© 2005 Towers Perrin STRIMA 2005 Conference Premium Development/Cost Allocation This document is incomplete without the accompanying discussion; it is confidential and intended solely for the information and benefit of the immediate recipient hereof. Martin Lewis, FCAS, MAAA

© 2005 Towers Perrin STRIMA 2005 Conference Premium Development/Cost Allocation 2 Cost Allocation General Principles Attributes of Sub-Optimal Systems Work Steps Summary

© 2005 Towers Perrin STRIMA 2005 Conference Premium Development/Cost Allocation 3 Cost Allocation General Principles “Optimal” Definition: the process of equitably allocating property/casualty risk financing costs within an organization in a manner that promotes loss control Cost Allocation vs. the Actuarial Report  Actuarial report: changes with new information/data  Cost allocation analysis: flexible  Cost Allocation vs. Rating Cost AllocationRating Number of Participants<50>50 Policies IssuedNot alwaysYes Fixed Number of Participants YesNo Entry/exitLittleHigh Split/mergeYesNo

© 2005 Towers Perrin STRIMA 2005 Conference Premium Development/Cost Allocation 4 Cost Allocation General Principles No single system is appropriate for all state entities The system cannot be properly designed until the level of risk sharing has been selected A properly designed and implemented system must address two distinct and classic tradeoffs: stability vs. responsiveness, and simplicity vs. equity A successful system requires a reasonable investment in data acquisition and maintenance Systems that initially focus on distributions, rather than absolute dollars, are easier to implement, explain, change, maintain, and update

© 2005 Towers Perrin STRIMA 2005 Conference Premium Development/Cost Allocation 5 Attributes of Sub-Optimal Systems Attributes of a sub-optimal system Does not promote loss control Participants frequently challenge results Participants do not understand the system No “buy-in” from participants Too much volatility Too simple Too complex No incentives to reduce losses Data problems Improper level of risk sharing Unwanted subsidies Improper application of loss limitation No capping of year-to-year changes Improper use of exposure data

© 2005 Towers Perrin STRIMA 2005 Conference Premium Development/Cost Allocation 6 Work Steps Evaluate risk sharing Meet with participants Obtain/maintain data Evaluate distributions Create universe of solutions Presentation of results

© 2005 Towers Perrin STRIMA 2005 Conference Premium Development/Cost Allocation 7 Work Steps Evaluate Risk Sharing/Meet with Participants Should exposures be used? Exposure weight? Is appropriate exposure data available? How many years of loss data should be used? Which years of loss data should be used? Should individual losses be limited? How should a new department be rated? Should year-to-year changes be capped? What is a reasonable cap?

© 2005 Towers Perrin STRIMA 2005 Conference Premium Development/Cost Allocation 8 Work Steps Obtain/Maintain Data: Losses “Traditional” Approach: Use 3-5 accident years, excluding the most recent and/or current year Losses and allocated loss adjustment expenses (ALAE) Reported (paid plus case reserve) loss and ALAE Losses not developed Losses not trended

© 2005 Towers Perrin STRIMA 2005 Conference Premium Development/Cost Allocation 9 Work Steps Obtain/Maintain Data: Losses Example of problem with “traditional” approach: report lag AY Report Lag 7/1/00 7/1/027/1/03 7/1/04 7/1/01 7/1/05

© 2005 Towers Perrin STRIMA 2005 Conference Premium Development/Cost Allocation 10 Work Steps Obtain/Maintain Data: Losses Example of problem with “traditional” approach: payment lag for under reserved claim AY Case reserve = $50,000 7/1/97 7/1/997/1/00 7/1/01 7/1/98 7/1/02 Cycle 1

© 2005 Towers Perrin STRIMA 2005 Conference Premium Development/Cost Allocation 11 Work Steps Obtain/Maintain Data: Losses Example of problem with “traditional” approach: payment lag for under reserved claim AY Case reserve = $50,000 7/1/98 7/1/007/1/01 7/1/02 7/1/99 7/1/03 Cycle 2

© 2005 Towers Perrin STRIMA 2005 Conference Premium Development/Cost Allocation 12 Work Steps Obtain/Maintain Data: Losses Example of problem with “traditional” approach: payment lag for under reserved claim AY Case reserve = $50,000 7/1/99 7/1/017/1/02 7/1/03 7/1/00 7/1/04 Cycle 3

© 2005 Towers Perrin STRIMA 2005 Conference Premium Development/Cost Allocation 13 Work Steps Obtain/Maintain Data: Losses Example of problem with “traditional” approach: payment lag for under reserved claim AY Settlement = $1,000,000 7/1/00 7/1/027/1/03 7/1/04 7/1/01 7/1/05 Cycle 4

© 2005 Towers Perrin STRIMA 2005 Conference Premium Development/Cost Allocation 14 Work Steps Obtain/Maintain Data: Losses Solution to problems of (1) report lag and (2) payment lag for under reserved claim: Traditional:AY Losses Revised:AY Losses RY Losses (report year) FY Paid Losses (cash flow)

© 2005 Towers Perrin STRIMA 2005 Conference Premium Development/Cost Allocation 15 Work Steps Obtain/Maintain Data: Exposures Exposure Bases for State Programs Sub-Optimal or BiasedBetterData Available?Relativities Available? Workers Compensation PayrollPayroll by NCCI ClassSometimes – periodic audit? Yes* Automobile LiabilityVehiclesVehicle by typeYesYes* General LiabilityFTE’s or expendituresFTE’s by Type?No Hospital Professional Liability FTE’s, visits, budgetVisits by type, surgeries, births, beds ?Yes* Physician/Surgeon Professional Liability FTE’sFTE’s by specialty?Yes* Bond/CrimeFTE’sFTE’s by type?? *Industry data

© 2005 Towers Perrin STRIMA 2005 Conference Premium Development/Cost Allocation 16 Work Steps Evaluate Distributions Prior Allocation Exposures Accident Year Reported Losses (by Limit) New Allocation Loss Limit 10% 12% 14% 16% 1,00050,000500,000 Prior Exposures Losses New Distribution

© 2005 Towers Perrin STRIMA 2005 Conference Premium Development/Cost Allocation 17 Work Steps Evaluate Distributions Avoid multiple allocation cycles by focusing on distributions, not dollars Dollars Distributions Allocation Steps 1-9 Submission Review Revision Allocation Step 10 Acceptance Allocation Steps 1-9 Submission Review Revision Allocation Step 10 Acceptance

© 2005 Towers Perrin STRIMA 2005 Conference Premium Development/Cost Allocation 18 Work Steps Create Universe of Solutions (Sensitivity Testing) Example: Cap on ChangeYears Reviewed ± 15%3, 4, 5 ± 30%3, 4, 5 ± 40%3, 4, 5 Universe of Solutions

© 2005 Towers Perrin STRIMA 2005 Conference Premium Development/Cost Allocation 19 Department Change due to Allocation Change due to FundingTotal A20%25% 50% B10%25%37.5% C-10%25%12.5% D-20%25% 0% Total0%25% Work Steps Presentation of Results Present the distributions to each department Components of change exhibit Components of Change

© 2005 Towers Perrin STRIMA 2005 Conference Premium Development/Cost Allocation 20 Summary Goals defined Buy-in Required Data Challenges Focus on Distributions Sensitivity Testing Presentation