1988 CASUALTY LOSS RESERVE SEMINAR IA: CONSIDERATIONS IN SETTING LOSS RESERVES. Faculty: Brian Z. Brown Manager CNA Insurance Companies

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1 1988 CASUALTY LOSS RESERVE SEMINAR IA: CONSIDERATIONS IN SETTING LOSS RESERVES Faculty: Brian Z. Brown Manager CNA Insurance Companies Susan M. Miller Actuary Milliman & Robertson, Inc. Recorder: 3ohn Stonehill Student Actuary American States Insurance Companies

2 MS. MILLER" Good morning, everyone. The purpose of our discussion here is to give you an introduction to the basic track, called "Basic Concepts and Methods". I think a lot of it will be review, it's just a way of getting your mind ready to talk about reserves for the next day and a half. We hope to provide you with a foundation so you can go to the fundamental sessions and learn quite a bit about reserving methods. So what I'd like to do is to start out by giving a very simple definition of what a loss reserve is. (Exhibit I) Okayl I think the simplest definition we can give for a loss reserve is "the amount set aside to settle claims." I think the key characteristic here is that a loss reserve is an estimated liabilityl this is opposed to what I would call a certain liability. For example, if your company takes out a loan, that loan is a liability~ but your company knows how much it will have to pay to fulfill the obligation under the loan, they know when they have to pay it, also -- they know who they have to pay it to, where they have to pay it, and probably -- why they have to pay it. But a loss reserve is estimated -- the precise amount needed to settle a claim won't really be known until after the claim is settled. So then, why bother to set a reserve? Why not wait until the claim is settled and simply book the precise payment? That's the most accurate way to do it -- but l assume you all know the answer as to why that can't be done. An insurance company needs to make a reasonably accurate evaluation of its financial position at any given time. And it needs to ultimately assure that it has the ability to fulfill the promises that it made to policy holders when it sold them insurance policies. Okay, let's step back and consider what reserving means in terms of an insurance company's recording of financial position and recording of income (Exhibit 2). The important function here is the matching of revenues and costl revenues for insurance usually meaning the premiums taken in and the costs usually meaning the losses and expenses related to the premium that has been earned on those policies. In terms of a balance sheet, the assets are created when you bring in premium, and get to cash the checks (that's the good part). In simplest terms the cashed checks really become the bulk of the assets. Actually, thanks to something called an "unearned premium reserve", the premium comes in as an unencumbered asset slowly over the life of the policy. It gets earned over time. But corresponding to these assets, you need liabilities, because you only brought in the premiums in return for a promise. And youne made a promise to pay losses to the policy holders, and that promise needs to be reflected as a liability on your balance sheet. A similar concept is true with the statement of income. If you want meaningful loss ratios and meaningful combined ratios, you reasonably have to match premiums with losses. What's most important to the insurer is not so much the reserves on any specific claims, but the total (Exhibit 3) guarantee management will see the big ones. The total loss reserve for a group of losses represents the estimated amount that must be paid in the

3 future to settle losses on all claims that have occurred on or before a particular accounting date. It is estimated as of a given evaluation date. For example, in the 1988 annual statement, the evaluation date will of course be December 31, Because reserves are estimates, the insurer's estimate of the total loss reserve will likely change from one evaluation date to the next -- as more information about claims becomes known. Now I'd like to go over some distinctions among different types of dates, which are important when you estimate reserves. (Exhibit 4) First, you have an accounting date. Actually, the accounting date just helps to define a specific group of losses for whatever accounting or statistical purposes are in mind. The evaluation date means the date as of which the evaluation of a loss grouping is made. The accident date is the date when the loss occurred. There are certain circumstances; for example, a long term exposure claim like asbestosis, when you don't really know the actual accident date when the claim occurred because the exposure happened over a long period of time. In this instance, judgment is involved in picking the accident date; so that's why it says on the slide, "when the loss is deemed to have occurred." Sometimes it's a bit of grey area. The report date is the date when the loss is first reported to the company, and in practice that usually means when it's entered into the company's statistical records. The transaction dates are the kinds of dates that correspond to certain activity on the claim. For example, when a reserve is set up or when the reserve is revised again and again, or when the claim is closed and payment is made. To get a better feel for what all of these dates mean~ I think it would be good to go through an example of the life cycle of a typical claim reserve. (Exhibit $) Okay, here's an example; let's say it's an automobile claim, as a matter of fact, the driver is a young budding actuary, an actuarial student cramming on April 15th by reading flash cards strung across the dashboard of his car, while he's driving on the freeway. Well, he's just getting into studying one of the more important actuarial concepts when the freeway traffic slows down, and then smack -- right into the back of someone's car. Now, I don't mean to imply that accidents are funny, but this one's not too serious, just a little whiplash, that kind of thing. At the moment the accident took place, that claim became what we call an IBNR Claim. IBNR stands for "incurred but not reported". On April I~, 1984, an accident occurred and we have an IBNR Claim. The insurance company doesn't know about it yet; actually the only people who know about it are police and the guys involved in the accident, and all of the rubber-neckers that looked when they drove by. A couple of weeks later, in typical procrastinating actuarial student fashion, the student reports the claim to the company. At this moment the claim is "in transit": the company knows of the claim, but it's not in the company's computer records yet. A couple of days later the claim gets coded into the computer system -- on May 2, but the adjuster hasn't looked at it yet.

