1. CREDIBILITY FROM THE EYES OF THE CUSTOMER Michael Round Rational Systems August 11, 1999

2. Rational Systems, formed by Michael Round in 1999, and located in Overland Park, Kansas, specializes in statistical and actuarial improvement. For a copy of “Credibility”, please e-mail me at: roundml@ix.netcom.com We are now accepting clients.

3. INTRODUCTION & BACKGROUND KBACKGROUND KDISRAELI vs. HUCKLEBERRY FINN

4. INTRODUCTION & BACKGROUND

5. THE EXISTENCE OF A PROBLEM KCONTEXT: the renewal rating process, the pricing actuary, and the group representative / layperson - all addressing the impending anniversary date of the group.

6. THE ACTUARIAL POSITION We want to have a reasonably priced insurance product. The pricing actuary must take into account claims variability. Credibility is used in the renewal rating process. goalrequirementsprerequisite

7. THE GROUPS’ POSITION We want to have a reasonably priced insurance product. My premium should reflect my experience. Numbers “speak for themselves”... no need for ‘credibility’. goalrequirementsprerequisite

8. THE CONFLICT We want to have a reasonably priced insurance product. My premium should reflect my experience. Numbers “speak for themselves”... no need for ‘credibility’. The pricing actuary must take into account claims variability. Credibility is used in the renewal rating process. goalrequirementsprerequisite

9. CONFLICT CONSEQUENCES Numbers “speak for themselves”... no need for ‘credibility’. Credibility is used in the renewal rating process. My group has an empirically low loss ratio. My expectation is a low renewal rate increase. Credibility may adjust data to an “average renewal rate increase”.

10. UNDESIREABLE EFFECT My expectation is a low renewal rate increase. Credibility may adjust data to an “average renewal rate increase”. Unhappy, angry, and confused, I go to the market for competing quotes.

11. THE ROOT CAUSE At first glance, we might suggest the root cause of the conflict and the inevitable action of the group is: FAILURE OF THE CLIENT TO UNDERSTAND THAT ADJUSTMENT OF DATA IS NECESSARY IN THE RENEWAL PROCESS... After all, the client has the perception: THE DATA IS WHAT IT IS!! However...

12. DATA ADJUSTMENTS THAT ARE UNDERSTOOD We often adjust the data prior to the application of credibility, and the group / layperson perfectly understands “the data is NOT what it is” - and is comfortable with data adjustments. For example … First-Year Cases on a Paid Basis Late-Year Rapid Contract Growth

13. DATA ADJUSTMENTS THAT ARE UNDERSTOOD

15. THE ROOT PROBLEM Credibility adjusts data in a numerical “black box”. The group accepts “data adjustments” they can understand. The group often does not understand the adjustment of their “good” data when adjusted via credibility.

16. INJECTION TO SOLVE THE PROBLEM CREDIBILITY - and what gives rise to its need - ARE INTUITIVELY presented. The group accepts “data adjustments” they can understand. The group has an understanding of what has happened to their data - and may not be as dissatisfied with the perceived gap between the “expected” and “actual” renewal rate increase.

17. THE SOLUTION TO THE PROBLEM CREDIBILITY seeks to quantify the variability, uncertainty, and predictability of a block of data. To intuitively present this idea, we need to bridge the gap between our level of knowledge and that of the group representative / lay-person - OR PROVIDE A VISUAL MEANS OF AFFORDING THE LAY-PERSON THE INTUITIVE KNOWLEDGE OF WHAT VARIABILITY IS. SIMULATION is an excellent mechanism for demonstrating variability and uncertainty at an intuitive level.

18. SIMULATING VARIABILITY IF the essence of credibility is “degree of predictability”, THEN one method of communicating intuitively this concept is a simple simulation probability distribution for three different group sizes: 25 Members 250 Members 2500 Members

19. A ‘25-MEMBER’ GROUP...

20. A ‘250-MEMBER’ GROUP...

21. A ‘2500-MEMBER’ GROUP...

22. CLAIMS: A COMPARISON BY GROUP SIZE

23. EXPLAINING CREDIBILITY IF we have achieved our goal of visually demonstrating the meaning of “variability”, “uncertainty”, and “predictability” [all of which CREDIBILITY is addressing], THEN the group representative / lay-person has some feel why their data is being adjusted. WHY NOT USE THE SAME SIMULATION PROCESS THAT EXPRESSES VARIABILITY VISUALLY TO TABULATE THE CREDIBILITY FACTORS WE NEED TO ACTUALLY ADJUST THE DATA?

24. THE ADVANTAGES When SIMULATION is used as described here, the advantages are numerous: 1. The source data [the continuance table] is ours; 2. We can visually and easily explain what the whole process means; 3. We can quantify ‘credibility’ numerous ways; 4. We can easily make continuance table adjustments to recognize certain characteristics of a group [e.g., low specific deductibles, carve-outs, annual maximums]; 5. We can operationally define to all parties exactly what is going on.

25. TABULATING CREDIBILITY There are many ways to tabulate credibility when approached from the perspective defined here. The two basic categories are: 1. Percentage of simulations falling within +/- x% of the expected PMPM; 2. Percentage of simulation dollars falling within +/- x% of the total expected dollars.

26. CREDIBILITY FOR OUR PURPOSES

29. WHICH METHOD TO USE? We can obviously choose from a number of tabular formulations to use as our “credibility” factors... Which one is best? Dr. Walter Shewhart, the founder of the Statistical Process Control Chart, is perhaps the best source to consult to address this question. The control limits of his charts are not solely statistical in nature, but PRACTICAL…that is, Dr. Shewhart addressed the question “WHAT MAKES ECONOMIC AND PRACTICAL SENSE?” and he developed a process from that perspective.

30. THE ANSWER? What tabular selection is best? Which should be used in the adjustment of data? WHICHEVER METHOD IS BEST FOR YOU IN YOUR MARKET DEALING WITH THE PEOPLE IN YOUR MARKET AND THE COMPETITION IN YOUR MARKET.`

31. CONCLUSION KHave I convinced you there is a problem? KHave I addressed the reason for this problem? KHave I developed the cause of the problem? KHave I solved the problem? KHave I quantified in practical terms what “solution” means? KHave I shown numerous advantages to such a solution, while not introducing negative consequences?

32. CONCLUSION KHave I convinced you there is a problem? KHave I addressed the reason for this problem? KHave I developed the cause of the problem? KHave I solved the problem? KHave I quantified in practical terms what “solution” means? KHave I shown numerous advantages to such a solution, while not introducing negative consequences?

33. CONCLUSION KHave I convinced you there is a problem? KHave I addressed the reason for this problem? KHave I developed the cause of the problem? KHave I solved the problem? KHave I quantified in practical terms what “solution” means? KHave I shown numerous advantages to such a solution, while not introducing negative consequences?

34. CONCLUSION KHave I convinced you there is a problem? KHave I addressed the reason for this problem? KHave I developed the cause of the problem? KHave I solved the problem? KHave I quantified in practical terms what “solution” means? KHave I shown numerous advantages to such a solution, while not introducing negative consequences?

35. CONCLUSION KHave I convinced you there is a problem? KHave I addressed the reason for this problem? KHave I developed the cause of the problem? KHave I solved the problem? KHave I quantified in practical terms what “solution” means? KHave I shown numerous advantages to such a solution, while not introducing negative consequences?

36. CONCLUSION KHave I convinced you there is a problem? KHave I addressed the reason for this problem? KHave I developed the cause of the problem? KHave I solved the problem? KHave I quantified in practical terms what “solution” means? KHave I shown numerous advantages to such a solution, while not introducing negative consequences?