1. Casualty Actuarial Society Ratemaking Seminar Shantelle Thomas March 17, 2008 Allocating the Cost of Multi-State Reinsurance Contracts to Individual States

2. Proprietary and Confidential Information...Do Not Reproduce...Prepared For The Purpose Of Allstate Management Discussion Only. 2008 CAS Ratemaking Seminar 1 Disclaimer This presentation does not cover all possible methods of allocating the cost of a multi- state contract or all the pros and cons of each method. I will share with you today some of the issues I’ve encountered when thinking about the subject and I welcome an expanded analysis that would include methods I did not consider, particularly more risk- based or financial methods.

3. Proprietary and Confidential Information...Do Not Reproduce...Prepared For The Purpose Of Allstate Management Discussion Only. 2008 CAS Ratemaking Seminar 2 Considerations when determining how the cost of a multi- state reinsurance contract may be allocated among states –Applicable Actuarial Standards –Regulatory Acceptability –Business Needs

4. Proprietary and Confidential Information...Do Not Reproduce...Prepared For The Purpose Of Allstate Management Discussion Only. 2008 CAS Ratemaking Seminar 3 Assumptions of this Presentation: –Reinsurance is being purchased for the purpose of Catastrophe Exposure Management –We are using a Net Cost of Reinsurance Methodology –Expected loss recoveries are known or have been modeled at the state/line of business level of detail

5. Proprietary and Confidential Information...Do Not Reproduce...Prepared For The Purpose Of Allstate Management Discussion Only. 2008 CAS Ratemaking Seminar 4 So, let’s take a simplified example and try a few methods. The following data is illustrative only and not representative of any actual company or reinsurance contract. Assume there are only 4 states: A, B, C and D. A reinsurance contract is purchased covering all four states for $60,000,000. The expected reinsurance recoveries under the contract are $15,000,000. The net cost of reinsurance is $45,000,000. Also assume: Direct Written PremiumAIYsHurricane AAL Expected Reinsurance Recoveries State A25%17%58%69% State B25%20%36%31% State C25%33%4%0% State D25%30%2%0% AIY – Amount of Insurance Year ($1000 of coverage in force for one year) AAL – Average Annual Loss

6. Proprietary and Confidential Information...Do Not Reproduce...Prepared For The Purpose Of Allstate Management Discussion Only. 2008 CAS Ratemaking Seminar 5 Suppose we allocate the gross cost of the contract in proportion to direct premium written Cost Expected Reinsurance RecoveriesNet Cost of Reinsurance State A $ 15,000,000 $ 10,350,000 $ 4,650,000 State B $ 15,000,000 $ 4,650,000 $ 10,350,000 State C $ 15,000,000 $ - $ 15,000,000 State D $ 15,000,000 $ - $ 15,000,000 $ 45,000,000 Under this scenario, there are two challenges that may surface: 1.Regulators in State C and D are unlikely to approve a substantial cost for their constituents if the expected reinsurance recoveries for their constituents are zero. 2.Policyholders in State A and B end up paying less than policyholders in State C and D, even though State A and B contribute most of the exposure in the reinsured layer.

7. Proprietary and Confidential Information...Do Not Reproduce...Prepared For The Purpose Of Allstate Management Discussion Only. 2008 CAS Ratemaking Seminar 6 Suppose we allocate the gross cost of the contract in proportion to AIYs (exposure) Under this scenario, both the problems noted on the previous page exist. In addition, the net cost for one state is actually negative. If you were to file the net cost in states with a positive net cost and did not file to give back the cost in a state with a negative net cost, you would actually pass on costs that are greater than your net cost. These examples are obviously fabricated to highlight some specific concerns, but the concerns are nevertheless real. Cost Expected Reinsurance Recoveries Net Cost of ReinsuranceFiled Amount State A $ 10,200,000 $ 10,350,000 $ (150,000) $ - State B $ 12,000,000 $ 4,650,000 $ 7,350,000 State C $ 19,800,000 $ - $ 19,800,000 State D $ 18,000,000 $ - $ 18,000,000 $ 45,150,000

8. Proprietary and Confidential Information...Do Not Reproduce...Prepared For The Purpose Of Allstate Management Discussion Only. 2008 CAS Ratemaking Seminar 7 Some of you may be thinking... The problem is that you allocated the gross cost and then calculated the net cost. Why don’t you calculate the net cost of the whole contract and then allocate the net cost? Recall that the net cost of this contract is $60M - $15M = $45M. If we allocate the net cost based upon direct written premium: This appears ok and that none of the problems on the previous pages exist. However, if you were to file in each of the four states, it is reasonable to anticipate that regulators in State C or D might ask what the expected recoveries are for their state. If you respond that expected recoveries are zero, you are back to the first problem noted on page 5— asking a state to approved costs associated with a contract that has no expected reinsurance recoveries for that state. Net Cost Expected Reinsurance Recoveries State A $ 11,250,000 $ 10,350,000 State B $ 11,250,000 $ 4,650,000 State C $ 11,250,000 $ - State D $ 11,250,000 $ -

