Pitfalls in Common Pricing/Reserving Methodologies David Skurnick St. Paul Re 2001 Seminar on Ratemaking

Pitfalls in... Underwriting Excess Miscellaneous

Pitfalls in Underwriting Accuracy and completeness of data Understanding of terms Local practices

Data Accuracy and Completeness How can you verify accuracy? –Audits –Consistency –Agreement with the market What’s missing? –Older cat losses –rate changes –experience on discontinued business

Experience on discontinued business -- my rule of thumb: If they have discontinued an entire segment that ran badly, say a territory or line of business, then I exclude the experience. If they have gotten off some unsuccessful business, then I include the experience -- this is normal underwriting.

Understanding of Terms Interlocking clause “FCA” (For common account) Lloyd’s ‘miscellaneous classes”

Interlocking clause E.g., a Worldwide ex. US catastrophe cover excess of $100m, with interlocking clause. If a hurricane hit the Caribbean and the US, cedant’s combined retention would be $100. Must read the contract to see how the retention is allocated. Cannot underwrite this deal without looking at US exposures.

“FCA” (For Common Account) E.g., a cedant has an 80% quota share. You write 5% of an excess treaty Is is “5% of net” or “5% of all”? If you’re covering the Common Account then you’re limits may be 5 times higher. Mandatory or optional?

What are you covering? “Miscellaneous Classes” could include anything, especially at Lloyd’s. E.g., Computer Leasing in early 80’s E.g., Typical wording is “All policies written in the Fire Department”, not “All Fire Policies.” You MUST verify what is actually covered.

Local Practices Egyptian “catastrophe” Egyptian personal accident European commutation European motor excess

Egypt Re “Catastrophe” The Heliopolis Sheraton Hotel burned down. Was this a cat loss? Yes! -- because there were two policies, one for the floors and one for the elevator shaft!

Egyptian Personal Accident Question: Treaty limits are : EGP 50,000 XS 50,000 / $ 20,000 XS 20,000 with 3 reinstatements. How large is the reinsurer’s maximum loss? (Assume 1 EGP = $0.40)

Egyptian Personal Accident (slide 2) Answer: EGP 200,000 PLUS $80,000 (The slash meant “and”, not “or”)

European Commutation Commutations in Europe are generally revocable The commutation will not apply to exceptionally large claims or to material change in claims cost.

European Motor Excess Most international motor covers are indexed for inflation.

Pitfalls in Excess Pricing Excess of Aggregate Inflation Aggregate Deductible

Excess of Aggregate (Stop Loss) Buyer knows more than seller Long-term or short-term relationship? LR affected by frequency, severity & cats LR affected by Rate Adequacy A total loss to the reinsurance layer could be likely.

Compare the Risk of Specific Excess Vs Excess of Aggregate Look at the impact of an error in estimating the Expected Loss Ratio E.g., suppose that the Expected Frequency is twice what you thought it was, and all other estimates are correct.

Specific Excess Example Suppose you are receiving 10% of original premium for a risk layer of $1m Xs $1m and your expected loss was 7%. Due to under-estimate of frequency, the ELR is 140% rather than 70% Note that this 2 to 1 ratio is independent of the original rate, frequency, severity, etc.

Excess of Aggregate Example You receive 6% of original premium to cover a loss ratio of 30% XS 80%. Your primary ELR = 70%. Your expected XS loss = 2%. Then, your XS ELR = 33%. Suppose exp. freq. Is twice what your think Then expected FGU LR = 140% Expected XS loss might be, say, 24%. Correct XS ELR = 400%, not 33%

Excess of Aggregate Example (slide 2) Suppose expected frequency is twice what your thought it was Then expected FGU LR = 140% Expected XS loss to the layer 30% XS 80% might be, say, 24%, not 2%. Correct XS ELR = 400%, not 33%

Per Risk Casualty Excess Treaty with High Inflation E.g., Avner -- old Israeli XS motor liability When Israeli Shekel had 100% inflation XS claims became routine, not exceptional The increase in premium (due to a higher exposure base) did not at all compensate for the enormous increase in claim frequency in this layer.

Aggregate Deductible on Per Risk Property E.g., layer of $1m XS $1m XS $4m. Reinsurer would would pay only after 4 total losses of $2 million or more (or equivalent in partial losses to the layer.) Assume the treaty limit is $25 million. This would protect against a frequency of losses in a low layer.

Aggregate Deductible on Per Risk Property (slide 2) Key is the average frequency of losses > $2m (ignoring partial losses to the layer) If you think the expected frequency of such losses = 5, then this treaty would be loss free more often than not. One might guess the expected loss to the layer as about $1 million (using a Poisson)

Aggregate Deductible on Per Risk Property (slide 3) What if the correct average frequency = 10 Then expected loss >$5 million Doubling the frequency caused the risk excess expected loss to grow 5X Note that frequency might be double because of unexpected growth in the underlying premium.

Miscellaneous Pitfalls Exchange Rate errors Individual company loss development Ending a Managing General Agent relationship

Exchange Rate Errors Several years ago, one of our underwriters slipped a decimal point in the exchange rate and wrote ten times as big a line as he intended. (Naturally, the deal turned out to be a big loss!)

Individual company loss development For several years we wrote a quota share of industrial property business. We learned to our sorrow that this property business took several years to develop. Slow development was partly due to the complex nature of the claims. Also, company claims procedures slowed the reporting and reserving of losses.

Ending an MGA Relationship A cedant of ours had a group of Managing General Agents They decided to get out of MGA business Several years later they decided to handle the remaining open claims themselves. They discovered that their loss reserve of $200 m should have been $600 million! It turned out that the cancelled MGA’s had stopped working on the claims.