Accident Year Development, Bonus Banks, and Insurance Incentive Compensation

ABSTRACT Insurance claims can take years to resolve, which makes insurance performance measurement-and incentive compensation based on such measurement-challenging. The insurance industry utilizes a method of analysis called accident year analysis to manage the temporal challenge inherent in insurance claims. Despite the managerial and economic utility of this method of analysis, it has generally not been applied to incentive compensation programs for insurance company executives and employees. This article will explain accident year analysis, and will show how it can be merged with the bonus bank concept and the Insurance Performance Measure, which is an insurance economic profit metric, to construct an economically consistent insurance incentive compensation program. INTRODUCTION Insurance claims can take years to resolve, which makes insurance performance measurement-and compensation based on such measurement-challenging. For example, assume an insurance company underwrote an insurance policy in the year 2000. If no claims were filed in that year the policy sale can appear profitable by the amount of premium collected (less all incurred expenses). However, assume now that a claim was filed against the policy in the following year, 2001, and that the insurance company retained an outside investigative firm to adjust the claim on its behalf. The effective profitability of the policy would erode by the amount of expenses being incurred despite the profitable appearance the year before. If we assume further that a lawsuit was filed on this claim in the year 2002, it can be seen that the insurance company will incur still further costs due to legal and court fees. Finally, assume that the lawsuit was resolved in 2005-five years after the insurance policy was sold-and that no further claims will be filed against it. Only at this point is it possible to definitively measure the profitability of the insurance policy sold in the year 2000. While the above example is both hypothetical and a generalization of the insurance claim process, it is not atypical of many insurance claims. However, despite the temporal challenge that claims pose to insurance performance, the measurement of that performance is generally based on simple 12-month calendar year results,1 and therefore generally so is incentive compensation.2 This approach is not consistent with the economics of the insurance industry, as will be explained, and as a result the incentives it generates are at best suboptimal. Instead, consider an alternative approach, one that utilizes accident year analysis (which is explained below), the bonus bank concept (Stewart, 1999 [1991]), and the Insurance Performance Measure (Calandro and Lane, 2002) to construct an economically consistent incentive compensation program for insurance company executives and employees. Below, background information is provided on the Insurance Performance Measure and bonus bank concept. Then accident year analysis is discussed in detail. The three theories are then integrated into an economically consistent insurance incentive compensation program that we illustrate by way of example. The findings are then summarized in a brief conclusion. BACKGROUND The Insurance Performance Measure (IPM) is an insurance economic profit metric that is composed of four key insurance variables: the investment return on all capital resources (including claim reserves), the cost of float (which measures the performance of insurance underwriting and claims handling), the cost of reinsurance (which measures the performance of insurance companies' risk transfer/management programs), and the opportunity cost of policyholders' surplus. Insurance operating profit is calculated as the sum of the investment return and cost of float less the cost of reinsurance.3 The opportunity cost of policyholders' surplus, calculated as the product of the cost of capital and policyholders' surplus (which is the insurance version of stockholders' equity), is subtracted from insurance operating profit to determine the amount of IPM or economic profit generated from insurance operations. …