1. ab Rate Monitoring Steven Petlick CAS Underwriting Cycle Seminar October 5, 2009

2. ab Slide 2 Rate Monitoring Table of Contents Rate monitoring from the perspective of the reinsurance pricing actuary The effect of new business What is the reinsurance pricing actuary to do? Effect of economic crisis on price monitor 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 2001 0 2002+10% 2003+35% 2004+9% 2005+3% 2006-1% 2007-9% 2008-10%

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 Economic Crisis Effect on Rate Monitors Most rate monitors calculate rate changes based on change in premium per exposure Exposures are typically estimated at time of policy renewal and premium is calculated based on exposure base Rate monitors are typically created using actual premium and estimated exposures at time of pricing For many types of policies, premium is not adjusted if exposure base turns out different than that assumed at time of pricing In most cases, rate monitors are not adjusted

25. ab Slide 25 Economic Crisis Effect on Rate Monitors This can result is distortions in rate monitors if exposure estimates are materially incorrect During current economic crisis, many exposures were overestimated, in particular for classes like Construction (sales), Manufacturing (sales) This may have resulted in overstatement of rate decreases during 2008 and possibly 2009

26. ab Slide 26 Economic Crisis Effect on Rate Monitors Example: Renewal rate change Portfolio of 20 risks with 2007 premium of $1.76m and exposure of $37.1m (could be sales) Portfolio renews in 2008 with premium of $1.66m and exposure of $37.9m Rate change = -7.80% Company provides this information to reinsurer for 1/1/2009 treaty renewal Assumed rate change for 2009 is +1.5%

27. ab Slide 27 Economic Crisis Effect on Rate Monitors Actual exposure for 2008 comes in on average 10.8% below projected. Since premium does not change, effective rate change becomes +3.40% (as opposed to original -7.80%.) Does the company go back and adjust their rate monitor for the revised exposure? Probably not. When 1/1/2010 renewal is done, the rate monitor should “self-adjust”; i.e.. the 2009 monitor should reflect the revised exposure and the effective 2009 rate change will be much higher, all other things being equal.

28. ab Slide 28 Economic Crisis Effect on Rate Monitors Example: Reinsurance treaty Effective 1/1/2009 Using 2008 rate change of -7.8% (2009 assumption +1.5%), indicated loss ratio = 87.6% Using “real” 2008 rate change of +3.4% (2009 assumption +1.5%), indicated loss ratio = 78.1% This would have a major impact on the reinsurance underwriting decision

29. ab Slide 29 Economic Crisis Effect on Rate Monitors Example: Renewal Effective 1/1/2010 “Real” rate change for 2009 is +1.5%; however, company does not go back and correct exposures used in 2008 rate monitor, so understated premium per exposure is used. With “real” 2009 premium per exposure (that is, reflecting reduced exposure), the 2009 rate change appears to be +13.8%. (+2% rate change is assumed for 2010.) Indicated loss ratio is 86.5%. If 2008 exposures are corrected, and 2008 rate change of +3.4% is used, along with real rate change of +1.5% for 2009 (and same +2% for 2010), indicated loss ratio is ________

30. ab Slide 30 Economic Crisis Effect on Rate Monitors Example: Renewal Effective 1/1/2010 86.5% So the process self-corrected. However, the underwriting decision for 2008 could have be affected. In addition, if the exposures continue to drop, this process could be perpetuated over multiple years.

31. ab Slide 31 Economic Crisis Effect on Rate Monitors Caveats: Just because exposure base falls short, does that mean that actual exposure has fallen short? For example, for a Construction risk, if sales decline, was it due to less actual work or lower fees for the same work? The latter may not represent a real drop in loss exposure. Is exposure auditable; i.e. can premium be adjusted for audited exposure? (Example: Workers Comp.)

32. ab Slide 32 Economic Crisis Effect on Rate Monitors Caveats: Is the chosen exposure base the best measure of exposure to loss? For example, for a Trucking risk, exposure base may be number of units. In the recession, the number of units may not change, but the miles driven may be down.

33. ab Slide 33 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 Understand how exposure base is being used in the rate monitor

34. ab Slide 34 Conclusions Summary: Determine if company is making corrections to rate monitor to account for revisions in exposure base Incorporate assumptions on going forward exposure base when projecting future rate movement