9. Proprietary and Confidential Information...Do Not Reproduce...Prepared For The Purpose Of Allstate Management Discussion Only. 2008 CAS Ratemaking Seminar 8 Is there any way to avoid these potential issues? Yes, allocate the gross cost of the reinsurance contract based upon the distribution of the expected reinsurance recoveries under the contract. When the net cost is incorporated in each state’s rates, this is essentially saying that the cost of each dollar of expected reinsurance recovery is equal. However, the cost of a dollar of recovery could vary from contract to contract. You might expect the cost per dollar of recovery to be higher for a contract covering a higher (riskier) layer of coverage. Cost Expected Reinsurance RecoveriesNet Cost of Reinsurance State A $ 41,400,000 $ 10,350,000 $ 31,050,000 State B $ 18,600,000 $ 4,650,000 $ 13,950,000 State C $ - State D $ - $ 45,000,000

10. Proprietary and Confidential Information...Do Not Reproduce...Prepared For The Purpose Of Allstate Management Discussion Only. 2008 CAS Ratemaking Seminar 9 Summary  Allocation by premium or amount of insurance year (exposure) may yield results that are counterintuitive and difficult to explain internally and present to regulators. In fact, any allocation other than allocation based upon expected reinsurance recoveries could result in such a situation.  The expected reinsurance recoveries used to calculate the net cost of reinsurance should be the same recoveries used to allocate the gross cost of the contract to state/line of business.

11. Proprietary and Confidential Information...Do Not Reproduce...Prepared For The Purpose Of Allstate Management Discussion Only. 2008 CAS Ratemaking Seminar 10 Additional considerations Ideally, one might want expected reinsurance recoveries under the reinsurance contract to be generated in a way that is consistent with how one generated expected losses in the pricing of your underlying policy (i.e. use the same version of the same model). If you allocate costs based on expected reinsurance recoveries, consider whether to generate the recoveries in house or whether to have that analysis performed by a third party (broker, consultant, or modeler). It may be beneficial to have the allocation come from an independent source. Consider the need to validate the analysis. Consider whether to make the allocation of the gross cost by state and line of business part of the contractual language of the reinsurance agreement.

12. Proprietary and Confidential Information...Do Not Reproduce...Prepared For The Purpose Of Allstate Management Discussion Only. 2008 CAS Ratemaking Seminar 11 Allocation based on modeled recoveries If the allocation is based on a set of modeled recoveries, then the modeled recoveries must be based on an exposure distribution. Its important to think through your choice of the exposure distribution carefully. For example, suppose it is 7/1/07 and you want to allocate the cost of a contract that will be effective on 1/1/08 for a period of one year. Ideally, you’d want modeled recoveries for the exposures that will be in force from 1/1/08 to 12/31/08. But it is only 7/1/07. You could use 7/1/07 exposures, but what if marketing, underwriting or sales actions will result in a different exposure mix in six months? You could use an exposure distribution that is projected for the period that the contract will be in effect. You projections may introduce uncertainty. In addition, if the actions you are adjusting for are different from state to state and you are allocating the cost of the contract based on expected recoveries, the cost of the contract in any individual state will be dependent on the adjustment assumptions you’ve made in every other state. This could prove problematic internally and externally.

13. Proprietary and Confidential Information...Do Not Reproduce...Prepared For The Purpose Of Allstate Management Discussion Only. 2008 CAS Ratemaking Seminar 12 Allocation within a state or by line of business It may be desirable to vary the amount of reinsurance cost in customer rates by any of several different variables, including amount of insurance, construction type, deductible, territory and/or mitigation device. If cost of reinsurance is built into base rate or package premium (say, as a %) it will implicitly vary as base rates or package premium changes due to other rating plans. If cost of reinsurance is a separate charge or rate, it may vary more explicitly. Relativities by deductible, etc. could be based on the relative level of expected losses in the reinsured layer. However, this requires a level of event detail that may be unavailable or cumbersome to work with for many companies.

14. Proprietary and Confidential Information...Do Not Reproduce...Prepared For The Purpose Of Allstate Management Discussion Only. 2008 CAS Ratemaking Seminar 13 Allocation within a state or by line of business Allocating reinsurance costs geographically within a state is a two step process:  First, define the geographical groupings to use in the state –Consider using existing territory definitions or groupings already defined for hurricane deductible pricing, wind exclusion credit pricing or underwriting criteria –Or, create groupings specifically for reinsurance. As noted on the previous page, these could be based on grouping together areas (zips, counties) with a similar relative level of expected losses in the reinsured layer. Most general territorial ratemaking considerations would apply.  Second, determine the relative level of the cost for each grouping –Again, if the data is available, you can base the relative level on the relative level of expected losses in the reinsured layer. –If that information is unavailable, it may be necessary to develop or select a proxy. It may not be possible to arrive at one methodology that satisfies all regulatory jurisdictions. Some are focused on affordability and prefer to have reinsurance costs spread broadly across the state. Others are very sensitive to the concerns of inland constituents who do not want to bear the cost of reinsurance that may primarily benefit those on the coast. This issue is not unique to reinsurance.

15. Proprietary and Confidential Information...Do Not Reproduce...Prepared For The Purpose Of Allstate Management Discussion Only. 2008 CAS Ratemaking Seminar 14 Questions?