Actuarial Audits of Umbrella Programs - “Observations From The Road” Gerard Palisi, FCAS, MAAA Seminar on Reinsurance Boston, MA June 7-8, 2004

Page 2 Presentation Overview Why Audit? Difficulties in Pricing Umbrella Treaties Categorizing Umbrella Programs Basics of Umbrella Pricing Pricing Issues Interview with an Actuary Making Sense of the Audited Files Other Issues Miscellaneous Observations & Conclusions Seminar on Reinsurance Boston, MA June 7-8, 2004

Page 3 Why Audit? To confirm that client is operating consistent with expectations and treaty terms Gain insight into client-specific nuances not available in a typical submission Determine the extent of actuarial involvement in the pricing and management processes Offer suggestions, make recommendations, provide benchmark versus peers Seminar on Reinsurance Boston, MA June 7-8, 2004

Page 4 Difficulties in Pricing Umbrella Treaties Wide variation / heterogeneity as to type of business written, limit/attachment philosophy, pricing, etc. Limited or no industry statistics or benchmarks Even within a program, continual shift in book of business - moving target (“as if” issue) Traditional pricing approaches strained due to extreme price level changes, large/uncertain trend and development factors Better understanding of the client’s business and pricing should translate into better treaty pricing assumptions Seminar on Reinsurance Boston, MA June 7-8, 2004

Page 5 Categorizing Umbrella Programs Layer: lead umbrella, excess, high excess/capacity Insured: small business, middle market, national account, global Insurer Size: regional/specialty, global/national Primary Insurer: supported, unsupported Regulatory: admitted, non-admitted/E&S Rating approaches can vary based on these distinctions! Seminar on Reinsurance Boston, MA June 7-8, 2004

Page 6 Basics of Umbrella Pricing - (Insurer’s Perspective) Start with “appropriate” underlying GL and Auto premiums Apply 1st million umbrella factor (or unit rate for auto) to derive 1st million umbrella layer Apply excess layer factors to specified reference layer(s) to derive excess layers For each layer, premium is the greater of the calculated layer premium, or the minimum premium for the layer If applicable, add charge for ancillary coverages (e.g. Liquor, Aircraft, Watercraft, Foreign) Seminar on Reinsurance Boston, MA June 7-8, 2004

Page 7 Umbrella Pricing Example - $25mm lead umbrella, E&S market Seminar on Reinsurance Boston, MA June 7-8, 2004

Page 8 Pricing Issues: Underlying Primary GL Common bases for deriving the first mil layer: –Manual premium (exposure x loss cost x ILF x LCM): the most common base. concern: may not be appropriate for a specific insured; may be too high/low due to inefficiencies in the ratemaking process – Manual with judgment credit/debit: adjustment of manual to reflect individual risk characteristics. concern: adjustment may be more market driven than risk driven; adjustment may not be appropriate for umbrella/excess layers Seminar on Reinsurance Boston, MA June 7-8, 2004

Page 9 Pricing Issues: Underlying Primary GL (cont’d) Common bases (cont’d): –Actual (sold) premium: usually available; may be used directly, or as a check on selected premium base concern: market price may be inadequate, or (if over other carrier) its derivation unknown –Adjusted Actual: e.g., 150% of actual. concern: market driven and arbitrary –Experience rated / Loss rated premium: concern: these adjustments may not be appropriate or credible for pricing severity layers Seminar on Reinsurance Boston, MA June 7-8, 2004

Page 10 Pricing Issues: Underlying Primary Auto Use actual or re-rated primary auto premium Unit Rating: price per unit times number of units Alternatively, take the higher of actual/manual premium or unit rated premium A variation on unit rating is to develop 1st mil umbrella unit rates rather than primary unit rates, and therefore avoid reference to primary Auto altogether. Seminar on Reinsurance Boston, MA June 7-8, 2004

Page 11 Pricing Issues - First Million Umbrella Layer 1st mil umbrella factors typically vary by ISO Table (or similar proxy for hazard) for GL, and vehicle type for Auto Factors can vary widely based on categorizations discussed above. For example, E&S programs tend to have much heavier factors than standard admitted programs. More common to have specific factors for this layer rather than ranges, so 1st mil price itself is usually the most straightforward and layer least susceptible to underwriting judgment Where do factors come from? Generally ISO ILF-based, but tend to be infrequently reviewed or updated Seminar on Reinsurance Boston, MA June 7-8, 2004

Page 12 Pricing Issues - Higher Layers For layers above the first million umbrella, two common approaches are: –single million layers - price is a % of previous million layer –“blocks” - 4 xs 1, 5 xs 5, 5 xs 10, etc. Price is a % of some previous layer (first $5mm, preceding $5mm) Percent ranges are generally very broad; enables rating plan to have maximum flexibility Actuarial rigor breaks down here (if it was ever present!) Factors may be dictated by management, or completely based on underwriter discretion. Seminar on Reinsurance Boston, MA June 7-8, 2004

