Pricing Excess and Surplus Lines (COM-4) Ronald J. Herrig, FCAS Markel Corporation Deerfield, Illinois

What Is the Surplus Lines Industry?

The Surplus Lines industry provides a market for hard-to- place risks; risks the standard market chooses not to write.

Why are these risks not written by the standard market? Distressed Risks/Markets Unique Risks High-Capacity Risks

Distressed Risks – Something about the risk itself that makes it undesirable to the standard market. Start-Up Manufacturer – No track record New Physician Physician with a History of Drug-Abuse

Distressed Markets – Something about the entire category of risks that makes it undesirable to the standard market. OB/GYNs - SOL Junk Yards Nutritional Supplements – What’s the new Ephedra?

Unique Risks – Characteristics of the risk make it too unusual to fall within standard U/W classes. Fireworks Accounts Shamu Transportation Architectural Projects

High-Capacity Risks – Risks needing high limits of protection and in-depth underwriting High Rise Buildings Directors & Officers Aviation Property/Liability

How Can Surplus Lines Companies write this Junk (Profitably)?

By being Fast, Fluid and Flexible!

Regulation No need to file rates/forms Licensing required only in state of domicile Not an unregulated industry, though

Regulations That Do Apply Annual Statements Triennial Reviews Market Conduct Exams Risk-Based Capital Requirements SEC Requirements

Adaptable Policies Claims-Made Coverage ALAE included within Limits Sublimits Customized Endorsements

And most importantly…

Expert Underwriting Underwriters need: to understand their company’s appetite for risk – and abide by it knowledge of book’s underlying statistics to understand each insured and its associated risks

Claims Handling Knowledgeable Claim Handlers Standardized Approach to Claims Reserving Consistent Approach to Claims Reserving

Effects of the Market Cycle

Hard Market and E&S Admitted Companies become more selective. Surplus Lines applications increase dramatically. Rates Firm, Coverages Contract. Small Decrease in Admitted Market can increase Non-Admitted Market Substantially.

Change in Applications (2000 Baseline = 100 units)

Soft Market and E&S Admitted Companies become less selective in their Underwriting. Fewer Risks are Declined. E&S companies develop new products to maintain volume.

Examples of New Products Employment Practices Liability Tenant Discrimination Environmental Impairment Liability

EPLI (1994 Baseline = 100 units)

New Product Development 1.Opportunity identification 2.Product design 3.Testing 4.Product introduction 5.Life-cycle management

Opportunity Identification Broker Recommendations Marketing New Product Teams Media

Product Design Target Market Coverages Policy Wording Rating

Testing Beta-Test on Select Market Honest Feedback Rate, rate, rate

Ratemaking Methods

Ratemaking Methods for New Products Pure Premium Methods Piggy-back Method Festus Method

Pure Premium Methods 1.Ultimate Losses / Ultimate Exposures 2.Frequency x Severity

Pure Premium Methods 1.Trend individual ‘ground-up’ losses; remove base deductible 2.Develop losses; cap at basic limit 3.Aggregate all adjusted losses.

Pure Premium Method Treatment of Exposures 1.Multiply individual units of exposure by applicable relativity factors (state, class code, claims-made step-rate, etc.) 2.Aggregate all adjusted exposures

Pure Premium Method Calculation of Rate Pure Premium = Aggregate Adjusted Losses Aggregate Adjusted Exposures Base Rate = Pure Premium Permissible L/R

Pure Premium Method Works well for an existing product Works best for a product with a well- defined exposure base (doctors, employees) Requires detailed loss and exposure info (claim-by-claim, policy-by-policy) Actuarially sound

Piggy-back Method 1.Start with Comparable Product 2.Adjust Rates for Coverage differences 3.Adjust for Limits/Deductible differences 4.Adjust for Expense differences 5.Others?

Piggy-back Method Works well for Enhancement of Existing Product Requires knowledge of Comparable Product Judgmental Danger of being too Conservative/Aggressive? Difficult to Support to Others

The Festus Method

Ratemaking Tools Imagination! Innovation! Intuition! Internet!

Useful Sites – Big Brother is Watching! - U.S. Government’s Official Web Portalwww.firstgov.gov - Bureau of Labor Statisticswww.bls.gov - Interest Rateswww.federalreserve.gov

Other Useful Websites Where ever else the web may take you!