4 At this point, the claim is given what we call an "average reserve". About three months later the claims examiner looks at the file and he establishes his first estimate of the ultimate cost of the claim, which is called a case reserve. Actually, the average reserve is usually also considered in the records as a case reserve, but it wasn't really set by a claims adjuster. Four or five months later the claim comes up for review, and the information in the file shows that new information has emerged about what the plaintiff wants to do, what kind of damages theyye expecting, what kind of injuries there were, etc. The case reserve estimate can be revised now. So, on December 17, 198% we have a revised case reserve. Over the next few months, some haggling occurs, they go on and on -- and finally a settlement amount is agreed upon. At this point, it still remains as a case reserve, although the case reserve is probably revised at this point to equal what the expected settlement amount will be. About a week later the company really knows that it has to pay so it pays the claim -- but the case reserve remains until the payment goes out to the claimant, the draft gets cashed, and the paid draft notice comes back to the company. At that point, the payment is recorded and the reserve is brought down to zero -- then the claim is closed. At this stage, there is some small possibility that this claim could reopen, due perhaps to some unforeseen injuries that the person didn't feel on the first day but feels a year later and says it had to have been caused by the auto accident! So it is possible the claim will reopen at a later date. Reopening reserve estimates are not estimated on a case by case basis, it's just not possible to do that. If it were possible to figure out which claims were going to reopen, you'd never close them in the first place. So conventionally, estimates are set by aggregate for reopenings, and are set by formula. Okay; let's go back to the concept of the total loss reserve. (Exhibit 6) There are five elements to the loss reserve, although most companies will not necessarily separate all five elements. Rather, companies generally use loss reserving methods to estimate various combinations of these five elements. The elements are: case reserves, a provision for the future development on claims that the company knows about, a reopening claims reserve, the provision for claims incurred, but not reported -- it's commonly referred to as IBNR -- but for reasons that I'll describe later, it is sometimes referred to as the true IBNR or pure IBNR. And the last one is a provision for claims in transit, sometimes also known as the Pipeline Reserve, or the reported but not recorded reserve. These are claims that were reported to the company, but that haven't entered the company's statistical records yet. As I mentioned, companies don't typically estimate each of these reserve elements separately; but they use methods to estimate combinations of these elements. Often this combination of the elements is referred to as IBNR -- but it's a loose, but common usage of the term. (Exhibit 7).

