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Establishing the Expected Loss Ratio

George M. Levine, FCAS, MAAASenior Manager, KPMG LLP

September 9, 2003Chicago, Illinois

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Expected Loss Ratio(Definition)

Ultimate Loss Ratio (Losses/Premium) expected to be incurred a-priori before consideration of actual experience

Loss Ratio discussed as REASONABLENESS check for reserves in CAS Loss Reserve Principles

ELR is basis of ratemaking: »Actual Loss Ratio/ELR –1=Rate

Change

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Expected Loss Ratio Why important now?

Several important changes on the Landscape

» HARD MARKET—Past Loss Ratios not indicative of Future Loss Ratios

» SARBANES OXLEY 404 REQUIREMENTS—Internal Control over Financial Reporting

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Expected Loss RatioHard Market

Loss Ratios decrease in times of Increasing Rates

60

65

70

75

80

85

90

95

1980

1983

1986

1989

1992

1995

1998

2001

Loss&LAERatios

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SARBANES-OXLEY 404Audit of Internal Control

1) Management’s annual report on internal control must:

State management’s responsibility for establishing and maintaining adequate internal controls

Contain management’s assessment as of year-end of effectiveness of internal control structure

2) Independent Auditor must attest to and report on management’s assessment in accordance with standards issued or adopted by the PCAOB (Public Company Accounting Oversight Board)

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SARBANES-OXLEY 404Audit of Internal Controls

1) COSO: Committee on Sponsoring Organizations of Treadway Commission (AICPA is one organization)

2) COSO’s 5 Areas of Internal Control1) CONTROL ENVIRONMENT2) RISK ASSESSMENT3) CONTROL ACTIVITIES4) INFORMATION + COMMUNICATION5) MONITORING

3) Conclusion: ELRs, the bridge between ratemaking and reserving, is important element for insurance controls

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Expected Loss Ratio Considerations: Experience Rating

» Loss Development» Loss Trend» Premium Rate Changes» New Business Penalty» # of Years to Consider

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Experience Rating Expected Loss Ratio Example

5% On-LevelDevl. Trended Earned Earned Loss

Year Losses Losses Prem. Prem. Ratio1999 5.2 6.3 6.0 8.0

79%2000 6.0 6.9 7.0 8.5

81%2001 5.6 6.2 7.5 8.3

75% 2002 7.0 7.4 8.0 8.0

93%Total 23.8 26.8 28.5 32.8

82% 2003 Select90%

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Experience Rating ELRFurther Adjustments

» Split History Into New and Renewal Business» Homogeneity and Credibility Considerations» Self-Insureds: Often Exposure Bases utilized for

Expected Loss Rates instead of Expected Loss Ratios, with same concepts applying– Industry Experience Important for Self-Insureds

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Expected Loss Ratio Considerations: Exposure Rating

» Exposure Bases» Industry Expected Loss Ratios/Loss

Rates» Extension of Exposures

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Reserving Methods: Initial Expected Loss Ratio

Selections1) Bornhuetter-Ferguson Method (PCAS 1972)

2) Cape Cod Method/Stanard-Bulhmann Method

3) Comments: Quarterly Adjustments

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Initial Expected Loss Ratio Bases

1) Bornhuetter-Ferguson Method (PCAS 1972) External Source for Initial Expected Costs Ultimate Costs Implied by Development Method,

ILC= LDF X AMT/EXP, where LDF is Ultimate Development Factor, AMT is Current Reported (Paid), EXP is Exposure ILC is Indicated Loss Cost

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Initial Expected Loss Ratio Bases

2) Cape Cod Method ULC=AMT/ (EXP/LDF) Where ULC= Undeveloped Loss Cost

Weights here are (EXP/LDF) for All Periods

Generalized Cape Cod Method: Unique Expected Loss Cost for Each

Accident Period as Weighted Average of Surrounding Accident Periods

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Bornhuetter-Ferguson Method95% Initial Expected Loss Ratio

Earned Expected Reported Expected

Year Prem. IELR Losses Losses Unreported %

2000 6.0 95% 5.7 5.8 .0312001 5.6 95% 5.3 4.8 .142 2002 7.0 95% 6.7 4.3 .394

ExpectedUnreported Ultimate Ultimate

Year Losses Losses Loss Ratio2000 0.2 6.0 100%2001 0.8 5.6 99% 2002 2.6 6.9 99%

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Bornhuetter-Ferguson Method70% IELR—How Judgment Affects

Earned Expected Reported Expected

Year Prem. IELR Losses Losses Unreported %

2000 6.0 70% 4.2 5.8 .0312001 5.6 70% 3.9 4.8 .142

2002 7.0 70% 4.9 4.3 .394

Expected 70%IELR 95% IELRUnreported Ultimate Ultimate Ultimate

Year Losses Losses Loss Ratio Loss Ratio

2000 0.1 5.9 99% 100%2001 0.6 5.4 96% 99%

2002 1.9 6.2 89% 99%

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Cape Cod MethodInitial Expected Loss Ratio

On-Level (3)x(5)

Earned Earned Reported Expected Expected

Year Prem. Prem. Losses Unreported % Unrep.Loss

(1) (2) (3) (4) (5) (6)2000 6.0 7.3 5.8.031 .22001 5.6 6.2 4.8.142 .92002 7.0 7.0 4.3.394 2.8Total 18.6 20.5 14.9 3.9

Cape Cod IELR =14.9/(20.5-3.9) =90%Actual Reported/Expected Reported

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Cape Cod Method90% Initial Expected Loss Ratio

Earned Expected Reported Expected

Year Prem. IELR Losses Losses Unreported %

2000 6.0 90% 5.4 5.8 .0312001 5.6 90% 5.0 4.8 .142 2002 7.0 90% 6.3 4.3 .394

Expected Cape Cod 95%Unreported Ultimate Ultimate B-F

Year Losses Losses Loss Ratio Ult. LR2000 0.2 6.0 99% 100%2001 0.7 5.5 98%

99%2002 2.5 6.8 97%

99%

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Quarterly Estimates @ 6/02Bornhuetter-Ferguson Method

Earned Expected Reported Expected

Year Prem. IELR Losses Losses Unreported %

2000 6.0 90% 5.4 5.5 .0672001 5.6 90% 5.0 4.6 .242 6/02 3.5 90% 3.2 2.0 .741Or 6/02 7.0 90% 6.3 2.0 .741

Unreported Ultimate Ultimate

Year Losses Losses Loss Ratio2000 0.4 5.9 98% 2001 1.2 5.8 104%

6/02 2.3 4.3 124% Or 6/02 4.7 6.7x.5=3.4 95%

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Conclusions

1) Expected Loss Ratio ever-increasing scrutiny in loss reserving due to changing landscape and hard market

2) Choice of Initial Expected Loss Ratio subject to judgment, but sophisticated techniques exist to assist in choosing IELRs