12 Nov Insurance Reserves: What are they and how do they work?
Inadequate pricing and deficient loss reserves have often been a significant factor when Canadian insurance companies have failed.[1] In fact, 14 of the 21 insolvent Canadian insurers over the past 30 years failed due to inadequate pricing, deficient loss reserves or rapid growth.[2]
In 1981, the insurance industry experienced its worst underwriting results in history calling upon the Canadian government to take action.[3] In 1987, the federal government introduced the Office of the Superintendent of Financial Institutions (OSFI) pursuant to the Office of the Superintendent of Financial Institutions Act 1985, c. 18 (3rd Supp.) (the “Act”). The purpose of the Act is to ensure that financial institutions and pension plans are regulated by the Government of Canada so as to contribute to public confidence in the Canadian financial system.[4]
The OSFI is presided over by the Minister of Finance and is divided into four sectors: a Corporate Services Sector, a Regulation Sector, a Supervision Sector, and the Office of the Chief Actuary. The OSFI is responsible for regulating and supervising all financial institutions in Canada, including all banks, federally incorporated or registered trust and loan companies, cooperative credit associations, life insurance companies, fraternal benefit societies, property and casualty insurance companies and federally regulated private (employer-sponsored) pension plans.[5] Therefore, the OSFI is responsible for ensuring that all financial institutions comply with their governing statute law, such as the Insurance Companies Act, 1991, c. 47.
Section 515 of the Insurance Companies Act, 1991, c. 47, provides:
Adequacy of capital and liquidity — companies and societies
515. (1) A company and society shall, in relation to its operations, maintain adequate capital and adequate and appropriate forms of liquidity and shall comply with any regulations in relation to adequate capital and adequate and appropriate forms of liquidity.
Regulations and guidelines
(2) The Governor in Council may make regulations and the Superintendent may make guidelines respecting the maintenance by companies and societies of adequate capital and adequate and appropriate forms of liquidity.
Directives
(3) Notwithstanding that a company or society is complying with regulations or guidelines made under subsection (2), the Superintendent may, by order, direct the company or society to increase its capital or to provide additional liquidity in any forms and amounts that the Superintendent may require.
Therefore, all insurance companies regulated by the federal and provincial governments are required to maintain minimum levels of capital and liquidity, as determined by the OSFI. Furthermore, the Actuarial Division within the Regulation Sector of the OSFI works closely with the Actuarial Standards Board and the Canadian Institute of Actuaries to ensure that appropriate actuarial standards are in place for properly assessing the insurance company’s risk or “actuarial liability”.[6]
The obligation of insurers to set appropriate reserves is designed to promote financial stability of insurance companies and protect the public. Whether or not insurance reserves might be a factor to be considered by counsel in their approach to resolution or adjudication of individual cases is the subject of this paper.
Insurance reserves: what are they and what are they designed to do?
The Dictionary of Insurance defines a “reserve” as:
Funds which are set aside by an insurance company for the purpose of meeting obligations as they fall due. Such obligations would include liabilities for unearned premiums and the estimated costs of unpaid claims.[7]
The United States Supreme Court defined “reserve” in Maryland Casualty Co. v. United States:
The term “reserve” or “reserves” has a special meaning in the law of insurance. While its scope varies under different laws, in general it means a sum of money, variously computed or estimated, which with accretions from interest, is set aside, “reserved,” as a fund with which to mature or liquidate, either by payment or reinsurance with other companies, further unaccrued, but contingent and indefinite as to amount or time.[8]
Courts in the United States have expanded the definition of “reserves” to include “internal opinions and conclusions of an insurer that are largely hypothetical in nature.”[9]
According to the Chartered Insurance Professionals’ Society (CIP), adjusters must assess the various elements of a claim in order to “formulate an objective appraisal of its financial worth.”[10] This is because insurers must establish reserves that accurately reflect their estimate of the costs of a claim. More significant for our purposes is the fact that the insurer’s representative cannot enter into negotiations to settle a claim until the insurer has set its initial reserve.[11]
When a claim is received by an insurance company, the insurer is under an obligation to investigate and analyze the claim in an effort to determine the reserve amount to be set aside in anticipation of the ultimate payment.[12]
We are advised by an insurer’s representative that the insurer has instructed that a claim reserve is to be established in one of two ways: (1) by using individual case factors or (2) by using a formula. An individual case reserve involves the adjuster conducting an appraisal of the case based on the specific circumstances of the case as well as the adjuster’s own experience. Formula reserves involve the use of statistical data to determine an average amount paid on a claim within a certain category. We are further advised that the latter mode of assessment is most often used when reserving on relatively minor accidents or health claims.