5 Let's consider for a moment what kind of definition a company might have for IBNR reserve. The first one) as I said, was true IBNR; those are the unreported claims. For example, the accident occurred, but the claimant might not have even known he needed to make a claim yetl say it was a back injury and when it happened, the claimant thought it didn't feel so bad -- but then a year later he claims that the slip and fall was pretty bad and the injury needs to be taken care of. That is when the claimant decided to make a claim. Until that time the claim was really unreported to the company. That doesn't mean the company wasn't obligated to do something about it, it just didn't really know exactly what was involved yet. The second definition is if you take the true IBNR and add the claims in transit -- the pipeline. This is a more likely combination for an IBNR reserve because the data is generally available right out of the statistical records. So you need to wait for those pipeline claims also. The third possibility for an IBNR reserve is the first two pieces plus a provision for the development on known claims. When a claim comes in, there is some information to put in the file) but not much. More information will come in over the life of the claim and probably some will come in after the claim is closed. You hope it's not bad news, though. So some provision needs to be made for the development that will occur as information comes in to a file for a known claim. The claims adjuster can't be expected the first time he sees the claim, to be able to pinpoint exactly how much it is going to cost. As the claim goes on and he learns more about the claim, he will be able to come up with a more accurate estimate; but it doesn't really converge to the actual amount until the claim is closed. The fourth possibility for an IBNR reserve would be the first two elements plus a provision for the reopening of claims. And the fifth possibility is all of the elements combined -- the true IBNR and claims in transit, the development on the known claims and the reopening claims reserve. I should note that all of the elements must be accounted for in some way. The reason that I think these definitions are important to you is that you should know what your particular company is referring to when they use the nomenclature "IBNR". It could be any of the above; in my experience) it's generally been number five, everything. Sometimes it was number four -- everything but the development on known claims. In that case) the company estimated the development on known claims separately. So far were been talking mostly about losses; otherwise known as indemnity losses, or payments to claimants. Reserves must also be established and maintained for the cost of settling claims. These are otherwise known as loss adjustment expenses. (Exhibit 8) Loss adjustment expenses are generally divided into two categories" allocated and unallocated. Allocated loss adjustment expenses are those that can be assigned to a specific claim. For example) you could have an attorney working on a certain claim trying to defend the claim. He's going to send bills to the company saying) "I'm working on claim number so and so and expect to be paid a certain amount of money." Well, that amount of money is tied to that certain claim, so it can be allocated to that claim in the statistical record.

6 Other examples of such expenses are legal expenses such as court costs or expert witness costs. And for some companies, the independent adjuster fees can also be allocated to certain claims. Then we have unallocated loss adjustment expenses. Unallocated are those that cannot be assigned to a specific claim. Generally, they are the overhead-type expenses related to the claims function at a company. They would include claims department salaries and benefits, claims department overhead like the cars that the adjusters need, rent for where the claims department spends their time, supplies, etc. Also, some of the total company overhead must be allocated or charged to the claims function. For example, the President of a company does spend some time thinking and talking about claims -- so some percentage of his salary should go to the claims function. For some companies, the independent adjusters' fees end up in allocated loss adjustment expenses. I think the determining factor in treating independent adjusters' fees as allocated or unallocated loss adjustment expense is whether the independent adjusters provide billing detail of their work on a claim by claim basis. Say, if they bill you monthly and send you a list that says "this is what we worked on this month; we worked on claims X and Y and we spent this many hours on each." In this case, you could theoretically put that cost back to every claim. On the other hand, sometimes they'll bill you monthly and will just say "we spent 5,000 hours this month working on your claims, so please pay us" but they don't tell you which claims they worked on. In that case, you really can't go back and allocate their expenses to individual claims. Loss adjustment expenses can be substantial, especially for liability-type lines like auto liability, general liability or products liability. In one of the basic track sections, you will learn some methods for handling reserving for loss adjustment expenses. Now I would like to discuss the conceptual difference between reserve maintenance and reserve testing. (Exhibit 9) A few minutes ago, I identified the five elements of a loss reserve and also pointed out that companies will use different approaches to develop these elements or combinations of the elements. Establishing and following procedures to build these elements is what I would call "reserve maintenance". But really, how does a loss reserve specialist know whether the procedures developed are working to establish adequate reserves? Well, one way would be to sit back and have a couple cups of coffee and wait for all of the claims to come in and settle, and then compare the amounts that were ultimately paid with the amounts that were set aside in reserve for those claims. That would be great, but obviously it would take too long -- and certainly longer than a company would and could wait to find out whether their reserve estimates were right. So instead, the loss reserve specialist will try to test the reserves. By testing reserves, I mean that the loss reserve specialist will apply certain statistical assumptions and see how the claims are likely to run off, which would be considered a prospective test.

