What Is Loss Development?

Loss development is the difference between the final losses recorded by an insurer and what the insurer originally recorded. Loss development seeks to account for the fact that some insurance claims take a long time to settle, and that estimates of the total loss that an insurer will experience will adjust as claims are finalized.

Key Takeaways

  • Loss development is the difference between what an insurer initially records for liabilities versus the final level of claims. 
  • A loss development factor allows insurers to adjust claims to their projected final levels. 
  • One of the most important factors for insurers when determining potential losses is the amount of time that it will take to process a claim. 

How Loss Development Works

Insurance companies use loss development factors in insurance pricing and reserving to adjust claims to their projected final level. Insurers have to take a number of factors into account when determining what, if any, losses they may face from the insurance policies that they underwrite. 

One of the most important factors is the amount of time that it takes to process a claim. While claims may be reported, processed, and closed during a particular policy period, they may also be reported in later policy periods and may not be settled for a long period of time. This can make reporting complicated and, at best, based off an approximation of the loss that the insurer will ultimately experience. 

Insurance claims in long-tailed lines, such as liability insurance, are often not paid immediately. Claims adjusters set initial case reserves for claims; however, it is often impossible to accurately predict what the final amount of an insurance claim will be for a variety of reasons. Loss development factors are used by actuaries, underwriters, and other insurance professionals to "develop" claim amounts to their estimated final value. Ultimate loss amounts are necessary for determining an insurance company's carried reserves. They are also useful for determining adequate insurance premiums, when loss experience is used as a rating factor.

Loss Development Factor

A loss development factor (LDF) is used to adjust losses to account for claim increases. The LDF is a number that is meant to adjust claims to their ultimate projected level. For example, an LDF of 2.0 means that for every $1 in claims, the ultimate payout will be $2. If an insurer had $100,000 in current claims, the ultimate payout would be $200,000 with an LDF of 2.0.  

Loss amounts are key for pricing insurance premiums and determining carried reserves.

Requirements for Loss Development 

Insurers use a loss development triangle when evaluating loss development. The triangle compares loss development for a specific policy period over an extended period of time. For example, an insurer may look at loss development for the 2018 policy period at twelve month intervals over the course of five years. This means that it will examine the 2018 loss development in 2018, 2019, 2020, 2021, and 2022.

Insurers are required to report their financial position to state regulators who use these reports to determine whether an insurer is in good financial health or if there is a risk of insolvency. Regulators may use a loss development triangle to compare the percentage change across time periods, and use this percentage when making estimates of its loss development for a particular insurer in upcoming periods. If the rate of change fluctuates substantially over time the regulator may contact the insurer to find out why its loss estimates are off the mark.