Incurred But Not Reported

Incurred But Not Reported (often abbreviated as IBNR) is an essential, if slightly spooky, concept from the world of insurance. It represents an estimate of claims that an insurance company owes to its policyholders for events that have already happened, but which haven't been reported to the company yet. Think of it as the insurer's financial ghost—a liability that is real and present, but not yet fully visible. For example, a driver might have a fender-bender on December 30th but not get around to filing the claim until January 5th. For the insurer closing its books on December 31st, that accident is an “incurred” loss that is “not yet reported.” Actuarial science is used to estimate the size of this ghost, which is then booked as a liability on the company's balance sheet. This isn't just an accounting footnote; it's a critical component of an insurer's financial health and a huge area where management's skill and integrity are tested.

For a value investor, understanding IBNR is like having X-ray vision into an insurance company's soul. Because IBNR is an estimate, it gives management a significant amount of discretion. This discretion can be used for good or for ill.

• The Red Flag: Aggressive or incompetent management might consistently underestimate their IBNR. This makes current profits look fantastic because they are booking lower expenses. However, reality always catches up. When the actual claims arrive and prove to be higher than estimated, the company will have to strengthen its reserves, causing past “profits” to evaporate and future earnings to take a massive hit. This is a classic “cookie jar” accounting trick where a company effectively borrows profits from the future.
• The Green Light: Prudent and conservative management, like that praised by Warren Buffett, often does the opposite. They consistently set aside more than enough for IBNR, a practice known as reserve strengthening. This might depress reported profits in the short term, but it builds a fortress-like balance sheet. In later years, if the actual claims come in lower than the conservative estimate, the excess reserve is “released,” providing a nice, and genuine, boost to earnings.

In short, analyzing a company's IBNR practices over time reveals the quality and honesty of its management, which is a cornerstone of understanding the true value of the business.

Estimating IBNR is more of an art than a precise science, relying heavily on historical data and statistical models. Actuaries are the artists who paint this picture, and their canvas is the company's history of claims.

A key factor in the difficulty of estimating IBNR is the “tail” of the insurance line—the time lag between when a loss occurs and when the claim is finally settled and paid.

• Short-Tail Lines: Think of property insurance (e.g., a house fire) or standard auto insurance. These claims are usually reported and settled quickly. The IBNR estimate is relatively straightforward and less prone to massive errors. You know pretty fast how much a burnt-out car is worth.
• Long-Tail Lines: This is where the real dragons lie. Lines like medical malpractice, workers' compensation, or product liability can have incredibly long tails. A claim related to asbestos exposure, for instance, might not be filed for 30 years after the policy was written. Estimating the ultimate cost of these claims is extraordinarily difficult, as it involves predicting decades of inflation, legal trends, and medical advancements. It's in these long-tail businesses that an investor must be most skeptical.

When you're looking at an insurance company, don't just glance at the income statement. Dig into the reserves.

The story of a company's reserving honesty is written in its financial reports, specifically in the notes to the financial statements and the Management's Discussion & Analysis (MD&A).

1. Look for the Reserve Development Triangle: Most insurers provide a table (often called a “loss reserve development triangle”) showing how their estimates for prior years have changed over time.
   1. Adverse Development: If a company consistently has to add money to its prior-year reserves, it means they were underestimating losses. This is a major red flag indicating poor underwriting or aggressive accounting.
   2. Favorable Development: If a company consistently releases reserves from prior years, it's a strong sign of conservative and prudent management. This is what you want to see.
2. Compare to Peers: How does the company's ratio of IBNR to total loss reserves compare to its competitors in the same line of business? An unusually low number might suggest they're not being conservative enough.

Warren Buffett built Berkshire Hathaway on the back of a world-class insurance operation. He focuses intensely on underwriting discipline—the practice of only taking on risks that are likely to be profitable, independent of the investment income from the insurance float. A key part of this discipline is honest and conservative reserving. Ask yourself: Is this company chasing growth by offering cheap policies and then hiding the inevitable losses with low IBNR estimates? Or is it patiently and profitably building its business for the long haul? The answer often lies hidden in the IBNR.