1998 CASUALTY LOSS RESERVE SEMINAR Intermediate Track III- Techniques SEPTEMBER 28, 1998

INTRODUCTION The Ideal Situation Loss reserve data should contain a long stable history of homogeneous claim experience, where no significant operational changes materially affect either the mix of business or the handling of claims, and there should be sufficient number of claims to produce credible loss patterns. Slide 1

INTRODUCTION The Reality Virtually All Elements of “The Ideal” are Periodically Violated: 1. The Mix Changes 2. Claim Handling Changes: Payments Accelerate / Decelerate Case Reserves are Strengthened / Weakened 3. The Environment Changes: New Causative Agents Impact Loss Costs Society’s Attitudes Change Court Decisions Change “The Rules” Changes in the Economy Affect Claim Inflation Slide 2

INTRODUCTION This Session Will Discuss 1. The potential impact of mix changes. (Slides 4-10) 2. Changes in claim closing patterns. (Slides 11-21) 3. Changes in case reserve adequacy. (Slides 22-31) 4. Tail factor selection. (Slides 32-37) Slide 3

CHANGE IN MIX Cumulative Paid Losses (Combined) Accident Months of Development Year $2,000 $4,000 $5, $2,000 $4,000 $5, $2,000 $4, $2,000 Slide 4

CHANGE IN MIX Cumulative Paid Losses (by Type of Claim) Each of % of Months of Development Total Category A (75%) $1,500 $1,800 $2,000 Category B (25%) $500 $2,200 $3,000 $2,000 $4,000 $5, Category A (25%) $500 Category B (75%) $1,500 $2,000 Slide 5

CHANGE IN MIX Cumulative Paid Losses (by Type of Claim) Each of Months of Development Category A $1,500 $1,800 $2,000 Category B $500 $2,200 $3,000 $2,000 $4,000 $5, If Forecasting By Claim Category Category A $500 $600 $700 Category B $1,500 $6,600 $9,000 $2,000 $7,200 $9, If Ignoring Claim Category Combined $2,000 $4,000 $5,000 Slide 6

CHANGE IN MIX Key Principle Always Search for Subdivisions of Data Related to Possible Causes of Variable Loss Development Slide 7

CHANGE IN MIX Suggested Subdivisions of Data Include Primary: 1. Geographic: Laws Vary, Regional Office May Use Different. Claims Personnel, Degree of Litigiousness Varies 2. New Products Versus Old 3. Subline or Coverage 4. Deductibles or Policy Limits 5. Type of Loss Payment (e.g. Medical vs. Indemnity) Reinsurance: 1. Attachment Point 2. Production Source 3. Line or Subline Slide 8

CHANGE IN MIX How Do You Decide? Ask: 1. Underwriters 2. Claims Department 3. Agents 4. Actuaries The Key: Learn as Much as Possible About the Book of Business You are Evaluating. What it has been historically What it is becoming Slide 9

CHANGE IN MIX What Should be Done if Mix Change Includes New Business for Which You Have Insufficient Data? 1. Seek Alternative Sources of Data. For example, perhaps a general. liability book formerly comprised solely of “OL&T” exposures, but in. recent years began adding “M&C” risks Possible Solution: Relate ISO development patterns for M&C to OL&T. and modify development factors for your evaluation. 2. Discuss Potential Impacts With Claims, Underwriting, and Other. Actuaries. Discuss how the change might affect: Length of the tail Frequency Severity Loss Ratios Slide 10

CLAIM CLOSING PATTERNS How Can Changes In Payment Patterns Be Recognized? Look at Settlement Rates for the Most Recent Accident Years Ask the Claims Department About Changes in: - Opening and Closing Practices - The Claims Handling Environment - Levels of Staffing, Reorganizations - Definition of a Claim (e.g. Multiple Claimants) Slide 11

CLAIM CLOSING PATTERNS Data Needed Reported Claims Development Triangle Closed Claims Development Triangle Projected Ultimate Claims Paid Loss Development Triangle Slide 12

