For groups and fleets with pooling agreements, the one-year reserve deficiency for the group is calculated on a consolidated basis and allocated to the member companies according to each company's pool percentage. This allocated deficiency or redundancy is then taken as a percentage of surplus for each company.

INTERPRETATION

OF TEST RESULTS

The usual range for the ratio of one-year reserve development to surplus is less than 25 percent. As shown in Exhibit XXI, 6 percent of all companies had a one-year reserve development of more than 25 percent of surplus in 1972. Of companies becoming insolvent during the past five years, 73 percent had one-year reserve development ratios in excess of the bench mark in the third year before insolvency, while 62 percent exceeded the bench mark in their final year.

The bench mark for this test has been set at 25 percent because very few insolvent companies had test results between the former bench mark of 10 percent and 25 percent (see Appendix B). However, any company with a significant positive score on this test should be given further analysis.

For companies whose reserves appear to be deficient, further analysis should focus on determining which lines of business caused the deficiency and whether the deficiency is the result of deliberate understatement of losses. The amount of deficiency for each line of business can be determined from Schedules O and P.

Two approaches are useful in efforts to determine whether reserve deficiencies result from deliberate understatement of liabilities. First, review results on the one- and two-year reserve development tests over the past several years. If reserves have been consistently deficient, or if the two-year test result is consistently worse than the one-year test result, the problem is more serious. Second, calculate the reserve development for longer periods of time for the liability lines of business, using Parts 3 and 4 of Schedule P. If the deficiencies increase with the time since the losses were incurred, the company may be deliberately underreserving, with deficiencies appearing only as losses are paid.

It is not possible to determine from the association blank itself whether reserve deficiencies result from payments in excess of the amounts reserved, increases in the reserves for losses still outstanding, or underestimation of Because it is also not possible to deterincurred but not reported losses. mine from the association blank whether loss payments and reserves have been assigned to the proper years, an on-site examination will generally be required to resolve any serious questions regarding the adequacy of reserves.

RESERVE TEST

TEST 10

TWO-YEAR RESERVE DEVELOPMENT TO SURPLUS

The two-year reserve development to surplus ratio is calculated in a manner similar to the calculation of the one-year reserve development test. The two-year reserve development is the sum of the current reserve for losses incurred more than two years prior plus payments on those losses during the past two years minus the reserves that had been established for those losses two years earlier. This calculation is illustrated in Exhibit XXII and laid out in detail in the work sheet for Test 10 in Appendix A.

The usual range for the two-year test is also less than 25 percent. As shown in Exhibit XXIII, 9 percent of all companies had two-year reserve development to surplus ratios above 25 percent in 1972. Of companies becoming insolvent during the past five years, 73 percent had test results in excess of the bench mark in the third year before insolvency, while 60 percent exceeded the bench mark in their final year.

For suggestions on interpreting test results and further analysis, please refer to the comments on the one-year reserve development test.

RESERVE TEST

TEST 11

ESTIMATED CURRENT RESERVE DEFICIENCY TO SURPLUS

This test provides an estimate of the adequacy of current reserves.

DESCRIPTION OF

THE CALCULATION

In this test, as shown in Exhibit XXIV, the estimated current reserve deficiency or redundancy is taken as a percentage of surplus. This estimated deficiency is the difference between the estimated reserves required by the company and the actual reserves maintained. The estimated reserves required is the current net premium earned multiplied by the average ratio between developed reserves and earned premium for the last two years. For each of these years the reserves as stated in that year are adjusted by the one- or two-year reserve development as calculated in Tests 9 and 10. This total is then divided by the net premium earned in the appropriate year to obtain the developed reserve to premium ratio. This calcuiation is laid out in detail in the work sheet for Test 11 in Appendix A.

INTERPRETATION

OF TEST RESULTS

The usual range for the ratio of estimated current reserve deficiency to surplus is less than 25 percent. As shown in Exhibit XXV (following), 8 percent of all companies had ratios in excess of the 25 percent bench mark in 1972. Of companies becoming insolvent in the past five years, 55 percent exceeded this bench mark in the third year prior to insolvency, and 58 percent did so in their final year.

Results on this test can be distorted by significant changes in premium volume. A major increase in premium earned can produce test results that indicate deficiencies greater than the actual deficiency, and vice versa. However, within the normal range of variations in premium from year to year, the distortion from changes in premium is not significant.