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CYCLES IN CASUALTY:

CYCLES IN CASUALTY:. Balancing Loops in the Insurance Industry Kawika Pierson MIT Sloan PhD Candidate. Presentation Outline. The Insurance Industry Past Research Economics Control Theory System Dynamics The Model Boundary Causal Loop Diagram Important Structures PID Control

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CYCLES IN CASUALTY:

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  1. CYCLES IN CASUALTY: Balancing Loops in the Insurance Industry Kawika Pierson MIT Sloan PhD Candidate

  2. Presentation Outline • The Insurance Industry • Past Research • Economics • Control Theory • System Dynamics • The Model • Boundary • Causal Loop Diagram • Important Structures • PID Control • Behavior • How You Can Help

  3. The Insurance Industry • Basic Idea • Two Sides to the Business • Insurance • Investing • Insurance Cycle – What is Cycling? • Underwriting Loss Ratio or Combined Loss Ratio • Loss Ratio – Adjustments/Premiums • Expense Ratio – Expenses/Premiums • Combined Ratio – Loss + Expense = (A + E) / P

  4. A View to A Cycle

  5. A View to A Cycle

  6. The Insurance Industry • Insurance Cycle – What Causes It? • Industry View: • “The next stage is precipitated by a catastrophe or similar significant loss, for example Hurricane Andrew or the attacks on the World Trade Center.” – “The Insurance Cycle” wikipedia • Academic View: • “Using quarterly data from 1974 through 1990, we provide evidence of a long-run link between the general economy and the underwriting performance as measured by the combined ratio.” – Grace and Hotchkiss, 1995 J o Risk and Insurance • “Fluctuations in the supply of property-liability insurance may be exacerbated by regulation.” Winter, 1991 Economic Inquiry

  7. Past Research in Economics • Early 1980’s through Mid 90’s • Three Main Schools of Thought • Cycle Caused by Interest Rate Fluctuations • Doherty and Kang (1988) – Insurance Prices Change in Lagged Response to Interest Rates • Grace and Hotchkiss (1995) – “External Impacts on the Property-Liability Insurance Cycle” • Cycle Caused by Limits to the Supply of Insurance • Winter (1988, 1991, 1994), Gron (1989, 1994) • Cycle Caused by Feedback Processes • Brockett and Witt (1982) – Loss expectations from the past inform current premiums, causing autocorrelation

  8. Past Research in Control Theory • If a Cycle Exists we Will Create a Lagged Negative Feedback Loop to Explain It • Balzer and Benjamin 1980 – “Dynamic Response of Insurance Systems with Delayed Profit/Loss Sharing Feedback…” Journal of the Institute of Actuaries • Zimbidis and Haberman 2001 – “The Combined Effect of Delay and Feedback on the Insurance Pricing Process: a Control Theory Approach” Insurance: Mathematics and Economics

  9. Past Research in System Dynamics • The Claims Game and Hanover Insurance • “claims management, quality and costs” • Quality = Claim Adjustment Quality • Daniel H. Kim • Learning Laboratories • Peter Senge – “The Fifth Discipline” • Moissis 1989 Masters Thesis (Sterman) • Focuses on Determining Decision Rules • Cavaleri and Sterman (1997) “Towards evaluation of systems thinking interventions: a case study” • Improved Manager’s Mental Models

  10. Past Research in System Dynamics • Insurance Cycle… • Are There Really no SD Articles on the Insurance Cycle? • Thomas Beck • Co-President of Swiss SD Society • Works for Large Swiss Reinsurer • No Published Articles on Insurance Cycle

  11. The Model – Boundary • Endogenous Variables • Premiums • Underwriting Quality (Risk) • Claims • Employees • Administrative Costs • Exogenous Variables • Desired Profit Margin • Size of the Total Market • Some Components of Administrative Costs

  12. The Model – Boundary • Many Feedbacks Excluded • Size of the Insurance Market • Investments and Interest Rates • Free Capital’s Influence on Underwriting • Effect of Time Pressure on Claim Settlement • Competitive Effects on Profit Margins • Random Claim Incidence • Employee Productivity • Is this Too Far Towards “Negative Loop w/ Delay”

  13. THE MODEL – CASUAL(TY) LOOP DIAGRAM

  14. The Model – Structures

  15. The Model – Structures

  16. The Model – Structures

  17. The Model – Structures

  18. The Model – Structures

  19. The Model – Structures

  20. The Model – Structures

  21. The Model – PID Control • Translating Equations to SD isn’t Always Easy • Proportional Control = Standard Structure • Integral Control = No Steady State Error • Reasonable that People Use IC • Derivative Control = Less Overshoot • Less Likely that People Use DC

  22. THE MODEL – PID CONTROL

  23. THE MODEL – PID CONTROL

  24. THE MODEL – PID CONTROL

  25. The Model – Behavior • Displays Decaying Oscillation to Step Input

  26. THE MODEL – CASUAL(TY) LOOP DIAGRAM

  27. The Model – Behavior • Instability A Function of Largest Source of Costs

  28. THE MODEL – CASUAL(TY) LOOP DIAGRAM

  29. The Model – Behavior • Loop Gain Very Important

  30. The Model – Potential Solutions • Derivative Control of Premiums? • Careful Tuning Is Necessary • Managerial Implementation • Industry Wide Application • Why Do Quality Standards Change? • Can This Loop Be Cut • Life Insurance • The Kalmanuclear Option? • Optimal LINEAR Filter • Just Build a Really Good Model Instead

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