Article originally appeared in PAMIC Pulse.
Most people working in the insurance industry did not plan this career in their youth. But, after finding a home in this exciting industry, many of us are glad we fell into it. So, how did we gain the knowledge required to be productive? On-the-job training of course. Still, some concepts are difficult to learn “on-the-job” without a good mentor or a solid classroom-style explanation. After years immersed in the claims side of the business, I gathered a few gold nuggets from mentors and formal claims training. One of the most compelling lessons that stuck with me was the “bucket analogy”.
The Bucket Analogy Lesson
The “bucket analogy” gives a physical form to the abstract concept of a claim reserve. Finance and accounting terms like claim reserves and “incurred” vs. paid loss can be confusing. The “bucket analogy” makes a comparison between posting claim reserves and setting aside money in buckets. Its imagery is accurate and memorable. On that basis, I want to share it so that others can get the same benefit.
Imagine that a certain insurance company called InsureCo holds all of its cash in a vault located in its center conference room. This room is located on the third floor of its headquarters. The cash in the vault goes to pay for everything from agent commissions to staff salaries to building rent. Of course, InsureCo issues thousands of insurance policies and it anticipates paying claims as well. But, while sitting in the vault, all of InsureCo’s cash is stacked in one pile. We refer to that pile as the General Fund. None of the dollars in the General Fund know where they are headed.
Here is where the process begins. Each day as new claims are reported, the assigned claims adjuster gets a tin bucket from the claims closet and brings it to the center conference room. The adjuster then writes the claim number on the outside of the bucket and goes to the vault. Then, the adjuster inserts a piece of cardboard inside the newly labeled bucket separating the space vertically into left and right.
Next, the adjuster uses a special claims key to open the vault. With the vault open, the adjuster stares at the cash pile and considers how much money will be needed to pay for that particular claim given all of its unique characteristics. Adjusters use information about coverage, limits, deductibles, damages and the likelihood of payment. Then, they make a good initial guess. In order to set aside the money for anticipated future payments, the adjuster removes the estimated amount from the vault. He places it in an envelope marked with the claimant’s name. The envelope is then put inside the left partition of the bucket. Depending on the type of claim, the claimant could be the policyholder (first party loss) or some other person seeking damages from the policyholder (third party liability). This process completes the initial setup of a loss reserve.
After an amount is set aside to pay the claimant, a separate envelope is filled with enough money to pay anticipated expenses. These expenses are necessary to administer handling of the claim such as appraisers, outside loss adjusters, experts, record services and defense attorneys. That envelope would be labeled “Expenses” and placed in the right-side partition of the bucket. This process completes the initial setup of expense reserves.
Once sufficient monies are in their respective spaces of the bucket, the vault can be closed and locked. At that point, the claim bucket is ready to be held in the “Claim Pickup Drive-through”. This area is a large room in the corner of the first floor of InsureCo’s building. It looks like an oversized coat-check room and has a sliding window facing the outside which serves as the pickup window. This room holds all the numbered claim buckets that contain envelopes with cash. Each claim has its own bucket.
With the cash now separated from the General Fund, it goes from being “available” to “reserved”. Once reserved, the total amount set aside is considered a “Loss” from a financial perspective. That’s right. Once it comes out of the vault and into a claim bucket, the company’s accountant scores it as a “loss” on that month’s profit and loss statement. The claims manager at InsureCo properly calls this reserved money, “Incurred”. True, the money is still within reach of InsureCo and it is still a company asset. But, now it is an asset tied to an equal and offsetting liability. The recognition of that liability happens as soon as the money is put in the bucket. The affected liability account at InsureCo is called, “Losses Payable”.
InsureCo is like all insurers. It must take steps to separate out money that it anticipates paying for claims. And, it must do so when it has a justifiable reason to know of the loss. This is true even if there is no immediate need to make a payment and even if the exact amount cannot be determined.
What happens next? The claims adjuster investigates the claim in terms of the scope and limits of coverage and he values the damages that are owed. The adjuster may decide to change the amounts originally set aside to reflect a better estimate. If he decides his initial estimate was low, he may get more money from the vault and put it in the bucket. That transaction is called a reserve increase. Conversely, he may decide the initial estimate was too high. In that case, he may take money out of an envelope and put it back into the vault. That transaction is a reserve decrease.
Eventually, the claim is settled by a final determination of the amount to be paid. When that happens, the adjuster notifies the claimant to meet at the drive-through window where delivery of the funds occurs. Claimants only pick up monies from the left side of the bucket, the “loss” side. Service providers and vendors get paid from the right side of the partitioned bucket. That is the “expense” side. If there are monies on either side remaining after all claimants and service providers have been paid, the adjuster returns those funds back to the vault in the conference room. Some people call that process, “zeroing out the remaining reserves”. This is important because the adjuster is not allowed to return a claim bucket to the closet if it still has money in it. All buckets returned to the closet must be empty. In other words, claims cannot be closed if there is still money sitting in reserve. The process of “zeroing out” reserves reduces the “incurred” amount for the claim.
Understand that the “incurred” increases only when money moves out of the vault and into a bucket. “Incurred” does not change just because someone at the drive-through window picks up money. Also, understand another rule. Claimants and service providers get paid at the drive-through window only. No one is allowed to be brought up to the third-floor conference room to get paid straight out of the General Fund, i.e. the vault. The movement of money first to reserves and then to paids is what helps an insurance company maintain an accurate and timely picture of its financial strength. If not for reserves, insurance companies would be overstating net worth and income. Reserving claim losses creates a more reliable financial picture.
Conclusion
Why the bucket analogy? The bucket analogy creates the image of a physical separation between general funds and money set aside for claim payments. Of course, with technology and electronic bank accounts, companies do not need to physically separate money in its currency form. They simply enter accounting transactions that match the reserve and payment instructions fed into the claims system by claims adjusters. The analogy also illustrates that each claim has two key components with regard to outgoing money (Indemnity paid to claimants and Expenses paid to service providers). The loss component must be further allocated with separate accounting for each claimant and each coverage part. Use the bucket analogy as part of your claims transaction training and discussions. I think you will find it helpful to get adjusters, underwriting and accounting professionals all on the same page.