Obviously, setting a reserve is an “inexact science”[13], if it is a science at all. The issue that therefore arises is whether, or in what circumstances, an insurer is obliged to disclose its reserve to a plaintiff or claimant, particularly as regards a first party claim.
What is the case worth?
Setting an appropriate reserve obliges the adjuster to develop a range of damages based on the adjuster’s assessment of liability, damages and the cost of litigation. Adjusters then use the reserve, and any adjusted reserves, as a guide through the settlement negotiations.[14] Adjusters draw upon their experience, the evidence relevant to the issues of liability and damages and the applicable law, including liability and damages rulings in previous cases. The objective is to develop a “best and worst case scenario”.[15] Obviously, there is considerable subjectivity to the process. However, adjusters are trained to approach each claim objectively – in other words, in this context: for what amount would a reasonable person value the claim.[16] Generally, an average value in between the best and worst case scenario will provide a reasonable reserve amount.
The factors to be considered when establishing a reserve in an automobile or general liability claim are:
facts of the accident;
nature and extent of injuries and resultant pain and suffering;
damages claimed;
damages likely to be proven;
available defences;
applicable law;
contributory negligence and/or contribution from joint tortfeasors;
witness credibility;
pre-accident health issues;
any claim for punitive damages;
age of plaintiff/claimant;
economic status of the plaintiff/claimant;
other insurance, and
subrogation.
An insurer has also advised that additional factors that might apply to fatality cases include:
age and life expectancy of decedent;
marital status;
number, age and sex of dependants;
health and habits of decedent;
earnings, and
earning capacity and prospects.
Property damage claims generally involve three principal factors:
liability and coverage;
determination of the extent of the property damage by inspections and/or estimates;
claim, if any, for loss of use.
As the claim progresses, further evidence or unforeseen matters may require the reserve amount to be adjusted up or down. [17]
Are insurers required to disclose reserve information?
Whether or not an insurer is obliged to disclose reserve information has been the subject of rulings in first-party claims for accident benefits and in tort clams where punitive damages have been claimed. The current state of the law is that unless there are “exceptional circumstances” the insurer’s reserve is not relevant and therefore need not be disclosed. In other cases, it has been ruled that litigation privilege protects the insurer from having to reveal its reserve.
Relevance
In Rama v. Allstate Insurance Co. of Canada[18], Ms. Rama was injured in a motor vehicle accident and applied for statutory accident benefits under the SABS-1996[19]. The matter proceeded to arbitration. At the pre-hearing, the arbitrator ordered Allstate to produce every document in its first-party adjusting file created before the commencement of mediation. This included reserve information.
A similar ruling was made in Qazi v. Security National Insurance Co.[20] and, in both cases, the insurance company appealed. The appeals were heard together by Director’s Delegate Evans.
