STRIMA 2005 Conference

1. STRIMA 2005 Conference Premium Development/Cost Allocation Martin Lewis, FCAS, MAAA This document is incomplete without the accompanying discussion; it is confidential and intended solely for the information and benefit of the immediate recipient hereof.

2. Cost Allocation General Principles • Attributes of Sub-Optimal Systems • Work Steps • Summary

3. Cost Allocation General Principles • “Optimal” Definition: the process of equitably allocating property/casualty risk financing costs within an organization in a manner that promotes loss control • Cost Allocation vs. the Actuarial Report • Actuarial report: changes with new information/data • Cost allocation analysis: flexible • Cost Allocation vs. Rating

4. Cost Allocation General Principles • No single system is appropriate for all state entities • The system cannot be properly designed until the level of risk sharing has been selected • A properly designed and implemented system must address two distinct and classic tradeoffs: stability vs. responsiveness, and simplicity vs. equity • A successful system requires a reasonable investment in data acquisition and maintenance • Systems that initially focus on distributions, rather than absolute dollars, are easier to implement, explain, change, maintain, and update

5. Attributes of Sub-Optimal Systems • Attributes of a sub-optimal system • Does not promote loss control • Participants frequently challenge results • Participants do not understand the system • No “buy-in” from participants • Too much volatility • Too simple • Too complex • No incentives to reduce losses • Data problems • Improper level of risk sharing • Unwanted subsidies • Improper application of loss limitation • No capping of year-to-year changes • Improper use of exposure data

6. Work Steps • Evaluate risk sharing • Meet with participants • Obtain/maintain data • Evaluate distributions • Create universe of solutions • Presentation of results

7. Work Steps Evaluate Risk Sharing/Meet with Participants • Should exposures be used? Exposure weight? • Is appropriate exposure data available? • How many years of loss data should be used? • Which years of loss data should be used? • Should individual losses be limited? • How should a new department be rated? • Should year-to-year changes be capped? • What is a reasonable cap?

8. Work Steps Obtain/Maintain Data: Losses “Traditional” Approach: • Use 3-5 accident years, excluding the most recent and/or current year • Losses and allocated loss adjustment expenses (ALAE) • Reported (paid plus case reserve) loss and ALAE • Losses not developed • Losses not trended

9. 7/1/00 7/1/01 7/1/02 7/1/03 7/1/04 7/1/05 AY AY AY AY AY 2001 2002 2003 2004 2005 Report Lag Work Steps Obtain/Maintain Data: Losses Example of problem with “traditional” approach: report lag

10. Cycle 1 7/1/97 7/1/98 7/1/99 7/1/00 7/1/02 7/1/01 AY AY AY AY AY 1998 1999 2000 2001 2002 Case reserve = $50,000 Work Steps Obtain/Maintain Data: Losses Example of problem with “traditional” approach: payment lag for under reserved claim.

11. Cycle 2 7/1/98 7/1/99 7/1/00 7/1/01 7/1/03 7/1/02 AY AY AY AY AY 1999 2000 2001 2002 2003 Case reserve = $50,000 Work Steps Obtain/Maintain Data: Losses Example of problem with “traditional” approach: payment lag for under reserved claim.

12. Cycle 3 7/1/99 7/1/00 7/1/01 7/1/02 7/1/04 7/1/03 AY AY AY AY AY 2000 2001 2002 2003 2004 Case reserve = $50,000 Work Steps Obtain/Maintain Data: Losses Example of problem with “traditional” approach: payment lag for under reserved claim.

13. Cycle 4 7/1/00 7/1/01 7/1/02 7/1/03 7/1/05 7/1/04 AY AY AY AY AY 2001 2002 2003 2004 2005 Settlement = $1,000,000 Work Steps Obtain/Maintain Data: Losses Example of problem with “traditional” approach: payment lag for under reserved claim.

14. Work Steps Obtain/Maintain Data: Losses Solution to problems of (1) report lag and (2) payment lag for under reserved claim: Traditional: AY Losses Revised: AY Losses RY Losses (report year) FY Paid Losses (cash flow)

15. Work Steps Obtain/Maintain Data: Exposures Exposure Bases for State Programs *Industry data

16. 16% 14% 12% 10% Work Steps • Evaluate Distributions • Prior Allocation • Exposures • Accident Year Reported Losses (by Limit) • New Allocation Losses New Prior Distribution Exposures 1,000 50,000 500,000 Loss Limit

17. Allocation Steps 1-9 Allocation Steps 1-9 Allocation Step 10 Allocation Step 10 Submission Submission Review Review Revision Revision Acceptance Acceptance Work Steps • Evaluate Distributions Avoid multiple allocation cycles by focusing on distributions, not dollars Dollars Distributions

18. Work Steps • Create Universe of Solutions (Sensitivity Testing) Example: Universe of Solutions

19. Work Steps • Presentation of Results • Present the distributions to each department • Components of change exhibit Components of Change

20. Summary • Goals defined • Buy-in Required • Data Challenges • Focus on Distributions • Sensitivity Testing • Presentation