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Understanding Expected Loss Ratios for Insurance Control in Hard Markets

This article covers the significance of Expected Loss Ratios (ELR) in insurance, focusing on their role as a bridge between rate-making and reserving, and the implications for internal controls under Sarbanes-Oxley 404 requirements. It discusses the changes in loss ratios during hard market conditions and provides insights into loss development, trend analysis, premium rate adjustments, and considerations for self-insured entities. The text delves into methods like the Bornhuetter-Ferguson and Cape Cod for establishing initial expected loss ratios and reserving estimates. It also highlights the importance of industry experience and judgment in determining ELRs.

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Understanding Expected Loss Ratios for Insurance Control in Hard Markets

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  1. Establishing the Expected Loss Ratio George M. Levine, FCAS, MAAA Senior Manager, KPMG LLP September 9, 2003 Chicago, Illinois

  2. Ultimate Loss Ratio (Losses/Premium) expected to be incurred a-priori before consideration of actual experience Loss Ratio discussed as REASONABLENESS check for reserves in CAS Loss Reserve Principles ELR is basis of ratemaking: Actual Loss Ratio/ELR –1=Rate Change Expected Loss Ratio(Definition)

  3. Several important changes on the Landscape HARD MARKET—Past Loss Ratios not indicative of Future Loss Ratios SARBANES OXLEY 404 REQUIREMENTS—Internal Control over Financial Reporting Expected Loss Ratio Why important now?

  4. Loss Ratios decrease in times of Increasing Rates Expected Loss RatioHard Market

  5. Management’s annual report on internal control must: State management’s responsibility for establishing and maintaining adequate internal controls Contain management’s assessment as of year-end of effectiveness of internal control structure Independent Auditor must attest to and report on management’s assessment in accordance with standards issued or adopted by the PCAOB (Public Company Accounting Oversight Board) SARBANES-OXLEY 404Audit of Internal Control

  6. COSO: Committee on Sponsoring Organizations of Treadway Commission (AICPA is one organization) COSO’s 5 Areas of Internal Control CONTROL ENVIRONMENT RISK ASSESSMENT CONTROL ACTIVITIES INFORMATION + COMMUNICATION MONITORING Conclusion: ELRs, the bridge between ratemaking and reserving, is important element for insurance controls SARBANES-OXLEY 404Audit of Internal Controls

  7. Loss Development Loss Trend Premium Rate Changes New Business Penalty # of Years to Consider Expected Loss Ratio Considerations: Experience Rating

  8. 5%On-Level Devl. Trended Earned Earned Loss YearLosses LossesPrem.Prem.Ratio 1999 5.2 6.3 6.0 8.0 79% 2000 6.0 6.9 7.0 8.5 81% 2001 5.6 6.2 7.5 8.3 75% 2002 7.0 7.4 8.0 8.0 93% Total 23.8 26.8 28.5 32.8 82% 2003 Select 90% Experience Rating Expected Loss Ratio Example

  9. Split History Into New and Renewal Business Homogeneity and Credibility Considerations Self-Insureds: Often Exposure Bases utilized for Expected Loss Rates instead of Expected Loss Ratios, with same concepts applying Industry Experience Important for Self-Insureds Experience Rating ELRFurther Adjustments

  10. Exposure Bases Industry Expected Loss Ratios/Loss Rates Extension of Exposures Expected Loss Ratio Considerations: Exposure Rating

  11. Bornhuetter-Ferguson Method (PCAS 1972) Cape Cod Method/Stanard-Bulhmann Method Comments: Quarterly Adjustments Reserving Methods: Initial Expected Loss Ratio Selections

  12. Bornhuetter-Ferguson Method (PCAS 1972) External Source for Initial Expected Costs Ultimate Costs Implied by Development Method, ILC= LDF X AMT/EXP, where LDF is Ultimate Development Factor, AMT is Current Reported (Paid), EXP is Exposure ILC is Indicated Loss Cost Initial Expected Loss Ratio Bases

  13. Cape Cod Method ULC=AMT/ (EXP/LDF) Where ULC= Undeveloped Loss Cost Weights here are (EXP/LDF) for All Periods Generalized Cape Cod Method: Unique Expected Loss Cost for Each Accident Period as Weighted Average of Surrounding Accident Periods Initial Expected Loss Ratio Bases

  14. Earned Expected Reported Expected YearPrem.IELRLossesLossesUnreported % 2000 6.0 95% 5.7 5.8 .031 2001 5.6 95% 5.3 4.8 .142 2002 7.0 95% 6.7 4.3 .394 Expected UnreportedUltimate Ultimate YearLossesLossesLoss Ratio 2000 0.2 6.0 100% 2001 0.8 5.6 99% 2002 2.6 6.9 99% Bornhuetter-Ferguson Method95% Initial Expected Loss Ratio

  15. Earned Expected Reported Expected YearPrem.IELRLossesLossesUnreported % 2000 6.0 70% 4.2 5.8 .031 2001 5.6 70% 3.9 4.8 .142 2002 7.0 70% 4.9 4.3 .394 Expected 70%IELR 95% IELR UnreportedUltimate Ultimate Ultimate YearLossesLossesLoss RatioLoss Ratio 2000 0.1 5.9 99% 100% 2001 0.6 5.4 96% 99% 2002 1.9 6.2 89% 99% Bornhuetter-Ferguson Method70% IELR—How Judgment Affects

  16. On-Level (3)x(5) Earned Earned Reported Expected Expected YearPrem.Prem.LossesUnreported %Unrep.Loss (1) (2) (3) (4) (5) (6) 2000 6.0 7.3 5.8 .031 .2 2001 5.6 6.2 4.8 .142 .9 2002 7.0 7.0 4.3 .394 2.8 Total 18.6 20.5 14.9 3.9 Cape Cod IELR =14.9/(20.5-3.9) =90% Actual Reported/Expected Reported Cape Cod MethodInitial Expected Loss Ratio

  17. Earned Expected Reported Expected YearPrem.IELRLossesLossesUnreported % 2000 6.0 90% 5.4 5.8 .031 2001 5.6 90% 5.0 4.8 .142 2002 7.0 90% 6.3 4.3 .394 Expected Cape Cod 95% UnreportedUltimate Ultimate B-F YearLossesLossesLoss RatioUlt. LR 2000 0.2 6.0 99% 100% 2001 0.7 5.5 98% 99% 2002 2.5 6.8 97% 99% Cape Cod Method90% Initial Expected Loss Ratio

  18. Earned Expected Reported Expected YearPrem.IELRLossesLossesUnreported % 2000 6.0 90% 5.4 5.5 .067 2001 5.6 90% 5.0 4.6 .242 6/02 3.5 90% 3.2 2.0 .741 Or 6/02 7.0 90% 6.3 2.0 .741 UnreportedUltimate Ultimate YearLossesLossesLoss Ratio 2000 0.4 5.9 98% 2001 1.2 5.8 104% 6/02 2.3 4.3 124% Or 6/02 4.7 6.7x.5=3.4 95% Quarterly Estimates @ 6/02Bornhuetter-Ferguson Method

  19. Expected Loss Ratio ever-increasing scrutiny in loss reserving due to changing landscape and hard market Choice of Initial Expected Loss Ratio subject to judgment, but sophisticated techniques exist to assist in choosing IELRs Conclusions

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