CAS Ratemaking Seminar Price Governance I: Price Monitoring for Standard and Middle Market Commercial Lines March 8, 9 2

1. CAS Ratemaking SeminarPrice Governance I: Price Monitoring for Standard and Middle Market Commercial LinesMarch 8, 9 2007 Chris Nyce Senior Manager KPMG LLP Brian Hughes Senior Vice President Arch Insurance Group

2. Disclaimer • The views expressed in this presentation are those of the speakers; and • They are not necessarily the views of the CAS, KPMG, Arch Insurance or any other sponsor of this seminar; • Anyone who says otherwise is not only wrong, but is itching for a fight.

3. Contents for the Presentation

4. Backdrop 2006 or “Why Measure Pricing”? • CIAB Pricing Survey shows prices are declining in the last few years • Yet III shows Industry consolidated ROE at 11% - Marginal even at the height of the cycle; below all industry average every year for past 18 years • Conclusion: Company must be better than average to earn a return equivalent to peers in other industries Source: Insurance Information Institute

5. Historical Price Changes Implied by Reported Industry Results Compared to Actual Results Note initially reported results stable from 1996-1999, but actual results deteriorated markedly Rate adequacy changes implied in reported results lag actual by 23%! Source: AM BEST Aggregates and Averages composite Schd P.

6. Historical Price Changes Implied by Reported Industry Results Compared to Actual Results Similarly for other commercial casualty lines, rate adequacy changes implied by reported results lagged actual adequacy declines by: CMP - 8.8% Workers’ Comp - 24.9% Casualty Re - 46.2% Source: AM BEST Aggregates and Averages composite Schd P.

7. Climbing the Continuum: Various Stages of Rate Adequacy Capabilities Measuring and Acting in Real Time Reconciling Price Monitoring Data to Financial Systems Capturing Changes in Classifications Automating Data Feeds from Policy Systems Capturing Other Changes in Terms and Conditions Capturing Changes in Limits, Deductibles, Term Establishing a Standard Benchmark to Measure New Business Basic Monitoring of Renewal Price Changes Climbing the Price Monitoring Pyramid!

8. While Actuarial Approaches Need Improvement - Need Focus also onIntegrating Price Monitoring into a Comprehensive Underwriting Program

9. Quality of Risk Within Class • Standard underwriting execution is key • Reasonable authorities and delegations • Data and risk validation • Field audit schedules • Self audit and management reviews • Strong field and home office referral processes • Underwriting Audits should include data quality • Exposure information, coverage additions if not considered in the price monitor • Rating plan refinements may be needed • Any recognition of variation of loss cost within a rating segment is candidate for new rating variable • If no manual rating differential, needs to be segmented and tracked

10. Discussion of a General Approach for Standard Commercial Lines • Today we will discuss general renewal monitoring • New business (to benchmark) can be generalized in an analogous manner • Note also that Actuaries are critical to the business management process:

11. Standardized Formula for Small Commercial Business - Basic PropertyState the Rate Change at Expiring or Renewing Coverages Expiring Coverages Renewing Coverages Wind Deductible AOP Extension Ordinance And Law Sprinkler Leakage Sprinkler Leakage Package Extension Package Extension Group I&II Coverage 100K Group I&II Coverage 100K Deductible Buy- down to $250 No Buydown

12. Standardized Formula for Small Commercial Business - Basic PropertyState the Rate Change at Expiring or Renewing Coverages Expiring Coverages Renewing Coverages Wind Deductible AOP Extension Ordinance And Law Option I: Rerate to Expiring coverages Sprinkler Leakage Sprinkler Leakage Benefit: Not “making up” expiring premium and then measuring change from fictional premium. Package Extension Package Extension Group I&II Coverage 100K Group I&II Coverage 100K Deductible Buy- down to $250 Deductible Buy- down to $250 Red coverages are rerated, or “normalized”

13. Standardized Formula for Small Commercial Business-Basic PropertyState the Rate Change at Expiring or Renewing Coverages Expiring Coverages Renewing Coverages Wind Deductible Wind Deductible Option II: Rerate to Renewal coverages AOP Extension AOP Extension Ordinance And Law Ordinance And Law Benefit: Capturing all renewal coverages, but at the cost of adding fictional coverages to the expiring Sprinkler Leakage Sprinkler Leakage Package Extension Package Extension Group I&II Coverage 100K Group I&II Coverage 100K Deductible Buy- down to $250 No Buydown Red coverages are rerated, or “normalized” Purple coverages are deleted