7 The statistical assumptions would generally come from evaluating the post history of claims and examining how the claims have developed in the past. To the extent that the loss reserve specialist uses these assumptions to reflect upon whether the reserves as of a prior accounting date were adequate, that would be known as a 'Yetrospective test". Both prospective and retrospective tests generally involve the analysis of loss development factors, which you will learn about in the next few sessions today and tomorrow. Okay. Let's say for example that you're ready to take over the loss reserving function for your company. What would be the first thing you'd need? And l don't mean a stiff drink, and l don't mean a crystal ball, either -- we don't use those! I would say the first thing you'd need is data. You know how actuaries arel they love their data. Obviously, data is essential to this process, and there are several important considerations that go along with determining how much data you need and what kind of data you need. You can't really talk about how much data is necessary without spending a little time talking about what we call "the law of large numbers". (Exhibit 10) Quite often this law of large numbers is misinterpreted as meaning "more is better." But that's not really the case. The law of large numbers states that the larger the volume of a sample of homogeneous data, the closer the sample value is likely to be to the expected value of the whole population from which the sample is taken. The word "homogeneous" is really the important one here. If you have a sample of data for some group of claims, and the claims are thought to have very similar characteristics to one another, but then you attempt to add to the size of your data by including claims whose characteristics are really nothing like the rest of the sample, you've really done nothing to improve the predictive quality of your data. Therefore, for loss reserving purposes, it's really best to put together types of claims that are very similar to one another in development patterns and claim sizes. Within homogeneous groups of claims, I think the "more is better n statement is more likely to hold. (Exhibit 11) This really creates a certain kind of balancing act between credibility -- which is having enough data to use to predict, and homogeneity -- which is having data grouped by the similarity of characteristics. One mustn't try to take the homogeneity idea too far. I think you could liken that to, say, making slices of bread and then taking thinner and thinner slices. Pretty soon, if you take a thin enough slice, all that you really have left are crumbs. You really don't want crummy data! So the key here is to organize the data into groups of claims with similar characteristics, but large enough groups of claims so that you will have statistically reliable, or credible, loss development patterns. Some examples of the claim characteristics you'd sort by are line of business, such as automobile, and coverage, such as liability versus physical damage. Liability and physical damage are very different in their loss development patterns. Liability takes a long time to developl with physical damage you might get all of the development in 12 months.

8 Another example of a claim characteristic to sort by is size of loss distributions. You could put together all losses less than $$,000 in size, and all losses greater than $$,000 in size. The tendency is that larger claims -- well, I can't really say this as it's a generality -- but you'd think that for some lines of business, larger claims take longer to come in than smaller claims. That's probably true in many lines of business; however, for physical damage a larger claim may come in faster because the claimant is really interested in getting the money. With a small claim like $50 they might say, "well, I don't know if I want to report it, I can pay it myself..." So that might take longer to come in. You can organize your data by type of settlement patterns you expect, or emergence patterns, meaning how the claims are reported over time. For example, BI (bodily injury) and PD (property damage) generally have different settlement patterns. Property damage claims are usually a little bit easier in determining how big they're going to be and what the damages really are, so you'd expect those to emerge and settle quicker than bodily injury claims. (Exhibit 12) Here's just another example of how the data can be divided; this is for general liability line of business. You could divide it into the several different types of general liability policies. For example, you have OL&T, owners, landlords and tenants policies --which are the premises-type risks. Then you have M&C, manufacturers and contractors, which are the operational-type risks. And you have products liability -- a class all by itself, professional liability, another real humdinger, and then nao" which stands for "all other." There could be more divisions like bodily injury claims separated from property damage claims, because you might expect that BI and PD have different settlement and emergence patterns. Companies will generally differ as to what kind of data is available, and what kind of specific divisions will have enough data to work with. So a considerable amount of judgment is involved in selecting the best divisions of data to use for your company. Well, I bet you were wondering when I was going to let my speaking partner, Brian, talk? Brian is going to continue this discussion with other considerations that are involved in setting loss reserves.

