Estimating the Predictive Distribution for Loss Reserve Models

1. Estimating the Predictive Distribution for Loss Reserve Models Glenn Meyers ISO Innovative Analytics CAS Annual Meeting November 14, 2007

2. S&P Report, November 2003Insurance Actuaries – A Crisis in Credibility “Actuaries are signing off on reserves that turn out to be wildly inaccurate.”

3. Background to Methodology - 1 • Zehnwirth/Mack • Loss reserve estimates via regression • y = a∙x + e • GLM – E[Y] = f(a∙x) • Allows choice of f and the distribution of Y • Choices restricted to speed calculations • Clark – Direct maximum likelihood • Assumes Y has an Overdispersed Poisson distribution

4. Background to Methodology - 2 • Heckman/Meyers • Used Fourier transforms to calculate aggregate loss distributions in terms of frequency and severity distributions. • Hayne • Applied Heckman/Meyers to calculate distributions of ultimate outcomes, given estimate of mean losses

5. High Level View of Paper • Combine 1-2 above • Use aggregate loss distributions defined in terms of Fourier transforms to (1) estimate losses and (2) get distributions of ultimate outcomes. • Uses “other information” from data of ISO and from other insurers. • Implemented with Bayes theorem

6. Objectives of Paper • Develop a methodology for predicting the distribution of outcomes for a loss reserve model. • The methodology will draw on the combined experience of other “similar” insurers. • Use Bayes’ Theorem to identify “similar” insurers. • Illustrate the methodology on Schedule P data • Test the predictions of the methodology on several insurers with data from later Schedule P reports. • Compare results with reported reserves.

7. A Quick Description of the Methodology • Expected loss is predicted by chain ladder/Cape Cod type formula • The distribution of the actual loss around the expected loss is given by a collective risk (i.e. frequency/severity) model.

8. A Quick Description of the Methodology • The first step in the methodology is to get the maximum likelihood estimates of the model parameters for several large insurers. • For an insurer’s data • Find the likelihood (probability of the data) given the parameters of each model in the first step. • Use Bayes’ Theorem to find the posterior probability of each model in the first step given the insurer’s data.

9. A Quick Description of the Methodology • The predictive loss model is a mixture of each of the models from the first step, weighted by its posterior probability. • From the predictive loss model, one can calculate ranges or statistics of interest such as the standard deviation or various percentiles of the predicted outcomes.

10. The Data • Commercial Auto Paid Losses from 1995 Schedule P (from AM Best) • Long enough tail to be interesting, yet we expect minimal development after 10 years. • Selected 250 Insurance Groups • Exposure in all 10 years • Believable payment patterns • Set negative incremental losses equal to zero.

11. 16 insurer groups account for one half of the premium volume

12. Look at Incremental Development Factors • Accident year 1986 • Proportion of loss paid in the “Lag” development year • Divided the 250 Insurers into four industry segments, each accounting for about 1/4 of the total premium. • Plot the payment paths

13. Incremental Development Factors - 1986 Incremental development factors appear to be relatively stable for the 40 insurers that represent about 3/4 of the premium. They are highly unstable for the 210 insurers that represent about 1/4 of the premium. The variability appears to increase as size decreases

14. Do Incremental Development Factors Differ by Size of Insurer? • Form loss triangles as the sum of the loss triangles for all insurers in each of the four industry segments defined above. • Plot the payment paths

15. There is no consistent pattern in aggregate loss payment factors for the four industry segments. Segment 1 Segment 3 Segment 2 Segment 4

16. Expected Loss Model • Paid Loss is the incremental paid loss in the AY and Lag • ELR is the Expected Loss Ratio • ELR and DevLag are unknown parameters • Can be estimated by maximum likelihood • Can be assigned posterior probabilities for Bayesian analysis • Similar to “Cape Cod” method in that the expected loss ratio is estimated rather than determined externally.