14. Balancing Capture of Complete Information with Accuracy of MeasurementLine of Business and Coverage - Basic Property Example • Perform calculations at the coverage level so you can include or exclude coverages depending on renewal status: Consider whether to treat each coverage at each location as separate calculation, or alternatively “normalize” Instead of one coverage : “Basic Group I-Building” “Property Coverage” “Basic Group II-Building” “Basic Group I-Contents” “AOP-Building” “Off Premises Power” “Basic Group II-Contents” “Earth Movement” “Adjacent Structures” “AOP-Contents” “Money and Securities “Brands and Labels” “Packaged Extension” “Fire Dept Charges” “Sprinkler Leakage” “Ordinance and Law” “Accounts Receivable” “Off Premises Contents” “Debris Removal” And so forth…….

15. Balancing Capture of Complete Information with Accuracy of MeasurementRating Factors to Normalize - Basic Property Example • Which coverage factors should be normalized? Examine the rating algorithm and classify each factor: • Generally normalize those that give or take real coverage, such as: • Increased limits factors, Deductibles, Wind Exclusions, Exposures • Not those that reflect real exposure to loss characteristic of the risk, such as: • Territory, Class • Not those that are used to achieve target pricing, such as: • IRPM, Schedule Rating • Then make a decision on the gray areas: • Mold/Lead/Terrorism exclusions, Dispersion credits, Experience rating, Expense reduction, Commission contribution, Loss free discount

16. Calculating a Normalized Renewal Rate Change - Basic Formula • Assume the “expiring coverage” approach (and decide to normalize based on expiring or current rates) • Define a “normalizing factor” for each coverage • Expiring factor/Renewal factor (example: Expiring ILF/Renewal ILF) • A robust and automated approach to renewal price change is then: Normalized Renewal Rate/Expiring Rate = (Normalized Renewal Premium/Renewal Exposure) (Expiring Premium/Expiring Exposure) • Where: Normalized Renewal Premium=Charged Renewal Premium × Normalizing Factor

17. Business is quoted by underwriter (not issued) Monthly quotes are issued to agents/insureds Quarterly reviews of business performed Price Monitoring and the Quote/Issuance Renewal Cycle Step in the process Practical Opportunity to Act On Price Monitoring Prices Measured When? Real Time Option Can influence underwriters to change quotes before issuance Batch Option Can react to influence next months quotes Can react a quarter in arrears to influence prices or just use to set ELR’s

18. Introducing Brian Hughes, Break for Brian’s Presentation

19. Price Monitoring in Situations that are not Straightforward - Examples • Example 1: Excess Casualty (Re)insurance • Use benchmark approach • Establish pricing model, with pricing parameters such as LDF’s, excess factors, even manual rating built in • Measure new and renewal business as a percentage of manual • Example 2: Excess Property (Re)insurance • Examine CAT models to determine expected loss • Measure price to expected loss benchmark • Don’t forget risk margin • Inland Marine or Other Judgment Rated Risks • Measure benchmarks to schedule of ELP’s

20. Driving Price by Segment-Mainstreet Commercial Example 2. Divide the book into a manageable number of segments (stratify into A,B,C, for example) 1. Analyze book of business by overall rate need and by meaningful segment 3. Get agreement on the price need by larger segments 4. Set up segmentation model to drive price achievement by segment, and communicate to all underwriters 5. Monitor, Measure, Report Deviations Drive Underwriting Quality Throughout the Process

21. Segmentation Approaches – Understand the Business • Understand internal experience • Understand market experience • Suggest at collected level, not manual • If performing Premium on Level, must account for discretionary price changes • Understand market rate adequacy • Again at collected premiums, not manual • Rating Bureaus can be a decent source for this information

22. How are the Segments Defined? • Meaningful segments that company/underwriters manage • Common Examples • NAICS code • Class code • Program • Geographical region • Size of risk • Combination of the above

23. Business Drivers – Set Specific Targets • Price change on renewals • Price on new business to benchmarks • Renewal retention desired • Underwriting approach

24. Basic Implementation Model for Segmented Pricing Targets

25. Sample Action Grid for Underwriters and/or Agents

26. Sample Appetite Guide