9 Hello. My name is Brian Brown, I'm an Actuary with CNA. Good morning everybody. I'd like to spend some time going over some definitions. (Exhibit 13) The first word I want to define is "emergence". Emergence is the time between the date that the accident occurred and the date it was recorded in company databases. The concept of emergence is important because it can give you a feel for the significance of the IBNR reserves. Obviously if a claim isn't reported to the company, a case reserve cannot be established. Therefore, in general the longer the emergence time, the more relative IBNR. Settlement is the time between when the claim is recorded in company data bases and when it's actually paid. This is significant because the longer a claim remains open, the more uncertainty is associated with it. Changes in the legal climate can occur, along with a number of other things that makes the actuary's job more difficult in setting IBNR and supplemental reserves. Now I'd like to go through the time lags between emergence and settlement for a number of different types of claims. (Exhibit 14) Susan alluded to before for auto physical damage, claims usually are reported quickly and settled quickly. For example, let's assume you buy a 1988 Jaguar and are driving down the street and you run into a tree. You're going to want to get a new car immediately, so you have to get the funds from the insurance company. You report the claim quickly and the claim will usually be settled relatively quickly. There's usually no coverage dispute for physical damage like there would be in something like pollution or asbestosis liability. Now for worker's compensation insurance, that covers people who get injured at work, the claim is usually reported fairly quickly but takes a long time to settle, excluding medical only claims. Now there are certain types of work comp claims where this is not true, for example the latent injury type claims, cumulative trauma and asbestosis. The date between the emergence and settlement is fairly long for workers' compensation; the person would get two-thirds of their wage in most states until they were able to return to work. So basically the settlement period here refers to how long it's going to take to rehabilitate the person and get them back to work. As.

10 In Reinsurance you have a fairly long lag on the emergence side, predominantly with excess of loss insurance. In excess of loss reinsurance the reinsurance is covering above a specific dollar amount, let's say $1 million per claim. It's going to take awhile for the primary company to be aware the claim is going to be over the million dollar threshold. There's going to be a relatively long lag in reporting the information to the reinsurer. The settlement time depends on the type of reinsurance, but can be relatively short as it is in this case. This example could be some type of excess property insurance. If you're talking about medical malpractice reinsurance, there could be a lot longer lag between the emergence and settlement of the specific claim. For products and medical malpractice, there is a very long emergence for most types of claims; this is because it can take the claimant a long time to realize they have a claim. Let's assume somebody went in to see their doctor and they had some condition that was curable at that time. The doctor didn't diagnose the condition. Three years later the person discovers the condition. The accident date occurred when they saw the doctor on , but the person is just now, three years later, becoming aware of it. They would report the claim or sue for negligence against the first doctor they saw, so it would take a number of years to actually emerge in the company's data base. After emergence it has to go through the court system to determine whether the doctor was really negligent or not. So we're talking very long time lags here. Now I'd like to go through an example on how data is arranged. (Exhibit 15) The exhibit represents all accidents that occurred in The accident date for the medical malpractice claim, is the date you saw a doctor and he failed to diagnose the specific condition, for an auto accident it's the date that you hit the tree. The first row across represents the incremental paid losses in a specific calendar year. For example, $1,000 was paid in 1985 for accidents that occurred in 1985; the reserve column is case reserves, so it's the reserves that a claims adjustor sets up or fast track reserves. So the outstanding claim reserve as of was $5,000. Now the cumulative paid, the next row down, represents how the payments have moved throughout time. For accidents that occurred in 1985, in '85 we paid one thousand, in '86 we paid four thousand, so that the cumulative amount would be five thousand as of 12/86. And, likewise for '87-'

11 Cumulative incurred is the sum of the case reserves and the paid losses, the cumulative numbers. So the claims department is estimating that as of we have six thousand dollars in ultimate losses. Now obviously that does not represent or take into account any actuarial reserves; IBNR reserves and supplemental reserves. You can see as we move throughout time, for accidents that occurred in '85, we see an upward development pattern for incurred losses. What I'd like to go over is a basic actuarial method for setting reserves, using development factors. I'm sure a number of sessions will be going over loss development factors. A paid development factor is paid losses for a specific accident year, as of a given calendar year evaluation divided by the previous calendar year values. For example, for paid loss development factors, there is $5,000 in paid as of the end of '86, and $1,000 as of the end of '85. So if we divide the $5,000 by the $1,000 we'd get a factor of five. Likewise, the month factor is $7,000 divided by $5, and that gives us a factor of 1.4. If we wanted to know what paid losses would be for accident year 1988 as of 12/89, we could multiply the paid loss for accident year 1988 as of 12/88 by a factor of five. And likewise, if you wanted to develop accident year 1988 paid losses to 48 months, you would multiply it by 5 and then 1.4 and then likewise for the incurreds. Now I'd like to go over the difference between calendar year and accident year. (Exhibit 16) This exhibit is important because it shows that your current calendar year may not give you an accurate picture of how the company is doing on existing (in force) business. For example, for accident year 1983, the current year, as of 6-83 we estimate we're going to have an ultimate value of $325 for losses. But if we're looking at a calendar year basis, the calendar year is the current accident year losses plus any changes in loss estimates of the prior accident years. In this case, for accident year 1982 as of 12-82, we set up an ultimate value of $500. Now six months later, we're reevaluating our data and let's say we've got a number of big claims in. We feel now that the $500 wasn't adequate. So we set up $650. We have adverse development of $150 for accident year For 1981, as of 12-82, we had an ultimate value of $400 for losses reflected in our annual statement, and six months later we think it should have been $350. We got some new information in, for example claims are closing quicker than we thought and at a lower dollar amount. So we have $50 of favorable loss development. 11.

