1. ab Rate Monitoring Steven Petlick Seminar on Reinsurance May 20, 2008

2. ab Slide 2 Rate Monitoring Table of Contents Rate monitoring from the perspective of the reinsurance pricing actuary The effect of new business The effect of changes in “quality” of book of business What is the reinsurance pricing actuary to do? Conclusions

3. ab Slide 3 Rate monitoring from the perspective of the reinsurance pricing actuary Standard Pricing Methodology includes: Trend historical losses to prospective treaty period Put historical premiums at rate level of prospective treaty period; i.e. put them “on level” During hard market periods, rate increases can turn dirt into gold Opposite holds true in soft market periods

4. ab Slide 4 Rate monitoring from the perspective of the reinsurance pricing actuary Rate Monitor for XYZ Insurance Company Casualty Excess of Loss Treaty Rate Change 2000-2% 2001 0 2002+10% 2003+35% 2004+9% 2005+3% 2006-1% 2007-9%

5. ab Slide 5 Rate monitoring from the perspective of the reinsurance pricing actuary What would you do? I would immediately get back to the client with questions: Are the rate changes written or earned? Are they adjusted for exposure changes? Are they adjusted for changes in limits/ attachments/ deductibles/ SIRs? Do they include new business or are they measured on renewals only? (most common)

6. ab Slide 6 Rate monitoring from the perspective of the reinsurance pricing actuary Do they include the effect of commission changes? Do they reflect changes in terms and conditions? What types of increases/ decreases are they observing on lost business? How are the rate changes actually calculated?

7. ab Slide 7 The Effect of New Business Suppose you are trending and onleveling a 2007 loss ratio for a reinsurance treaty incepting at 1/1/2009. (In reality you would likely use at least 5 historical years, but, for simplicity, we will consider only 2007.) Assume the following: 2007 Ultimate Loss Ratio = 60% Expected Annual Trend = 6% Renewal Rate Changes = 2008 -10%, 2009 -10%

8. ab Slide 8 The Effect of New Business If you assume that these rate changes apply to the entire book of business (i.e. new business rate adequacy = renewal rate adequacy) then your projected 2009 loss ratio would be: 60% x 1.06 / (1-.10) X 1.06/(1-.10) = 83.2%

9. ab Slide 9 The Effect of New Business Now suppose that you believe that new business is less adequately priced than renewal business. How would this affect your projection? In order to answer this, you would need a few more pieces of information: Expected renewal retention rate Projected premium growth

10. ab Slide 10 The Effect of New Business Simulation Model for New Business Effect Initial Assumptions 2007 base portfolio of 100 policies with premium of $50mm and loss ratio of 60% Renewal rate changes of -10% for 2008 and 2009 Renewal retention rate of 80%

11. ab Slide 11 The Effect of New Business Simulation Model for New Business Effect Initial Assumptions New business for 2008 and 2009 will consist of 20 new policies with same average premium as renewal book “New business differential” values of 0, -10% and -20%

12. ab Slide 12 The Effect of New Business What is “new business differential?” It is defined as the difference in rate adequacy between new business in the portfolio as compared to the renewal book for the same period. It is NOT the rate change on new business. More about this later.

13. ab Slide 13 The Effect of New Business Simulation model operation: Base year 2007 portfolio is simulated: premium is generated from uniform distribution on 0-$1000; loss ratio from normal, mean 60%, SD 10% Each policy is either renewed or non- renewed for 2008 according to the renewal retention probability (80%) If a policy is renewed, the premium reflects the renewal rate change (-10%)

14. ab Slide 14 The Effect of New Business Simulation model operation: For renewed policies, the loss ratio reflects assumed loss trend of 6% and renewal rate change 20 new business policies are generated using same uniform distribution reduced for renewal rate change Loss ratio for new business policies is simulated using renewal loss ratio adjusted for new business differential

15. ab Slide 15 The Effect of New Business Previous results assume that the base book of business carries a loss ratio of 60%, and after lost (i.e. non-renewed) business the renewed book is unchanged (i.e. base at 60%.) The reality is that there may be a bias in the quality of the lost business, and in the soft market we might expect “better” business to be leaving. Companies report that lost business frequently moves at rate reductions of 20-30% or more!

16. ab Slide 16 The Effect of New Business We next assumed that the expected retention rate for an individual policy varies according to the loss ratio of the policy. For this simulation, we assume that for each point of loss ratio variation from the mean, the probability of renewal varies by one percentage point from the expected renewal retention rate. For example, if the base loss ratio for the book of business is 60%, and the renewal retention rate is 80%, a policy with a loss ratio of 62% would have a probability of renewal of 82%.

17. ab Slide 17 The Effect of New Business: Results of Simulation

18. ab Slide 18 The Effect of New Business We next ran the simulations assuming a renewal retention of only 60%; not unheard of for some E&S writers.

19. ab Slide 19 The Effect of New Business: Results of Simulation

20. ab Slide 20 What is the reinsurance pricing actuary to How do we estimate the “new business differential? Typically, such a quantity is not included in reinsurance submissions Ask the ceding company if they have attempted to estimate the effect of new business/ lost business on their portfolio Some rate monitors will already include these effects: e.g. ratio of actual to benchmark

21. ab Slide 21 What is the reinsurance pricing actuary to Look for ways to extract this information from the data that is provided: e.g. if you can identify new business in current bordereau of policies, then compare price per million for like limits, attachments, classes, etc. If you cannot identify new business, then look at changes in price per million from year to year, again for like limits, attachments, classes, etc. This can at least give you an indicator of the total (new + renewal) rate change – compare to the rate change provided in the submission

22. ab Slide 22 What is the reinsurance pricing actuary to Compare the rate change that the ceding company provides to that of similar portfolios and to industry benchmarks (CIAB, MarketScout.) If they are very different and you have no way of estimating the new business effect, then you might assume that the differences are at least partially attributable to new business/ lost business.

23. ab Slide 23 What is the reinsurance pricing actuary to NewAdjusted WrittenRenewalRateBusinessExposureRate YearPremiumRetentionChangeDifferentialInflationChange 2003 40,00080% 2004 40,00080%15.0%0%0.0%15.0% 2005 40,00080%29.0%0%0.0%29.0% 2006 40,00080%10.0%0%0.0%10.0% 2007 49,47080%2.0%-5%0.0%0.3% 2008 44,40980%-10.0%-10%0.0%-11.8% 2009 43,05480%-8.0%-10%0.0%-10.2%

24. ab Slide 24 Conclusions Summary: Always understand how rate monitors in reinsurance submissions are computed In addition, ask the client if new business is being included in the rate monitor If not, request information that would enable you to estimate the new business effect Initiate a discussion regarding lost business; do they measure how much of a decrease business is leaving for?

25. ab Slide 25 Conclusions Summary: Engage the client in a conversation regarding the effect of lost business on the quality of their remaining book of business – this is difficult, as there is no objective way to measure this