The key to the rulings at first instance in Rama and Qazi was that in first-party claims there is no “zone of privacy” in the insurer’s file, and therefore no basis for the insurer to withhold information as to its reserve.[21]
On appeal, Director’s Delegate Evans disagreed:
I am not persuaded that there is no “zone of privacy” with respect to the first-party insurer’s file. As stated in Allstate Insurance Co. of Canada v. Al-Obaidi [2000 CarswellOnt 55404 (F.S.C.O. App.)], (FSCO P99-00009, May 2, 2000), the relevance of the production request must be weight against considerations like the sensitivity of the information, the practicalities of compliance and the timing of the request…the courts have stated that, except in rare and exceptional circumstances, reserves should not be required to be disclosed. Such circumstances might arise where the setting of a reserve actually had an impact on the adjusting of a file, not, as in the cases under review, where the adjusting of the file allegedly had an impact on the setting of the reserves. I am not persuaded that production of the reserves under the guise of consumer protection serves any useful purpose. I am also not persuaded that arbitral jurisprudence should be different from that of the courts regarding the production of reserve information.[22]
Similarly, in Griscti v. Non-Marine Underwriters, Lloyd’s London Renahan Member ruled:
The guiding principle in exercising the discretion to make a production order is relevance and reasonableness. ‘The degree of relevance is weighed against other factors such as the sensitivity of the information.’ I look at the issues for hearing and the allegations of the parties to determine whether the productions requests are relevant to those issues and reasonable and then consider any reason why Lloyd’s need not produce relevant and reasonable documents.[23]
Judicial treatment varies. In Simpson v. Gafar, the court ordered the insurer to produce reserve information on the basis that the plaintiff’s bad faith claim was pleaded “comprehensively and with a great deal of particularity.”[24]
Conversely, in Osborne v. Non-Marine Underwriters, Lloyd’s of London, the plaintiff was injured in a motor vehicle accident and sued his insurer for statutory accident benefits and damages for bad faith.[25] Blair R.S.J ruled:
In the absence of unusual circumstances, supported by the existence of sufficient facts – which are not alleged here – the level of the reserves set by an insurer is, in my opinion, immaterial to the bad faith claim and can have no effect upon the result of the action.
…
I would be very reluctant to place on a defendant a continuing obligation at law to tell the plaintiff how much it estimates the claim is worth. The plaintiff would be provided with an unfair, and unnecessary, advantage in the lawsuit. At the same time, the ability of the defendant to negotiate a settlement would be impaired because knowledge of the reserve might well create a feeling of entitlement in the plaintiff to a settlement in that amount, whereas the reserve is nothing more than an intelligent estimate of the risk as a whole by the insurer and its solicitor, based upon the facts as known at the time.[26]
A principle enunciated in some cases – “you plead it, you get it” – has not been uniformly applied. [27] In Rex v. General Accident Assurance Co. of Canada, the plaintiff’s bad faith claim was described at some length in the pleadings. However, Master MacLeod declined to order production of all documentation relating to the insurer’s reserve:
The setting of reserves per se does not have a semblance of relevance. That is not to say that the level of reserves may not become relevant in response to proper questions put on discovery nor that the reserve information is entitled to any particular special treatment. I am simply not persuaded on the evidence before me that there is a semblance of relevance to ‘all documentation relating to reserves’ as requested in the notice of motion.[28]
In Contos v. Kingsway General Insurance Company, Master Dash, relied on Rex, supra, and ruled:
With respect to the reserve documents requested in…the notice of motion, I concur with the reasoning of Master MacLeod in Rex…Master MacLeod was not persuaded on the evidence before him that reserve documentation was relevant to the issues in that case, nor am I persuaded of such in the evidence before me. I note that there is no pleading that reserves were set inappropriately or that such constituted an act of bad faith, nor has there been evidence presented of such. I would grant such order in only the clearest of cases, as it is equivalent to asking a party or its representative what it believes its case is worth.[29]
The California Court of Appeal in Lipton v. Superior Court (Lawyers’ Mutual Insurance Co.) described reserves as “statutorily compelled estimates” likely to be adjusted throughout the course of litigation. The court then ruled:
We cannot conclude…that loss reserve information has no discovery relevance…The evaluation of a case made by an insurer, whether compelled by law or business prudence, is information which might well lead to discovery of evidence admissible on any number of issues which commonly are presented in bad faith actions.[30]
In Taxel v. Equity Gen. Ins. Co., the court considered the relevance of the insurer’s reserve information and ruled: “Because insurers are obligated to set them, reserves cannot accurately or fairly be equated with an admission of liability or the value of a particular claim, even more so when a reserve includes estimates of claim-handling expenses, attorneys’ fees and court costs of defense.”[31]
We suggest that even in the context of a well-pleaded first-party claim that includes damages for bad faith, the insured must show that there are special or exceptional circumstances making the insurer’s reserve information relevant.