12 Now the calendar year statement, which is basically annual statement type data would show $425 in losses. I believe a number of companies publish profit and loss on a calendar basis for their operating departments which in this example would show $425 of ultimate loss. The calendar year is not an accurate portrayal of how you're doing in the current year because we have 100 of adverse or unfavorable development for the prior accident years. Also, the current calendar year equals the current accident year if the prior accident years have no development. The important principle from here is that you should connect calendar year results to accident year results. At CNA we have a computer report that shows for each of the operating departments how they're doing on a calendar year basis, along with any development of prior accident years to show them how they're doing for the current accident year. You want to tell the operating department whether they're making or losing money on the current or recent business they wrote. Accident year results answer this question better than calendar year results. Now I'd like to go through some of the data elements actuaries typically like to look at. (Exhibit 17) Paid losses are very important, a number of methods involve projecting paid loss using a development pattern; loss reserves are again very important, and incurred losses are the sum of the case reserves and the paid losses. As Susan mentioned before, paid allocated can be a very significant dollar amount in certain types of insurance. Generally products and medical malpractice, types of insurance that involve a lot of legal fees, have a lot of an ALAE. Allocated reserves are estimates of what additional ALAE will be paid on given types of claims. The next four here are different types of claim count information -- reported, closed, open and pending counts. The count information is important because a number of the reserving methods that will be taught here go through a counts times averages method. In a counts times averages method you project the number of counts, project the severity you expect in the current year, multiply the two together -- and you have ultimate losses. 12.

13 Usually counts are relatively easy to project because for most lines of insurance, almost all of the counts are reported in the first 3-4 years. Again, we'll have to rule out asbestos and long latency type claims. Earned and written premium and exposures are important because once you do your reserving technique, you must test what type of loss ratio your ultimate loss projection implies, what type of frequency, what type of severity. Then ask yourself -- is this reasonable? I think the best thing to do in setting ultimate losses is to project losses 3 or 4 different ways and then say, "okay, what type of severity does that imply, what type of frequency does this imply, what type of loss ratio does it imply?" If you go through a projection method and your ultimate losses imply a loss ratio for medical malpractice occurrence of 40 percent, you have to ask yourself -- is that reasonable? One thing that's also important when you're using count data is to understand the data, what exactly is a count (Exhibit 18). Let me give you a simple example. Say we're talking about workers' compensation insurance and there's an explosion at a factory and 20 workers are injured. Now if you're counting on a claim basis, that's one claim. So it'd be one count. On a claimant basis that would be 20 claims. I think the most important thing is to see whether there is any change over time in how your claim department or system is counting claims. Also if your reinsurance is per claim, and not per claimant, you want to project your severities on the same basis (per claim). You have to understand how reopens are treated, whether you count the claim again or you reopen a claim and put any activity back to the year that the claim was initially reported. You also have to understand how closed claims are treated, whether they're closed with payment or without payment. Exhibit 19 displays some other considerations on how actuaries like to look at data. Accident year data contains information on all accidents that occur in that specific year, and you track the development on those claims throughout time. Calendar year includes any activity in the current year, and again, calendar year doesn't give you a good indication of the profitability of current writings because it includes any changes in reserves for the prior accident years. 13.

