CLRS Establishing the Expected Loss Ratio George M. Levine, FCAS, MAAA Senior Manager, KPMG LLP September 9, 2003 Chicago, Illinois

CLRS Expected Loss Ratio (Definition) l Ultimate Loss Ratio (Losses/Premium) expected to be incurred a-priori before consideration of actual experience l Loss Ratio discussed as REASONABLENESS check for reserves in CAS Loss Reserve Principles l ELR is basis of ratemaking: »Actual Loss Ratio/ELR –1=Rate Change

CLRS Expected Loss Ratio Why important now? Several important changes on the Landscape »HARD MARKET—Past Loss Ratios not indicative of Future Loss Ratios »SARBANES OXLEY 404 REQUIREMENTS—Internal Control over Financial Reporting

CLRS Expected Loss Ratio Hard Market Loss Ratios decrease in times of Increasing Rates

CLRS SARBANES-OXLEY 404 Audit of Internal Control 1)Management’s annual report on internal control must: State management’s responsibility for establishing and maintaining adequate internal controls Contain management’s assessment as of year-end of effectiveness of internal control structure 2)Independent Auditor must attest to and report on management’s assessment in accordance with standards issued or adopted by the PCAOB (Public Company Accounting Oversight Board)

CLRS SARBANES-OXLEY 404 Audit of Internal Controls 1)COSO: Committee on Sponsoring Organizations of Treadway Commission (AICPA is one organization) 2)COSO’s 5 Areas of Internal Control 1)CONTROL ENVIRONMENT 2)RISK ASSESSMENT 3)CONTROL ACTIVITIES 4)INFORMATION + COMMUNICATION 5)MONITORING 3)Conclusion: ELRs, the bridge between ratemaking and reserving, is important element for insurance controls

CLRS Expected Loss Ratio Considerations: Experience Rating »Loss Development »Loss Trend »Premium Rate Changes »New Business Penalty »# of Years to Consider

CLRS Experience Rating Expected Loss Ratio Example 5% On-Level Devl. TrendedEarned EarnedLoss YearLosses LossesPrem. Prem.Ratio % % % % Total % 2003 Select90%

CLRS Experience Rating ELR Further Adjustments »Split History Into New and Renewal Business »Homogeneity and Credibility Considerations »Self-Insureds: Often Exposure Bases utilized for Expected Loss Rates instead of Expected Loss Ratios, with same concepts applying –Industry Experience Important for Self-Insureds

CLRS Expected Loss Ratio Considerations: Exposure Rating »Exposure Bases »Industry Expected Loss Ratios/Loss Rates »Extension of Exposures

CLRS Reserving Methods: Initial Expected Loss Ratio Selections 1)Bornhuetter-Ferguson Method (PCAS 1972) 2)Cape Cod Method/Stanard-Bulhmann Method 3)Comments: Quarterly Adjustments

CLRS Initial Expected Loss Ratio Bases 1)Bornhuetter-Ferguson Method (PCAS 1972)  External Source for Initial Expected Costs  Ultimate Costs Implied by Development Method,  ILC= LDF X AMT/EXP, where  LDF is Ultimate Development Factor,  AMT is Current Reported (Paid),  EXP is Exposure  ILC is Indicated Loss Cost

CLRS Initial Expected Loss Ratio Bases 2)Cape Cod Method  ULC=AMT/ (EXP/LDF)  Where ULC= Undeveloped Loss Cost  Weights here are (EXP/LDF) for All Periods  Generalized Cape Cod Method:  Unique Expected Loss Cost for Each Accident Period as Weighted Average of Surrounding Accident Periods

CLRS Bornhuetter-Ferguson Method 95% Initial Expected Loss Ratio Earned Expected Reported Expected YearPrem. IELR LossesLosses Unreported % % % % Expected UnreportedUltimate Ultimate YearLossesLossesLoss Ratio % % %

CLRS Bornhuetter-Ferguson Method 70% IELR—How Judgment Affects Earned Expected Reported Expected YearPrem. IELR LossesLosses Unreported % % % % Expected 70%IELR95% IELR UnreportedUltimate UltimateUltimate YearLossesLosses Loss RatioLoss Ratio % 100% % 99% % 99%

CLRS Cape Cod Method Initial Expected Loss Ratio On-Level (3)x(5) Earned Earned Reported Expected Expected YearPrem. Prem. Losses Unreported % Unrep.Loss (1)(2) (3) (4)(5)(6) Total Cape Cod IELR =14.9/( ) =90% Actual Reported/Expected Reported

CLRS Cape Cod Method 90% Initial Expected Loss Ratio Earned Expected Reported Expected YearPrem. IELR LossesLosses Unreported % % % % ExpectedCape Cod95% UnreportedUltimate Ultimate B-F YearLossesLossesLoss RatioUlt. LR %100% % 99% % 99%

CLRS Quarterly 6/02 Bornhuetter-Ferguson Method Earned Expected Reported Expected YearPrem. IELR LossesLosses Unreported % % % / % Or 6/ % UnreportedUltimate Ultimate YearLossesLosses Loss Ratio % % 6/ % Or 6/ x.5=3.4 95%

CLRS Conclusions 1)Expected Loss Ratio ever-increasing scrutiny in loss reserving due to changing landscape and hard market 2)Choice of Initial Expected Loss Ratio subject to judgment, but sophisticated techniques exist to assist in choosing IELRs