However, relevance alone may not be sufficient.
Litigation Privilege
An insurer’s “zone of privacy” was recognized by the Supreme Court of Canada in Blank v. Canada (Department of Justice) in the context of litigation privilege. The insurer’s “zone of privacy” was described as arising in the context of pending litigation and ensuring the efficacy of the adversarial process.[32]
A two-fold test is applied to determine if a document is protected by litigation privilege. First, communications with third parties must have been made specifically with existing or contemplated litigation in mind and not simply in the context of general legal advice.[33] Second, the privilege only attaches if the “dominant purpose” of the communications was in furtherance of the impending litigation.[34]
When considering litigation privilege in the context of reserve information, Ontario and U.S. courts have ruled that information regarding reserves should only be disclosed in exceptional cases.
In Guaranty Corp. v. National Union Fire Insurance Co., the U.S. District Court held that an insurer’s reserve amount “may reveal the mental impressions, thoughts and conclusions of an attorney in evaluating a legal claim” and therefore may be protected from disclosure as “attorney work product.”[35]
In Contos, supra, Master Dash indicated that ordering a party to disclose its reserve information is equivalent to asking the party what it believes its case is worth. Therefore, the court found that production of reserve information should only be ordered in the “clearest of cases”.[36]
Master Dash reiterated this ruling in Mamaca (Litigation Guardian of) v. Coseco Insurance Co.[37] The plaintiff claimed as against his insurer damages for bad faith in dealing with his income replacement benefits (IRB) claim. Master Dash held: “Information about setting a reserve is not relevant to the insurer’s conduct in assessing and responding to the claim absent rare and exceptional circumstances.”[38]
Master Dash also considered a request for disclosure of reserve information in Samoila v. Prudential of America General Insurance Co. (Canada).[39] Mr. Samoila claimed damages for bad faith after his insurer declined payment of accident benefits for over four years. The plaintiff sought production of the insurer’s file. The insurer asserted litigation privilege. Master Dash ordered the insurer to produce its entire claims file, but with reserve information deleted. Nevertheless, the ruling was reconsidered, albeit not reversed, on appeal.
The Master’s analysis had not included consideration of litigation privilege. The Master had essentially concentrated on the issue of relevance:
The only way that an insured can ascertain whether his claim was treated in good faith is by production of the insurer’s internal file and other information available to it, thereby indicating how it handled the investigation and determined whether to honour the claim. This makes almost every document in the insurer’s file critical and relevant to the issue of bad faith if properly pleaded.[40]
Macdonald J, affirmed the decision on appeal because the insurer had not been ordered to disclose reserve information: “…while the Master held that litigation privilege does not apply to documents described as addressing the appellant’s reserve position, the Master permitted the appellant to delete references to its reserve figures. The Master clearly was correct in this regard.”[41]
However, Macdonald J. ruled that the Master erred in distinguishing between investigating an accident and the ensuing claim as opposed to contemplating litigation:
If an investigation and the reports about it have a dual purpose, one of which is to assist in anticipated litigation, the duality of purpose does not mean that litigation privilege cannot exist. A document may be prepared for a multitude of purposes and, if the dominant purpose is to assist in anticipated litigation, then litigation privilege applies to the document.[42]
Macdonald J. also ruled that:
Litigation privilege, when properly asserted, will shield an insurer’s claims file from disclosure despite the fact that the documents therein are highly relevant to the plaintiff’s bad faith claim. It is not correct that, in the Ontario context, a plaintiff’s need for disclosure of the claims file in a bad faith claim is “overwhelming”. Specifically, the relevance or importance of that information to a plaintiff seeking to prove bad faith does not overwhelm litigation privilege… litigation privilege overwhelms or “trumps” relevance in most cases, even if that deprives the plaintiff of necessary proof.[43]
In Ghaedsharagy v. Kingsway General Insurance Co.[44] the insured brought a motion for production of adjuster’s log notes in mediation with respect to his accident benefits. Bujold Member held that the plaintiff was entitled to production of all adjuster’s log notes up to the date of the last Application for Mediation, however the insurer was not required to disclose entries related to reserve information:
As with the insured’s clinical notes and records, there is no cost effective and efficient process to determine the relevance of documents in the insurer’s file. Given that arbitrations at the Commission are intended to be an efficient and cost effective alternative to the Courts, I agree with Arbitrator Blackman that a broad stroke approach is appropriate and an insured should generally have access to the insurer’s file, subject to privilege and reserve information, without vetting by the insurer as to the relevance of specific documents or entries.[45]
Ouimet v. Wawanesa Mutual Insurance Co.[46] arose from Wawanesa’s rejection of Mr. Ouimet’s request to review Wawanesa’s post-mediation adjusting file. Sampliner Member ruled:
Wawanesa claims that litigation privilege protects its accounting reserves from Mr. Ouimet’s discovery. Reserves are estimated amounts assigned by an insurer to account for the total possible future payout of a person’s claims arising from an accident, and do not discriminate between the various types of no-fault benefits or time periods.
In my view, evidence about total claims serves little to advance an insured person’s claim for the specific benefits, while offering potential to sidetrack the disability or treatment issues. More importantly, I accept that the dominant purpose of a reserve decision is integral to an insurer’s assessment of the dispute.
Most information in Wawanesa’s November 10, 2005 “file synopsis” concerns its reserves for Mr. Ouimet’s accident. Based on the principal that reserves are integral to decisions in the legal action, I find that the November 10, 2005 summary is subject to litigation privilege, and should not be disclosed to Mr. Ouimet.
The top 6 lines and last 2 lines of the adjuster’s July 12, 2005 log note, the second entry for July 13, 2006, the November 9, 25, 28, 29, 30, 2005, February 15 and 20, 2006 notes likewise discuss changes to reserves. I find all of these entries contain confidential internal valuations of the disputed claims to which litigation privilege applies, and should not be disclosed to Mr. Ouimet.[47]
In Griscti, supra, Renahan Member ruled that reserve information is akin to settlement information in that “[reserve information] is the insurer’s estimate of what the case is worth for reserve purposes just as a settlement offer is an estimate of what the case is worth for settlement purposes.” [48]
The privilege accorded to settlement discussions, as noted in the Law of Evidence in Canada, is necessary in order to encourage parties to negotiate freely. “In the absence of such protection, few parties would initiate settlement negotiations for fear that any concession they would be prepared to offer could be used to their detriment if no settlement agreement was forthcoming.”[49]
We therefore suggest that unless there is prima facie proof of bad faith by the insurer, the courts will not order disclosure of the reserve information in the insurer’s claims file. Certainly, a “bald” pleading of bad faith will not entitle the plaintiff to such information.
When, if ever, will the insurer be compelled to disclose its reserve?
Contos, Rex, and Mamaca, appear to have left the door open in “exceptional cases” for an insurer to be ordered to disclose reserve information. However, we have not found a case where such exceptional circumstances have been found to exist. Perhaps an allegation of bad faith in the context of an insurer not settling a tort claim for an amount within the insured’s policy limits would be such a case.