14 policy year experience is the experience associated with all policies written during a specific year. Policy year usually is not good for reserving, because there is a very long time delay in policy year reporting patterns. Let's assume we're looking at '87 policy year -- the '87 policy year will cover all losses associated with policies written in '87. If you write a policy on the last day of 1987, you could theoretically have a claim on the last day of '88 (assuming annual policies). For policy year '87 not all of your claims occur until 12 months after the last day the policy was written; so it takes a year longer than accident year data for all claims to occur. Report year is the year the claim was reported to the company. It's very important if you're writing relatively high limits to segregate or layer losses. Use two reserving techniques: One for a a low layer (that's usually very predictable) and the other method for excess or larger losses. For example, at CNA we use a straight development approach technique for the first $100,000 of workers' compensation loss. We have a lot of W.C. experience, and the development patterns are fairly predictable for the first $100,000. However, the losses excess of $100,000 are not that predictable; so we have a different approach for those types of claims. For excess losses, we estimate what we expect to be reported and average that with what is actually reported. Another reserving method to use is report year by accident year. What I mean by this is that accidents that occurred in 1980 and were reported in 1980 have a report year of O. Accidents that occurred in 1980, but were reported in 1981 have a report year of one and likewise if an accident occurred in '80 and was reported in '88, it would have a report year of eight. Now claims that were reported at different points in time have significantly different development patterns. Again, if we want to take the quintessential example, we can look at asbestosis claims which is basically a products type coverage. Let's say we wrote a policy in 1960, and in 1986, report year of 26, asbestos claims are reported. The asbestos claims obviously are going to have a much different development pattern than claims that were reported in 1960 for the policy written in You should also reconcile your reserving data with your annual statement data. Let me give an example of how important reconciling data is. Let's say you're working for a company that writes excess or surplus lines and you segregate policy types into primary and excess. Let's say you write a policy over a self insured retention; and the coder doesn't know how to code that in, so instead of giving it one of the two codes, they code it to O0 or a dummy code. You've got to make sure that you are including that data in your reserving data base or you're going to be missing some data. You're going to be understating your reserves. So it's very important to be able to reconcile data that is in your annual statement to any company data base. 14.

15 Another point is data limitations or incomplete data. If you're a new writer, just started writing medical malpractice in 1988, you have no history. So how do you set reserves? Well, you can hire (and I'll do a plug for Susan) M&R to do your reserve analysis, or use some type of industry type data -- ISO publishes some development patterns. You can use your pricing department's expected losses. If your pricing actuaries or pricing group is pricing to an 80 percent loss ratio, you can initially pick that as a loss ratio. If you're a new writer or start writing a new type of insurance it's difficult to try and estimate what your loss reserves should be. Now there are a number of things that you should be aware of when you're establishing your reserves levels (Exhibit 20). One is the relative adequacy of case reserves. Let's say that a big claim has come in the past year that had a low case reserve. Your claim department may over compensate for the claim and start setting up larger case reserves so they don't get burned again. A number of things can also affect your claim handling practice. One is Fast track reserves. Those are reserves for claims that are set up for an average value. The actuaries have established average reserves for certain types of claims. For example, Homeowner claims, if the claims adjustor assess that the claim will be less than $500 than an average reserve is established, say $250, instead of a claim adjustor setting the reserve. We talked about claim counts before and the difference between per claim and per claimants. You have to understand any changes in ALAE, allocated loss adjustment expense, and procedures. If you were paying legal fees once a year and when the claim closed, then you change to paying monthly, it's obviously going to have a significant impact on your historical development. Loss payments -- if you start using structured settlement or benefit settlement options, buying an annuity for a claimant, it's going to have a significant effect on your loss payment history. Claims litigation, let's say you paid a number of the nuisance claims, instead of taking them to court, because you assumed you would spend more on allocated than settling the claim. Now your company decided on a get tough policy where you defend questionable or nuisance type claims. Your loss payments will probably decrease but your allocated payments will increase. Using company versus independent adjustors is also an important consideration in setting reserves. The most important thing here, as Susan mentioned earlier, is whether the adjustors cost is coded to unallocated or allocated. For example, suppose if the claim department was handling the claim the cost was coded to unallocated; but now independent adjustors bill by claim and their cost is coded to allocated payments. It is significantly going to change your history of ALAE versus unallocated claim costs. 15.