CLAIM CLOSING PATTERNS Unadjusted Paid Loss Development Method Accident Months of Development Year Ultimate 1995 $1,000 $4,000 $6,000 $6, $1,000 $3,500 $5, $750 $4, Ult Age - Age Age - Ultimate Slide 13

CLAIM CLOSING PATTERNS Accident Reported Claims Year Ultimate ,000 1, Accident Closed Claims Year , Slide 14

CLAIM CLOSING PATTERNS Accident Closed / Reported Year % 90.0% 100.0% % 80.0% % Accident Closed / Ultimate Year % 81.0% 100.0% % 71.8% % Slide 15

CLAIM CLOSING PATTERNS Accident Closing Percent Year % 71.8% 100.0% % 71.8% % Accident Adjusted Closed Claims Year * 1, * 718 = 71.8% x 1,000 Slide 16

CLAIM CLOSING PATTERNS - AY 1995 Actual Adjusted Actual Adjusted Closed Closed Paid Paid Age Claims Claims Losses Losses $0 $ $1,000 ? $4,000 ? 36 1,000 1,000 $6,000 ? Slide 17

CLAIM CLOSING PATTERNS Linear Interpolation of Adjusted Paid Losses AY = Months x (1, ) + 0 = 800 AY = Months x (4, ,000) + 1,000 = 3,507 AY = Months x (1, ) + 0 = 817 Slide 18

CLAIM CLOSING PATTERNS Adjusted Paid Loss Development Method Accident Months of Development Year Ultimate 1995 $800 $3,507 $6,000 $6, ,500 5, , Ult Age - Age Age - Ultimate Slide 19

CLAIM CLOSING PATTERNS Impact of Adjustment Accident Revised Original Year Forecast Forecast Difference 1995 $6,000 $6,000 $ ,985 5, ,550 4,223 1,327 Total $17,535 $15,473 $2,062 Slide 20

CLAIM CLOSING PATTERNS Step 1: Review Closing Rates to Determine Whether There Has Been a Change Step 2: Seek Independent Confirmation That Change Occurred Step 3: Restate Historical Closed Claims Using Current Closing Rates Step 4: Restate Historical Paid Losses Using Restated Closed Claims Step 5: Apply Standard Loss Development Method To Restated Paid Losses Slide 21

CASE RESERVE ADEQUACY Claim Data Accident Reported Claims Year Ultimate ,000 8,000 10,000 10, ,000 8,000 10, ,000 10,000 Accident Closed Claims Year Ultimate ,000 6,000 10,000 10, ,000 6,000 10, ,000 10,000 Slide 22

CASE RESERVE ADEQUACY Loss Data Accident Incurred Losses ($000) Projected Year Ultimate 1995 $10,000 $40,000 $50,000 $50, $10,000 $45,000 $56, $10,417 $55,340 Accident Paid Losses ($000) Projected Year Ultimate 1995 $2,000 $24,000 $50,000 $50, $2,500 $30,000 $62, $3,125 $78,125 The Issue: What Is Driving The Divergence? Slide 23

CASE RESERVE ADEQUACY STEP 1: Review Paid-To-Incurred Triangles: Accident Months of Development Year % 60% 100% % 67% % Does the Change in These Ratios Portray a Speed-Up in Payments, a Decrease in Case Reserve Adequacy, or Both? Slide 24

CASE RESERVE ADEQUACY STEP 2: Review Settlement Rates (No. Closed/No. Reported) Accident Settlement Rate Year % 75% 100% % 75% % Observation: The settlement rates appear to be consistent. Slide 25

CASE RESERVE ADEQUACY STEP 3: Review Trends in Average Paid Claims Versus Trends in Average Case Reserves Accident Average Paid Average Case Reserves Year $2,000 $4,000 $2,000 $8, $2,500 $5,000 $1,875 $7, $3,125 $1,823 Trend 25% 25% -4.5% -6.3% Observations: Case reserve trend is much lower than paid trend. Slide 26