In Insurance Law in Canada, Craig Brown summarized the law relating to the insurer’s duty of good faith and fair dealing with respect to its insured. As regards the insurer’s obligation to consider settlement for an amount within policy limits, Mr. Brown wrote:
When a person bringing the lawsuit makes a settlement offer within the policy limits, the insurer may not reject it without taking account of its customer’s interest. Remember, if, in the normal course, a case is allowed to go to judgment, and the court awards the person bringing the action damage in excess of the policy limits, the customer has to pay the extra amount personally. [50]
Mr. Brown cited Dillon v. Guardian Insurance Co.[51] and Shea v. Manitoba Public Insurance Corp.[52] in describing the test for determining whether the insurer has met its duty of good faith in this regard: did the insurer give “at least equal consideration to the customer’s interest as it did its own interest.” [53]
In Dillon, the court held: “If an insurer does not use reasonable care in settling a claim against its insured, that want of care is a want of good faith. The standard of absolute liability is that if an insurer can settle a claim against an insured within its limits and does not do so, it is liable to reimburse the insured for whatever claim goes against him.”[54]
In Shea, the court offered the following analysis:
The standard used in judging whether a liability insurance company has complied with its duty regarding settlement involves two major issues. The first issue is whether the basis of liability is bad faith, or negligence, or some variant on one of these standards. Some cases have held that only good faith toward the insured is required, and at the opposite extreme some have held that both good faith and ordinary care are required. In the middle ground fall numerous cases that do not make a clear-cut choice; many of these recognize at least a duty of good faith and either expressly or silently leave unresolved the question whether there is also a requirement of ordinary care…[T]he second major issue involved in setting the standard by which the company’s conduct regarding settlement is tested concerns the relative degree of consideration the company must give to the insured’s interests in comparison with its own, when they come into conflict. The prevailing view among courts that have squarely faced this issue is that the company must give the insured’s interests at least equal weight…
With respect to the decision whether to settle or try the case, the insurance company must in good faith view the situation as it would if there were no policy limit applicable to the claim.[55]
In the U.S. context, the California Court of Appeal in Lipton, supra, stated:
…[reserve] evidence may or may not be relevant in a subsequent bad faith action, depending on the issues presented…an argument can be made for the proposition that loss reserve information might have some relevance to the question of whether a reasonable likelihood of an excess verdict existed or the insurer had conducted a proper investigation or given reasonable consideration to all of the factors involved in a specific case which might expose its insured to an excess verdict.[56]
Furthermore, in Brown v. Superior Court (Continental National Insurance Co.), an Arizona court ruled that solicitor-client privilege or “work product” privilege is not absolute. The court held:
…[T]he reasons the insurer denied the claim or the manner in which it dealt with it are central to [the plaintiff’s] claim of bad faith…When mental impressions and the like are directly at issue in a case, courts have permitted an exception to the strict protection of Rule 26(b)(3) and allowed discovery.[57]
Again, this exception will only be permitted where the information requested is central to a party’s claim or defense.[58]
We therefore suggest that where an insured properly pleads bad faith against his or her insurer after the insured has been found liable for damages over the policy limits, the insurer’s reserve information may be compellable on the issue of whether or not the insurer adequately considered the interests of its customer in deciding whether or not to settle within limits – if such settlement was ever available to the insurer.
Working with the insurer that must set a reserve
It has been suggested that plaintiffs may benefit from an appropriately reserved file.
We agree that this is so, even if the reserve is never disclosed by the insurer, because in our experience the insurer’s representative is often content to settle a case at or below the amount reserved.
Thus, it is recommended by at least one commentator that the insurer be kept fully informed concerning the plaintiffs’ claims because this will assist the insurer in properly reserving the file. According to the author, an inadequate claim reserve is usually the result of the adjuster’s inexperience or the plaintiff lawyer’s failure – intentional or unintentional – to provide the insurer with sufficient information about the claim.[59]
Providing the adjuster with as much information as possible, as promptly as possible, is therefore seen as improving the likelihood that the claim will be resolved promptly and within a range that accurately reflects the value of the case.[60]