Page 13 Pricing Issues - Minimum Premiums Can have account minimums and layer minimums Layer minimums may vary by class or hazard (low, medium, high) and/or layer Layer minimums presumably cover operating and capital costs In reality, they are of undetermined origin and are market driven Underwriter’s layer factor selections determine how fast the price is driven to the minimum premium Seminar on Reinsurance Boston, MA June 7-8, 2004

Page 14 Pricing Issues - Other Features Accounts with large underlying deductibles or SIR’s –often priced incorrectly: primary premium reflecting deductible/SIR credit is used as base for umbrella –presence of deductible on underlying GL should have no impact on umbrella price –presence of SIR does shift umbrella attachment higher, but credit associated with this can be estimated (e.g. via ILF’s), and effect decreases as layer increases Primary attachments other than $1mm –can price properly using ILF’s Seminar on Reinsurance Boston, MA June 7-8, 2004

Page 15 Interview with an Actuary Additional insight and perspective can be gained by setting aside some time during the audit to discuss the program with the actuary (or management) Key areas for discussion: –extent of actuarial involvement, in general –support for account pricing –role in model development and maintenance –price monitoring –market conditions and trends Underwrite the actuary! Seminar on Reinsurance Boston, MA June 7-8, 2004

Page 16 Interview with an Actuary - Discussion Points Seminar on Reinsurance Boston, MA June 7-8, 2004 What is the extent of actuarial involvement in the pricing process? Do actuaries get involved in pricing for specific accounts? If so, what criteria prompts their involvement? Do actuaries determine/monitor/update the various pricing factors used by underwriters? If not, who does? How often? How are minimum premiums determined? What prompts a change in the minimums? If an umbrella/excess pricing model is used, what is the extent of actuarial involvement in the development/monitoring/updating of the model? If external inputs to the model are required (e.g. ISO loss costs and ILF’s), how often are they updated, and by whom? How sophisticated is the pricing model? Is it based on ISO methodology (current or prior?) or some other approach? How much flexibility does the model provide to underwriters to input values or deviate from default factors?

Page 17 Interview with an Actuary - Discussion Points (cont’d) If an account involves large primary deductibles or SIR’s are they handled properly in the pricing formulas? Does the pricing model explicitly price for drop-down or first dollar coverages? For cessions treaties, is the determination of ceded premium automated, manual or some combination? Is there a cessions model linked to the pricing model? Are underlying primary and umbrella/excess carriers (if any) identified in the file? Are the underlying premiums captured? Are multiple pricing models, or different versions of the same model, being used concurrently by different underwriters/offices? Is there a consistent pricing approach among underwriters? Among the branch offices? Seminar on Reinsurance Boston, MA June 7-8, 2004

Page 18 Making Sense of the Audited Files First order of business: is the client’s pricing methodology clear from the files? Is the pricing consistent: –with the rating plan –with client management’s perception –among accounts? Are shortfalls in one layer offset by overages in another? (see example - next slide) Seminar on Reinsurance Boston, MA June 7-8, 2004

Page 19 Price Comparison: Two Competitors Seminar on Reinsurance Boston, MA June 7-8, 2004

Page 20 Making Sense of the Audited Files (cont’d) Particularly for High Excess, does the file document the actual premium charged by underlying carriers? How does the actual compare to the client’s theoretical price for the underlying layer? Valuable to collect data across multiple accounts: –judgment credits/debits –4 xs 1 factors (explicit or implicit) –5 xs 5 factors –average and dispersion of these statistics can shed light on pricing consistency, and (over multiple years) on umbrella market pricing cycles Seminar on Reinsurance Boston, MA June 7-8, 2004

Page 21 Other Issues Price change analysis & monitoring –does calculation properly adjust for changes in exposure, limit, and attachment? –does calculation include all business (e.g. minimum premium accounts, high excess)? Validation of ceded premium for cessions treaties –review reinsurance layoff sheets for accuracy –is process automated, manual, or some combination? –does cession follow pricing exactly, or is it estimated (e.g. via curves)? Seminar on Reinsurance Boston, MA June 7-8, 2004

Page 22 Miscellaneous Observations & Conclusions Underwriters have a great deal of discretion in pricing umbrella/excess - deal with it For a given insured, Umbrella is often the last line of business to be priced; limitations on insurance budget may influence price Clients want to hear reinsurer’s perspectives on the market, and on how their pricing and practices measure up against peers Actuaries can help advance the “state of the art” by continuing to research excess trend, loss development, and loss distributions Seminar on Reinsurance Boston, MA June 7-8, 2004

Page 23 Miscellaneous Observations & Conclusions (cont’d) Favorite Quotes (common to all clients): Seminar on Reinsurance Boston, MA June 7-8, 2004 “All our underwriters have at least 20 years experience underwriting umbrella” “Competitors X, Y, … are pricing irresponsibly and undermining the market” “No one is getting better price increases than we are” “Thanks. We value your observations and input”