2001 CLRS September 2001 New Orleans, Louisiana

1. Basic Track III 2001 CLRS September 2001 New Orleans, Louisiana

2. THIS SESSION WILL DISCUSS I. Expected Loss Ratio Technique II. Allocated Loss Adjustment Expenses (ALAE) (Defense and Cost Containment) III. Unallocated Loss Adjustment Expenses (ULAE) (Adjusting and Other Expenses) IV. Schedule P - Part 1 Summary

3. EXPECTED LOSS RATIO TECHNIQUE EXPECTED LOSS RATIO (ELR) The anticipated ratio of projected ultimate losses to earned premiums. Sources: • Pricing assumptions • Historical data such as Schedule P • Industry data

4. EXPECTED LOSS RATIO TECHNIQUE EXAMPLE OF ELR USING PRICING ASSUMPTIONS Commissions 20% Taxes 5% General Expenses 15% Profit (2%) Total 38% Amount to pay for loss & loss expense ---- 62% of premium

5. EXPECTED LOSS RATIO TECHNIQUE

6. EXPECTED LOSS RATIO TECHNIQUE Estimating Reserves Based on ELR Earned Premium x ELR = Expected Ultimate Losses Ultimate Losses - Paid Losses = Total Reserve Total Reserve - Case Reserve = IBNR Reserve

7. EXPECTED LOSS RATIO TECHNIQUE Estimating Reserves Based on ELR - Example Earned Premium = $100,000Expected Loss Ratio = 0.65 Paid Losses = $10,000 Case Reserves = $13,000 Total = ($100,000 x 0.65) - $10,000 Reserve = $65,000 - $10,000 = $55,000 IBNR = $55,000 - $13,000 Reserve = $42,000

8. EXPECTED LOSS RATIO TECHNIQUE Estimating Reserves Based on ELR Use when you have no history such as: New product lines Radical changes in product lines Immature accident years for long tailed lines Can generate “negative” reserves if Ultimate Losses < Paid Losses

9. EXPECTED LOSS RATIO TECHNIQUE Reserves Based on ELR and Reported Incurred (Bornhuetter-Ferguson Approach) (Earned Premium x ELR) x (IBNR Factor) = (IBNR Reserves) Where IBNR Factor = (1.000 - 1.000/LDF*) Reported Incurred + IBNR Reserve = Ultimate Losses Case Reserve + IBNR Reserve = Total Reserve *LDF is the cumulative Loss Development Factor to ultimate based on incurred losses. The IBNR Factor is the percent of expected losses unreported.

10. EXPECTED LOSS RATIO TECHNIQUE

11. EXPECTED LOSS RATIO TECHNIQUE

12. EXPECTED LOSS RATIO TECHNIQUE

13. BORNHUETTER-FERGUSON APPROACH APPLIED TO A NON INSURANCE EXAMPLE Given the following, how many home runs will Ken Griffey, Jr. hit this year? • He has hit 20 home runs through 40 games • There are 160 games in a season Three pieces of information are need to perform a Bornhuetter-Ferguson (B-F) projection: • Expected Ultimate Value • Cumulative Loss Development Factor • Amount Incurred To Date

14. BORNHUETTER-FERGUSON APPROACH APPLIED TO A NON INSURANCE EXAMPLE The three pieces of information for our example : • Before the season started, how many home runs would we have expected Ken Griffey, Jr. to hit? Expected Ultimate Value = 40 • To project season total from current statistics, multiply the current statistics by 4 since the season is 1/4 completed. Cumulative Loss Development Factor = 4.000 • He has already hit 20 home runs. Amount Incurred To Date = 20

15. BORNHUETTER-FERGUSON APPROACH APPLIED TO A NON INSURANCE EXAMPLE B-F Projection: Ultimate Value = (Expected Value*IBNR Factor)+(Inc. to Date) IBNR Factor = 1.000 - (1.000/LDF) = 1.000 - (1.000/4.000) = .75 (In Other Words, 75% of the season is left to be played) Ultimate Value = (40 * .75) + 20 = 50 The B-F Method projects that Ken Griffey, Jr. will hit 50 home runs this year. Games 0-40 Games 41-80 Games 81-120 Games 121-160 20 Home Runs 10 Home Runs 10 Home Runs 10 Home Runs

16. BORNHUETTER-FERGUSON APPROACH APPLIED TO A NON INSURANCE EXAMPLE Comparison of B-F with Two Other Methods Incurred Loss Development Method Ultimate Value = Incurred To Date * Cumulative LDF = 20 * 4.000 = 80 Home Runs Games 0-40 Games 41-80 Games 81-120 Games 121-160 20 Home Runs 20 Home Runs 20 Home Runs 20 Home Runs Expected Loss Ratio Method Ultimate Value = Expected Value = 40 Home Runs Games 0-40 Games 41-80 Games 81-120 Games 121-160 10 Home Runs 10 Home Runs 10 Home Runs 10 Home Runs

17. EXPECTED LOSS RATIO TECHNIQUEReserves Based on ELR and Reported Incurred(BORNHUETTER-FERGUSON) SAMPLE PROBLEMS Pricing inconsistency Instability in accident year loss ratios Introduction of automated claim system Backlog in processing ASSUMPTIONS Premium accurate measure of exposure Expected loss ratio predictable Constant reporting, reserving and settling

18. EXPECTED LOSS RATIO TECHNIQUEReserves Based on ELR and Reported Incurred(BORNHUETTER-FERGUSON) ADVANTAGES Compromises between loss development and expected loss ratio methods Avoids overreaction to unexpected incurred losses to date Suitable for new or volatile line of business Can be used with no internal loss history Easy to use DISADVANTAGES Assumes that case development is unrelated to reported losses Relies on accuracy of expected loss ratio and reporting pattern Less responsive to losses incurred to date Relies on accuracy of earned premium

