1. Managing Overconfidence Douglas J. Collins, FCAS, MAAA doug.collins@towersperrin.com Tillinghast London (Tel: 44 (0)207 170 2162) CAE Zurich – 23 April 2004

2. © Copyright Towers, Perrin, Forster & Crosby, Inc 2 Many factors contribute to errors (and bias!) in pricing and underwriting Common Sources of Pricing and Underwriting Error/Bias (Micro) n Inadequate internal [historical] data upon which to develop estimates (e.g., old, incomplete or inaccurate data; inadequate/inappropriate sample) n Inability to collect and synthesize all relevant sources of data within the organization n Lack of reliable information about external market conditions and trends (e.g., inflation, tort costs) n Excessive concern for “competitive pressures” n Lack of adequate oversight over pricing decisions n Lack of “metaknowledge” — reinforces inherent overconfidence when making estimates, forecasts and predictions Systemic Sources of Pricing and Underwriting Error/Bias (Macro) n Long feedback loop n No skin in the game

3. © Copyright Towers, Perrin, Forster & Crosby, Inc 3 The results of a recent Tillinghast “Confidence Quiz” illustrate the prevalence of overconfidence The Quiz Objective: To test respondents understanding of the limits of their knowledge Respondents were asked to answer ten questions related to their general knowledge of the global property/casualty industry For each answer, respondents were asked to provide a range that offered a 90% confidence interval that they would answer correctly Ideally (i.e., if “well calibrated”), respondents should have gotten nine out of ten questions correct Number of Respondents Raw Scores of Online Respondents Note: based on 374 respondents as of 4/5/04. Profile of respondents: 86% work in P/C industry; 73% are actuaries. Tillinghast Confidence Quiz

4. © Copyright Towers, Perrin, Forster & Crosby, Inc 4 The best way to manage overconfidence is to implement a control cycle for pricing and underwriting The Control Cycle: Retrospective Test of Pricing/Underwriting n A control cycle for P/C pricing and underwriting entails identifying, testing and validating all of the assumptions that underlie the projection of future loss costs used to price and underwrite the business 1. Define/Refine Process 2. Implement Process 3. Measure Performance 1. Pricing and Underwriting Process Elements n Data required n Actuarial methods employed n Underwriting policies and rules n Decision authorities and reporting n Quality assurance 3. Formal Retrospective Performance Testing n Data accurate and adequate? n Pricing methods sufficiently robust? n Policies and rules effective? n Decision authorities appropriate? n Variances between projected and actual experience within tolerances?

5. © Copyright Towers, Perrin, Forster & Crosby, Inc 5 While improving pricing/underwriting requires a sustained commitment over time, three near-term steps will jump start the process Retrospective Analysis Process Design/Refinement Case-study Training Analyze relevant sample of pricing and underwriting results to identify/pinpoint specific causes and sources of error Define (or refine) and institutionalize an ongoing process of continuous improvement (i.e., control cycle) for pricing and underwriting Incorporate insights from retrospective analysis to address key challenges and deficiencies Develop/institute case-study oriented training modules for underwriters and pricing actuaries to provide practical experience and rapid feedback Base training materials on past business where results are already known

6. © Copyright Towers, Perrin, Forster & Crosby, Inc 6 Managing overconfidence in pricing and underwriting Pricing Element Best Estimate Standard Deviation 90% Confidence Low High Historical experience not fully credible 9575.0%8971,020 Historical experience not fully mature 19120.0%146242 Subtotal Ultimate Historical Loss Costs 1,1496.7%1,0521,249 Frequency and severity changes 13850.0%67226 Mix of business or underlying exposure changes 10200.0%123 Subtotal Projected Future (Attritional) Loss Costs 1,29712.0%1,1051,500 Non-attritional loss elements 61033.0%383874 Total Projected Expected Future Loss Costs 1,90617.3%1,5082,340 -20.9%22.7%