CASE RESERVE ADEQUACY STEP 4: Review Potential Reasons For Observed Trends Is the book shifting to a lower severity mix? Have policy limits and/or reinsurance retentions kept pace with claims inflation? Has anything material changed in the handling of claims? - Turnover in claim department staff - Changes in philosophy If you conclude there has been case reserve weakening (or. strengthening), the data should be adjusted. Slides give. one approach. Slide 27

CASE RESERVE ADEQUACY STEP 5: Adjust Historical Case Reserves to Current Adequacy Levels Accident Adjusted Average Case Reserves Year $1,166 $6,000 $ $1,458 $7, $1,823 Examples: $6,000 = $7,500 / 1.25 $1,116 = $1,823 / (1.25 ^ 2) ASSUME: 25% is the Actual Rate of Claim Inflation Slide 28

CASE RESERVE ADEQUACY Adjust Paid to Number Adjusted Formula Incurred = Date + of x Average Losses Losses Open Case Reserves AY = 12 Months 6,664 = 2,000 + (4,000 x 1.166) AY = 24 Months 36,000 = 24,000 + (2,000 x 6.000) AY = 12 Months 8,332 = 2,500 + (4,000 x 1.458) Note: All dollar amounts are in thousands. Slide 29

CASE RESERVE ADEQUACY STEP 6: Project Ultimate Losses Using Adjusted Incurred Losses and Standard Loss Development Method Accident Adjusted Incurred Losses ($000) Year Ultimate $6,664 $36,000 $50,000 $50, $8,332 $45,000 $62, $10,417 $78,125 Slide 30

CASE RESERVE ADJUSTMENT Comparison of Estimates Original Original Revised Accident Incurred Paid Incurred Year Estimate Estimate Estimate 1995 $50,000 $50,000 $50, $56,250 $62,500 $62, $55,340 $78,125 $78,125 Slide 31

TAIL FACTORS The Need For Tail Factors Accident Reported Claims. Year Accident Open Claims. Year Accident Incurred Losses. Year , , , , , , , , ,000 IT APPEARS LOSS DEVELOPMENT WILL CONTINUE BEYOND THE ENDPOINT OF THE DATA. Slide 32

TAIL FACTOR SELECTION METHODS Techniques To Derive Tail Factors 1. Examine broader data sources: e.g. ISO, NCCI, RAA, Best’s (Caution: Learn. the limitations of such data.) 2. Curve Fitting 3. “Generalized Bondy Method” which assumes that the age-to-age factors are. decaying at a constant rate over time. Example: Determine a tail factor based on the following observed age-to-age factors (LDFs) LDF LDF LDF LDF Slide 33

TAIL FACTOR SELECTION Using Generalized Bondy Method To Calculate Tail Factors (1) (2)=Ln(1) (3)=(2)/(2 prior) (4) Months Actual LDFs Ln(Actual) Decay Ratio Predicted LDFs =(1.040) =(1.024) =(1.014) Selected Decay Ratio Tail Factor (144 months to Ultimate) 1.061=(1.040) Notes: 1. This method can be misleading when decay rates are unstable. 2. The tail factor is very sensitive to the last selected age-to-age factor. Slide 34

TAIL FACTORS When To Use These Different Approaches To Tail Factors Situation Source Reinsurance lines RAA Data Standard Workers Compensation line NCCI Unusual line where industry data is Curve fitting or Bondy difficult to obtain, e.g. aviation Company’s own data is unstable or not Industry Data credible, or a start-up line Slide 35

TAIL FACTORS How Much Tail Can There Be In Development In Reinsured Layers? Line of Selected Cumulative Age to Ultimate Factors*. Business 15 Years to Ult. 25 Years to Ult. W.C. Treaty G.L. Treaty A.L. Treaty * Based on RAA Data. Slide 36

TAIL FACTORS Some Examples Of When Development Occurs Beyond 10 Years LINE REASONS Products and Issues complex (Who’s liable? How to prove the Pollution/Environmental injury was caused by the product? Date of loss?) Workers Compensation Occupational Disease Life pension cases, with escalation clauses in some states Medical Malpractice Delayed manifestation, with subsequent complex issues Slide 37