Course on Professionalism Statement of Principles

2 Introduction Statement of Principles for Ratemaking, Loss Reserving, Valuations and Risk Classification Statement of Principles for Ratemaking, Loss Reserving, Valuations and Risk Classification Specific guidance on definitions, principles, considerations, and conclusions Specific guidance on definitions, principles, considerations, and conclusions Template for items to include in the documentation Template for items to include in the documentation

3 Ratemaking - Definitions Incurred Losses Incurred Losses ALAE / ULAE ALAE / ULAE Commission and brokerage expenses Commission and brokerage expenses Other Acquisition expenses Other Acquisition expenses Taxes, licenses and fees Taxes, licenses and fees Policyholder Dividend Policyholder Dividend General Expenses General Expenses Underwriting profit and Contingency provisions Underwriting profit and Contingency provisions

4 Ratemaking - Principles 1: A rate is an estimate of the expected value of future costs 1: A rate is an estimate of the expected value of future costs 2: A rate provides for all costs associated with the transfer of risk 2: A rate provides for all costs associated with the transfer of risk 3: A rate provides for the costs associated with an individual risk transfer 3: A rate provides for the costs associated with an individual risk transfer 4: A rate is reasonable and not excessive, inadequate, or unfairly discriminatory if it is an actuarially sound estimate of the expected value of all future costs associated with an individual risk transfer 4: A rate is reasonable and not excessive, inadequate, or unfairly discriminatory if it is an actuarially sound estimate of the expected value of all future costs associated with an individual risk transfer

5 Ratemaking - Considerations Data – relevance, organization, homogeneity, credibility Data – relevance, organization, homogeneity, credibility Loss development, trends, catastrophes, policy provisions, mix of business Loss development, trends, catastrophes, policy provisions, mix of business Reinsurance, operational changes, external factors Reinsurance, operational changes, external factors Class plans, individual risk rating Class plans, individual risk rating Actuarial judgment Actuarial judgment

6 Question #1 Which of the following are required for a rate to be reasonable and not excessive, inadequate or unfairly discriminatory: A: A rate needs to be an estimate of the expected value of future costs A: A rate needs to be an estimate of the expected value of future costs B: A rate needs to provide for all costs associated with the transfer of risk B: A rate needs to provide for all costs associated with the transfer of risk C: A rate needs to provide for the costs associated with an individual risk transfer C: A rate needs to provide for the costs associated with an individual risk transfer D: All of the above D: All of the above

7 Loss Reserving - Definitions Loss reserve Loss reserve Case reserve Case reserve Provision for future development on known claims Provision for future development on known claims Reopened claims Reopened claims Provision for claims incurred but not reported Provision for claims incurred but not reported Claims in transit Claims in transit Loss adjustment expenses Loss adjustment expenses

8 Loss Reserving - Principles 1: Actuarially sound loss reserve …is a provision, … for the unpaid amount required to settle all claims, whether reported or not, …. 1: Actuarially sound loss reserve …is a provision, … for the unpaid amount required to settle all claims, whether reported or not, …. 2: Actuarially sound loss adjustment expense reserve …is a provision, … for the unpaid amount required to settle all claims, whether reported or not, …. 2: Actuarially sound loss adjustment expense reserve …is a provision, … for the unpaid amount required to settle all claims, whether reported or not, ….

9 Loss Reserving – Principles (continued) 3: The uncertainty inherent in the estimation… implies that a range of reserves can be actuarially sound 3: The uncertainty inherent in the estimation… implies that a range of reserves can be actuarially sound 4: The most appropriate reserve within a range… depends on both the relative likelihood of estimates and the financial reporting context 4: The most appropriate reserve within a range… depends on both the relative likelihood of estimates and the financial reporting context

10 Question #2 Which is not true for the following question: The most appropriate reserve within a range depends on: Which is not true for the following question: The most appropriate reserve within a range depends on: A. The size of the reserve A. The size of the reserve B. The relative likelihood of the estimates B. The relative likelihood of the estimates C. The financial reporting context C. The financial reporting context

11 Loss Reserving - Considerations Data – relevance, organization, homogeneity, credibility, availability Data – relevance, organization, homogeneity, credibility, availability Loss development, trends, catastrophes, freq/severity mix of business, form of coverage Loss development, trends, catastrophes, freq/severity mix of business, form of coverage Reinsurance, operational changes, external factors, discounting Reinsurance, operational changes, external factors, discounting Uncertainty, reasonableness, methodology Uncertainty, reasonableness, methodology Standards of practice Standards of practice

12 Valuations - Definitions Valuation Valuation Risk bearer Risk bearer Cashflow Cashflow Asset Asset Obligation Obligation Consideration Consideration

