves will be on the weak side. Claims equalisation reserves are there to save up money in the good years to cover the bad years. They are a very specific vehicle for smoothing peaks and troughs in experience. I should think many people will be claiming off these reserves this year because of the World Trade Centre disaster."

The accumulation of the latest array of loss factors means insurers will be addressing their reserving strategies to cope with unforeseen expenses.

"If companies need to bolster prior year reserves through current and future-year profits, then the only way to do that is successfully charge more than you would have to - for example, policyholders pay or you persuade shareholders to put money in to fill the gap," says managing director of European operations at rating agency AM Best, Stuart Shipperlee. "And shareholders are only likely to do that if they believe the company will be able to charge enough in the future to give them a return which justifies the required extra investment."

Reserves are invested, typically, in low-risk, low-yield securities. According to Shipperlee, AM Best adjusts a company's reported capital by the extent to which we believe it may be over- or under-reserved. "The bigger pressure on companies is that increasing reserves reduces current profitability and their shareholders do not usually want to hear that."

If there are lessons to be learnt following the collapse of Independent, it seems the industry regulator, the Financial Services Authority (FSA), is intent on preventing any knee-jerk reactions. Indeed, the work on a new integrated prudential sourcebook began before the collapse of Independent and the finished document will be a handbook for management and supervision of solvency for all firms under the FSA's regulatory umbrella.

Due for consultation next year, the FSA's sourcebook aims to harmonise the rules for general insurance reserving with those for the banking sector.

"We are looking for more effective regulations," says an FSA spokesperson. "We are trying to bring insurance regulations closer to the banking regulation model, in that the assessment of reserves is more closely related to the company."

The FSA intends to send special risk teams into companies that are reported to have problems. the teams will have the power to scrutinise books and interview senior executives. The hit squads, according to FSA UK managing director John Tiner will also have power over Lloyd's syndicates. Although how it fits in with the current regulatory regime, as defined by the Lloyd's Act, is unclear

It will ultimately fall to the FSA to make sure problems with company reserves are identified and dealt with earlier. It is apparent the FSA was in talks with Independent long before the tip-off from the French authorities, yet there was little outside indication of the severity of the problems. There was no regulation forcing Independent to use an external actuary and what is not clear is whether Independent would have been able to raise the cash from the stock market if the whistle hadn't been blown by the actuary. This is a gap in the rules that the FSA must concern itself with.

The wider UK insurance market may fall in line with Lloyd's, the US and Ireland in making actuarial sign-off of reserves mandatory, a move which many believe would help improve the practice of reserving.

"Most insurance companies already use actuaries," says Miranthis. "Making them mandatory would formalise the arrangements that already exist and formalise some duties and obligations in the sign-off."

Sheaf agrees. "Generally speaking, mandatory actuarial sign-off would be a good thing since it would provide a high degree of comfort for brokers and policyholders."