17. Distribution of Actual Loss around the Expected Loss • Compound Negative Binomial Distribution (CNB) • Conditional on Expected Loss – CNB(x | E[Paid Loss]) • Claim count is negative binomial • Claim severity distribution determined externally • The claim severity distributions were derived from data reported to ISO. Policy Limit = $1,000,000 • Vary by settlement lag. Later lags are more severe. • Claim Count has a negative binomial distribution with l = E[Paid Loss]/E[Claim Severity] and c = .01 • See Meyers - 2007 “The Common Shock Model for Correlated Insurance Losses” for background on this model.

18. Claim Severity Distributions Lags 5-10 Lag 4 Lag 3 Lag 2 Lag1

19. Where

20. Likelihood Function for a Given Insurer’s Losses – where

21. Maximum Likelihood Estimates • Estimate ELR and DevLag simultaneously by maximum likelihood • Constraints on DevLag • Dev1 ≤ Dev2 • Devi≥ Devi+1for i = 2,3,…,7 • Dev8 = Dev9 = Dev10 • Use R’s optim function to maximize likelihood • Read appendix of paper before you try this

22. Maximum Likelihood Estimates of Incremental Development Factors Loss development factors reflect the constraints on the MLE’s described in prior slide Contrast this with the observed 1986 loss development factors on the next slide

23. Incremental Development Factors - 1986(Repeat of Earlier Slide) Loss payment factors appear to be relatively stable for the 40 insurers that represent about 3/4 of the premium. They are highly unstable for the 210 insurers that represent about 1/4 of the premium. The variability appears to increase as size decreases

24. Maximum Likelihood Estimates of Expected Loss Ratios Estimates of the ELRs are more volatile for the smaller insurers.

25. Testing the Compound Negative Binomial (CNB) Assumption • Calculate the percentiles of each observation given E[Paid Loss]. • 55 observations for each insurer • If CNB is right, the calculated percentiles should be uniformly distributed. • Test with PP Plot • Sort calculated percentiles in increasing order • Vector (1:n)/(n+1) where n is the number of percentiles • The plot of the above two vectors against each other should be on the diagonal line.

26. Interpreting PP Plots Take 1000 lognormally distributed random variables with m = 0 and s = 2 as “data” If a whole bunch of predicted percentiles are at the ends, the predicted tail is too light. If a whole bunch of predicted percentiles are in the middle, the predicted tail is too heavy. If in general the predicted percentiles are low, the predicted mean is too high

27. Testing the CNB AssumptionsInsurer Ranks 1-40 (Large Insurers) This sample has 55×40 or 2200 observations. According to the Kolomogorov-Smirnov test, D statistic for a sample of 2200 uniform random numbers should be within ± 0.026 of the 45º line 95% of the time. Actual D statistic = 0.042. As the plot shows, the predicted percentiles are slightly outside the 95% band. We are close.

28. Testing the CNB AssumptionsInsurer Ranks 1-40 (Large Insurers) Breaking down the prior plot by settlement lag shows that there could be some improvement by settlement lag. But in general, not bad! pp plots by settlement lag

29. Testing the CNB AssumptionsInsurer Ranks 41-250 (Smaller Insurers) This is bad! pp plots by settlement lag

30. Using Bayes’ Theorem • Let W = {ELR, DevLag, Lag = 1,2,…,10} be a set of models for the data. • A model may consist of different “models” or of different parameters for the same “model.” • For each model in W, calculate the likelihood of the data being analyzed.

31. Using Bayes’ Theorem • Then using Bayes’ Theorem, calculate the posterior probability of each parameter set given the data.

32. Selecting Prior Probabilities • For Lag, select the payment paths from the maximum likelihood estimates of the 40 largest insurers, each with equal probability. • For ELR, first look at the distribution of maximum likelihood estimates of the ELR from the 40 largest insurers and visually “smooth out” the distribution. See the slide on ELR prior below. • Note that Lag and ELR are assumed to be independent.