13 Valuations - Principles 1: Every obligation, consideration or asset is associated with one or more items of cash flow 1: Every obligation, consideration or asset is associated with one or more items of cash flow 2: Value of every item depends on: 2: Value of every item depends on: Occurrence Occurrence Amount Amount Timing Timing Interest rate Interest rate 3: Degree of uncertainty depends on: 3: Degree of uncertainty depends on: Nature Nature Environment (regulatory, judicial, social, financial) Environment (regulatory, judicial, social, financial) Predictive value Predictive value

14 Valuations - Principles 4: Value of items … are not only uncertain, they are also not independent of each other. Uncertainty should reflect interactions 4: Value of items … are not only uncertain, they are also not independent of each other. Uncertainty should reflect interactions 5: Value of every item is equal to the combined values of its constituent items of cash flow 5: Value of every item is equal to the combined values of its constituent items of cash flow 6: Result of a valuation is the combined value of the items involved with due recognition of receipts and disbursements 6: Result of a valuation is the combined value of the items involved with due recognition of receipts and disbursements

15 Valuations – Principles (continued) 7: Principles can apply to all items or only specific segments 7: Principles can apply to all items or only specific segments Commitments made on or before valuation date Commitments made on or before valuation date Commitments made after the valuation date Commitments made after the valuation date Both Both

16 Valuations - Considerations Data – relevance, organization, homogeneity, credibility Data – relevance, organization, homogeneity, credibility Operating conditions, Environmental, Loss and LAE Operating conditions, Environmental, Loss and LAE Rules and Assumptions, Valuation variables Rules and Assumptions, Valuation variables Uncertainty Uncertainty Interaction with other professionals Interaction with other professionals Actuarial Judgment Actuarial Judgment

17 Valuations - Considerations Valuation Risk Valuation Risk Asset Risk - The risk that the occurrence, amount or timing of items of cash flow connected with assets will differ from that anticipated as of the valuation date for reasons other than a change in the interest environment Asset Risk - The risk that the occurrence, amount or timing of items of cash flow connected with assets will differ from that anticipated as of the valuation date for reasons other than a change in the interest environment Obligation and Consideration Risk - The risk that the occurrence, amount or timing of items of cash flow connected with obligations and considerations will differ from that anticipated as of the valuation date for reasons other than a change in the interest environment Obligation and Consideration Risk - The risk that the occurrence, amount or timing of items of cash flow connected with obligations and considerations will differ from that anticipated as of the valuation date for reasons other than a change in the interest environment

18 Valuations - Considerations Interest Risk – The risk that different amounts of change in the anticipated values, and the degree of uncertainty therein, of obligations and of the assets and considerations with which the obligations are being compared will occur due to changes in the interest environment Interest Risk – The risk that different amounts of change in the anticipated values, and the degree of uncertainty therein, of obligations and of the assets and considerations with which the obligations are being compared will occur due to changes in the interest environment

19 Question #3 Which of the following is not considered a Valuation Risk? Which of the following is not considered a Valuation Risk? A. Asset Risk A. Asset Risk B. Parameter Risk B. Parameter Risk C. Obligation & Consideration Risk C. Obligation & Consideration Risk D. Interest Rate Risk D. Interest Rate Risk

20 Risk Classification - Purpose Protection of Program’s Financial Soundness Protection of Program’s Financial Soundness Primary solvency threat is through adverse selection Primary solvency threat is through adverse selection Enhanced Fairness Enhanced Fairness Economic Incentive Economic Incentive

21 Risk Classification - Principles 1.System should reflect expected cost differences. 2.System should distinguish among risks on the basis of relevant cost-related factors. 3.System should be applied objectively. 4.System should be practical and cost effective. 5.System should be acceptable to the public.

22 Risk Classification - Considerations Underwriting Underwriting Marketing Marketing Program Design Program Design Includes degree of choice available to buyer, experience based pricing, and premium payer Includes degree of choice available to buyer, experience based pricing, and premium payer Statistical Considerations Statistical Considerations Homogeneity Homogeneity Credibility Credibility Predictive Stability Predictive Stability

23 Risk Classification – Considerations (continued) Operational Considerations Operational Considerations Expense Expense Constancy Constancy Availability of Coverage Availability of Coverage Avoidance of Extreme Discontinuities Avoidance of Extreme Discontinuities Absence of Ambiguity Absence of Ambiguity Manipulation Manipulation Measurability Measurability

24 Risk Classification – Considerations (continued) Hazard Reduction Incentives Hazard Reduction Incentives Public Acceptability Public Acceptability Not differentiate unfairly among risks Not differentiate unfairly among risks Based upon clearly relevant data Based upon clearly relevant data Respect personal privacy Respect personal privacy Risks tend to identify with their classification Risks tend to identify with their classification Causality Causality Controllability Controllability

25 Question #4 Which of the following is not one of the stated purposes of a risk classification system? Which of the following is not one of the stated purposes of a risk classification system? A. Enhance Fairness A. Enhance Fairness B. Full Employment of Actuaries B. Full Employment of Actuaries C. Protection of Financial Soundness of System C. Protection of Financial Soundness of System D. Promote economic incentives D. Promote economic incentives