Insurance companies deal with large and complex claims made against policies that they sell. It can often take months, or even years, to settle some claims, making it a challenge to determine how each will affect the company's profitability and liquidity. To ensure the company reports the loss on their financial reports accurately and to avoid unpleasant surprises, insurers will assign a claims reserve to each incident, reflecting their best estimate of the liability.
When a claim is reported to an insurance company, the claims adjuster will open a file and start documenting the nature of the claim, while estimating the amount payable. This type of reserve is common practice across the industry and is used by the insurance company to measure profitability, as well as manage cash-flow. Normal claims reserves fluctuate to reflect the information gathered throughout the claims settlement process. Typical reserves include the amount expected to be paid to the insured along with expenses incurred by the insurer, such as lawyer fees, as part of the settlement process. When a claim is finally settled, the reserve is assigned to the payment, with any excess amount returned to the company's general coffers.
In most jurisdictions, insurance companies report and assign claims to the date the loss took place. Incurred but not reported (IBNR) reserves are calculated to reflect claims that have taken place, but have not been reported to the insurer. In some cases, IBNR reserves cover short-term issues, such as a claim at a seasonal home that will not be noticed until the owners arrive at the start of the next vacation season. In other cases, the losses can take years or even decades to be reported, such as claims made by individuals in the 1990s who experienced health issues caused by asbestos exposure in the 1950s. IBNR helps companies set aside sufficient money to cover these claims.
In many jurisdictions, government regulators require insurance companies to set aside funds in statutory reserve finds. These funds ensure companies remain solvent, even when unexpected long-tail claims arise. Environmental claims have largely driven statutory reserves, because it can take decades before a company's pollution can affect the water tables and wildlife. Product liability claims are similar, in that it can take years before a product, such as a drug, can be proven to cause bodily injury to a user. In most cases, these types of claims are massive in size and tragic in nature. By requiring insurers to set aside funds, governments try to head off situations where liability cannot be assigned or restitution paid.