33. Prior Distribution of Loss Payment Paths Prior loss payment paths come from the loss development paths of the insurers ranked 1-40, with equal probability Posterior loss payment path is a mixture of prior loss development paths.

34. Prior Distribution of Expected Loss Ratios The prior distribution of expected loss ratios was chosen by visual inspection.

35. Predicting Future Loss PaymentsUsing Bayes’ Theorem • For each model, estimate the statistic of choice, S, for future loss payments. • Examples of S • Expected value of future loss payments • Second moment of future loss payments • The probability density of a future loss payment of x, • The cumulative probability, or percentile, of a future loss payment of x. • These examples can apply to single (AY,Lag) cells, of any combination of cells such as a given Lag or accident year.

36. Predicting Future Loss PaymentsUsing Bayes’ Theorem forSums over Sets of {AY,Lag} • If we assume losses are independent by AY and Lag • Actually use the negative multinomial distribution • Assumes correlation of frequency between lags in the same accident year

37. Predicting Future Loss Payments Using Bayes’ Theorem • Calculate the Statistic S for each model. • Then the posterior estimate of S is the model estimate of S weighted by the posterior probability of each model

38. Sample Calculations for Selected Insurers • Coefficient of Variation of predictive distribution of unpaid losses. • Plot the probability density of the predictive distribution of unpaid losses.

39. Predictive DistributionInsurer Rank 7 Predictive Mean = $401,951 K CV of Total Reserve = 6.9%

40. Predictive DistributionInsurer Rank 97 Predictive Mean = $40,277 K CV of Total Reserve = 12.6%

41. CV of Unpaid Losses

42. Validating the Model on Fresh Data • Examined data from 2001 Annual Statements • Both 1995 and 2001 statements contained losses paid for accident years 1992-1995. • Often statements did not agree in overlapping years because of changes in corporate structure. We got agreement in earned premium for 109 of the 250 insurers. • Calculated the predicted percentiles for the amount paid 1997-2001 • Evaluate predictions with pp plots.

43. PP Plots on Validation Data KS 95% critical values = ±13.03%

44. Feedback • If you have paid data, you must also have the posted reserves. How do your predictions match up with reported reserves? • In other words, is S&P right? • Your results are conditional on the data reported in Schedule P. Shouldn’t an actuary with access to detailed company data (e.g. case reserves) be able to get more accurate estimates?

45. Response – Expand the Original Scope of the Paper • Could persuade more people to look at the technical details. • Warning – Do not over-generalize the results beyond commercial auto in 1995-2001 timeframe.

46. Predictive and Reported Reserves • For the validation sample, the predictive mean (in aggregate) is closer to the 2001 retrospective reserve. • Possible conservatism in reserves. OK? • “%” means % reported over the predictive mean. • Retrospective = reported less paid prior to end of 1995.

47. Predictive Percentiles of Reported Reserves • Conservatism is not evenly spread out. • Conservatism appears to be independent of insurer size • Except for the evidence of conservatism, the reserves are spread out in a way similar to losses. • Were the reserves equal to ultimate losses?

48. Reported Reserves More Accurate? • Divide the validation sample in to two groups and look at subsequent development. 1. Reported Reserve < Predictive Mean 2. Reported Reserve > Predictive Mean • Expected result if Reported Reserve is accurate. • Reported Reserve = Retrospective Reserve for each group • Expected result if Predictive Mean is accurate? • Predictive Mean  Retrospective Reserve for each group • There are still some outstanding losses in the retrospective reserve.

49. Subsequent Reserve Changes Group 1 Group 2 • Group 1 • 50-50 up/down • Ups are bigger • Group 2 • More downs than ups • Results are independent of insurer size

50. Subsequent Reserve Changes • The CNB formula identified two groups where: • Group 1 tends to under-reserve • Group 2 tends to over-reserve • Incomplete agreement at Group level • Some in each group get it right • Discussion??