19. ALAE RESERVING METHODS ALLOCATED LOSS ADJUSTMENT EXPENSE (ALAE) Previous Definition : Expenses that are specifically assigned to an individual claim Currently Called: DEFENSE AND COST CONTAINMENT EXPENSE

20. ALAE RESERVING METHODS DEFENSE AND COST CONTAINMENT EXPENSE Current Definition (effective 1/1/98) : Limits ALAE to internal or external expenses relating to the following · Defense · Litigation · Medical Cost Containment Therefore, the ability to assign a particular type of expense to a single claim is no longer the determining factor as to whether the expense is ALAE or ULAE “Loss Adjustment Expenses” other than allocated expenses are assigned to the group Unallocated Loss Adjustment Expense

21. ALAE RESERVING METHODS 1. PAID ALAE DEVELOPMENT 2. CUMULATIVE PAID ALAE TO CUMULATIVE PAID LOSSES

22. ALAE RESERVING METHODS

23. ALAE RESERVING METHODS

24. ALAE RESERVING METHODS ALAE Reserves Based on Paid ALAE Development ADVANTAGESDISADVANTAGES Similar to paid losses; easy & straightforward Ignores relationship to losses May work well for older AYs Heavily influenced by amount of highly volatile initial payments

25. ALAE RESERVING METHODS

26. ALAE RESERVING METHODS

27. ALAE RESERVING METHODS

28. ALAE RESERVING METHODS

29. ALAE RESERVING METHODS ADVANTAGES Recognizes relationship of ALAE to losses. Straightforward methodology, predictable. Provides tool for monitoring relationship of ALAE to losses. DISADVANTAGES Over or under estimation of losses reflected in ALAE estimates. More complex than paid ALAE development. Heavily influenced by volatile initial ratios of ALAE to loss. Significant ALAE can be spent to close claims without payment. Changes in legal defense strategies may distort.

30. ULAE RESERVING METHODS UNALLOCATED LOSS ADJUSTMENT EXPENSE (ULAE) Previous Definition : Expenses incurred in connection with settling claims which are not readily assigned to specific claims Currently Called: ADJUSTING & OTHER EXPENSE

31. ULAE RESERVING METHODS ADJUSTING & OTHER EXPENSE Current Definition (effective 1/1/98) : Those expenses, other than allocated expenses, assigned to the expense group “Loss Adjustment Expense”. Unallocated expenses include but are not limited to the following : Fees of adjustors and settling agents Attorney fees incurred in the determination of coverage, including litigation between insurer and policyholder Fees or salaries for appraisers, private investigators, hearing representatives, reinspectors and fraud investigators

32. ULAE RESERVING METHODS THE “50/50” Rule Assumes 50% of ULAE is paid when the claim is opened, and 50% is paid when the claim is closed.

33. ULAE RESERVING METHODS • The “50/50” Rule • 3 year average of the ratio of calendar year paid ULAE to paid losses. • 50% of the ratio applied to known case loss reserves. • 100% of the ratio applied to IBNR reserves. • It may be necessary to separate the “broad” IBNR reserve into development on known case reserves and “pure” IBNR.

34. ULAE RESERVING METHODS • Consideration in Selecting Ratio of Calendar Year Paid ULAE to Paid Losses • Average over 3 years may not produce appropriate factor: • ULAE payments may not completely correlate to the years’ loss payments • May need to judgmentally select factor based on: • Steadily increasing or decreasing factors • Changes in expense allocation procedures

35. ULAE RESERVING METHODS

36. ULAE RESERVING METHODS

37. ULAE RESERVING METHODS Assumptions in Applying “50/50” Rule Age of claim does not affect the ratio of paid ULAE to Losses ULAE and Losses are paid at the same rate These assumptions should be reviewed for each situation where the “50/50” rule is used

38. ULAE RESERVING METHODS Recent Developments in ULAE Reporting Effective with the 1997 Annual Statement, the “50/50” rule no longer underlies annual statement Schedule P reporting of paid unallocated expenses. Rather, unallocated loss expense payments and reserves should be allocated to the years in which the losses were incurred based on the number of claims reported, closed and outstanding in those years. An insurer is permitted to use the “50/50” rule or some other reasonable procedure when suitable claim information is not available.

39. SCHEDULE P - PART 1 SUMMARYANNUAL STATEMENT FOR THE YEAR 2000 OF THE TYPICAL P&C INSURANCE COMPANY

40. DATA AVAILABLE FROM SCHEDULE P Losses Direct+Assumed, Ceded Cumulative Paid Losses, Net of Salvage and Subrogation (columns 4-5) Case Reserves Held (columns 13-14) Bulk + IBNR Reserves Held (columns 15-16) Incurred Losses = Paid + Case Reserves + IBNR Reserves Claim Counts Reported (column 12) Outstanding (column 25) Closed = Reported - Outstanding Loss Adjustment Expenses Defense and Cost Containment (ALAE) and Adjusting and Other (ULAE) Direct+Assumed, Ceded Paid, Case Reserves, Bulk + IBNR Reserves Earned Premium (columns 1-3)

41. SCHEDULE P TERMINOLOGY Bulk + IBNR reserves include: Reserves for claims not yet reported (pure IBNR) Claims in transit Development on known claims Reserves for reopened claims Reserves = Liabilities = Accruals = Unpaid = Case Reserves + IBNR Incurred losses may have various meanings!