Pitfalls in Common Pricing/Reserving Methodologies

Pitfalls in CommonPricing/Reserving Methodologies David Skurnick Leonard Chung Clive L. Keatinge CARe June 15, 2000

Pitfalls in Common Pricing/Reserving Methodologies David Skurnick, St.Paul Re CARe June 15, 2000

Pitfalls in... • Underwriting • Excess • Miscellaneous

Pitfalls in Underwriting • Accuracy and completeness of data • Understanding of terms • Local practices

Data Accuracy and Completeness • How can you verify accuracy? • Audits • Consistency • Agreement with the market • What’s missing? • Older cat losses • rate changes • experience on discontinued business

Experience on discontinued business -- my rule of thumb: • If they have discontinued an entire segment that ran badly, say a territory or line of business, then I exclude the experience. • If they have gotten off some unsuccessful business, then I include the experience -- this is normal underwriting.

Understanding of Terms • Interlocking clause • “FCA” (For common account) • Lloyd’s ‘miscellaneous classes”

Interlocking clause • E.g., a Worldwide ex. US catastrophe cover excess of $100m, with interlocking clause. • If a hurricane hit the Caribbean and the US, cedant’s combined retention would be $100. • Must read the contract to see how the retention is allocated. • Cannot underwrite this deal without looking at US exposures.

“FCA” (For Common Account) • E.g., a cedant has an 80% quota share. • You write 5% of an excess treaty • Is is “5% of net” or “5% of all”? • If you’re covering the Common Account then you’re limits may be 5 times higher. • Mandatory or optional?

What are you covering? • “Miscellaneous Classes” could include anything, especially at Lloyd’s. • E.g., Computer Leasing in early 80’s • E.g., Typical wording is “All policies written in the Fire Department”, not “All Fire Policies.” • You MUST verify what is actually covered.

Local Practices • Egyptian “catastrophe” • Egyptian personal accident • European commutation • European motor excess

Egypt Re “Catastrophe” • The Heliopolis Sheraton Hotel burned down. Was this a cat loss? • Yes! -- because there were two policies, one for the floors and one for the elevator shaft!

Egyptian Personal Accident Question: Treaty limits are : EGP 50,000 XS 50,000 / $ 20,000 XS 20,000 with 3 reinstatements. How large is the reinsurer’s maximum loss? (Assume 1 EGP = $0.40)

Egyptian Personal Accident(slide 2) Answer: EGP 200,000 PLUS $80,000 (The slash meant “and”, not “or”)

European Commutation • Commutations in Europe are generally revocable • The commutation will not apply to exceptionally large claims or to material change in claims cost.

European Motor Excess • Most international motor covers are indexed for inflation.

Pitfalls in Excess Pricing • Excess of Aggregate • Inflation • Aggregate Deductible

Excess of Aggregate (Stop Loss) • Buyer knows more than seller • Long-term or short-term relationship? • LR affected by frequency, severity & cats • LR affected by Rate Adequacy • A total loss to the reinsurance layer could be likely.

Compare the Risk of Specific Excess Vs Excess of Aggregate • Look at the impact of an error in estimating the Expected Loss Ratio • E.g., suppose that the Expected Frequency is twice what you thought it was, and all other estimates are correct.

Specific Excess Example • Suppose you are receiving 10% of original premium for a risk layer of $1m Xs $1m and your expected loss was 7%. • Due to under-estimate of frequency, the ELR is 140% rather than 70% • Note that this 2 to 1 ratio is independent of the original rate, frequency, severity, etc.

Excess of Aggregate Example • You receive 6% of original premium to cover a loss ratio of 30% XS 80%. • Your primary ELR = 70%. • Your expected XS loss = 2%. • Then, your XS ELR = 33%. • Suppose exp. freq. Is twice what your think • Then expected FGU LR = 140% • Expected XS loss might be, say, 24%. • Correct XS ELR = 400%, not 33%

Excess of Aggregate Example(slide 2) • Suppose expected frequency is twice what your thought it was • Then expected FGU LR = 140% • Expected XS loss to the layer 30% XS 80% might be, say, 24%, not 2%. • Correct XS ELR = 400%, not 33%

Per Risk Casualty Excess Treatywith High Inflation • E.g., Avner -- old Israeli XS motor liability • When Israeli Shekel had 100% inflation • XS claims became routine, not exceptional • The increase in premium (due to a higher exposure base) did not at all compensate for the enormous increase in claim frequency in this layer.

Aggregate Deductible on Per Risk Property • E.g., layer of $1m XS $1m XS $4m. • Reinsurer would would pay only after 4 total losses of $2 million or more (or equivalent in partial losses to the layer.) • Assume the treaty limit is $25 million. • This would protect against a frequency of losses in a low layer.

Aggregate Deductible on Per Risk Property (slide 2) • Key is the average frequency of losses > $2m (ignoring partial losses to the layer) • If you think the expected frequency of such losses = 5, then this treaty would be loss free more often than not. • One might guess the expected loss to the layer as about $1 million (using a Poisson)

Aggregate Deductible on Per Risk Property (slide 3) • What if the correct average frequency = 10 • Then expected loss >$5 million • Doubling the frequency caused the risk excess expected loss to grow 5X • Note that frequency might be double because of unexpected growth in the underlying premium.

Miscellaneous Pitfalls • Exchange Rate errors • Individual company loss development • Ending a Managing General Agent relationship

Exchange Rate Errors Several years ago, one of our underwriters slipped a decimal point in the exchange rate and wrote ten times as big a line as he intended. (Naturally, the deal turned out to be a big loss!)

Individual company loss development • For several years we wrote a quota share of industrial property business. • We learned to our sorrow that this property business took several years to develop. • Slow development was partly due to the complex nature of the claims. • Also, company claims procedures slowed the reporting and reserving of losses.

Ending an MGA Relationship • A cedant of ours had a group of Managing General Agents • They decided to get out of MGA business • Several years later they decided to handle the remaining open claims themselves. • They discovered that their loss reserve of $200 m should have been $600 million! • It turned out that the cancelled MGA’s had stopped working on the claims.

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Pitfalls in Common Pricing/Reserving Methodologies