16 Changes in pricing strategy -- if your company wants to increase market share by buying insureds, cutting your rates in certain lines of insurance, you should be aware of that when establishing your reserves. Your loss ratio would be higher for your new business. Changes in underwriting. Let's say your company thought you'd grown too much and wanted to cut back by getting rid of the marginal risks; your loss ratio should go down and you should take that into account when you're picking a loss ratio for the current year. New versus renewal. New business traditionally has a higher loss ratio than renewal business, so if you're growing a lot, all other things being equal, you would expect your loss ratio to be increase. Types of reinsurance and retention levels -- this is extremely important if you were writing low limits, say $50-100,000 per occurrence and change to high limits. Obviously your development patterns are going to be significantly different because the high value claims take longer to be reported and longer to be paid so your historical development would.understate your future development. The same is also true for change in policy limits and deductibles. If you write higher deductibles, you're going to have a longer tail. It's going to take longer to pay out the claims or for the claims to be reported. Another thing you have to be aware of when setting up your reserves is external forces. (Exhibit 21) In a number of states, you don't have a choice; you've got to participate in an involuntary pool. For example, in Texas, for the workers' compensation pool, we've seen significant adverse development in the assigned risk results. Now you as an actuary have to set up funds to pay for your company's share of the assigned risk results. As inflation increases your development factors you may underestimate results if you use historical experience. Claims consciousness. Currently, when someone is injured, they are more likely to sue than they would have been twenty years ago. We are seeing a lot of the deep pocket type theories, and that's obviously reflected in development patterns. So you've got to be aware of that. Seasonality of loss experience. Some lines of insurance have significantly different development by quarter. For example, castastrophes for property insurance usually occur in the first and the fourth quarter. So if you're projecting your reserves, you've got to be aware of that fact. 16.

17 Legal and legislative -- A number of states have passed some type of tort reform. It may be difficult to estimate the cost of tort reform, given that you don't have any experience on it, and given that you don't know whether the courts are going to overrule reform passed by the legislature. And the economy can affect loss experience -- workers' compensation is again a good example. If a factory closes and people are put out of work, you're going to see a lot of work comp claims. Some other considerations are displayed on Exhibit 22. You should see what type of frequencies and severities are implied by your loss reserve picks and ask yourself does that make sense given everything I know about what my company is doing? If you project your reserves and the average severity has been increasing eight percent per year but using your reserving methods, you're implying a decrease in severity for '88, you've got to ask yourself -- does that make sense? It may make sense, given some other things, but it's probably unlikely. Reopen claim potential. If your claim department has a get tough policy, claims may be closed prematurely whereas in the past they may not have been so the potential for reopened claims has increased. Aggregate limits -- If you wrote a million dollar policy limit, and have $1 million of case reserves you don't have to set up any IBNR. It's important to get a computer run by policy or by insured. If you had aggregate limits for an insured, with a lot of claims, you can take the insured's experience out of your data and set a reserve up for the insured separately. You also have to know whether allocated is included in your policy limit or not. If it's not, you have to set up some additional funds for allocated even if the policy limit has been exceeded. Collateral sources -- If an employee is driving a defective forklift and the wheel blows out and the employee falls down and get injured you as the work comp insurer have to provide coverage. However, you have the right to sue the manufacturer of the forklift and receive subrogation from their insurance company to offset what you're paying in work comp claims. The last thing I'd like to talk about is the application of professional judgment (Exhibit 23). A Loss reserve is a point estimate; but everyone realizes that you can have a very wide range on your estimates. For example, suppose you have a group of medical malpractice policies that you wrote in 1988 through the first six months of You don't have a lot of claims reported yet so you have to use a number of different methods. 17.

18 Document your work and your assumptions very well. Determine what the assumptions imply as far as frequency and severity and ask yourself whether these reserves makes sense and whether a reasonable reserving analyst would think that these assumptions made sense. If your underwriting department tells you that "we've become better underwriters," we're rejecting a lot more risks, we're getting rid of our marginal risk, be skeptical -- in a lot of lines of insurance, it's very difficult to do that. I think l'd be a little wary if my underwriting department told me we had gotten rid of all of our doctors who had poor loss experience in the past, and now we expect our loss ratio to be 50 percent the upcoming year. You have to have some data to verify whether that's actually going to happen. The reasonableness of the loss reserve should be measured against other factors -- again, frequency, severity, loss ratio -- and document everything. If you possibly can, try and use some sensitivity analysis. Let's say you're assuming that inflation or claim severity is going to increase eight percent per year -- what happens if severity increases 12 percent, how is that going to change your estimate? Say you were assuming frequency was going to change five percent each year; what happens if you change that assumption to eight percent? See what type of loss ratios that implies or what type of reserve level that implies, so you have a feel for how bad the loss experience can be. If you've got a fairly narrow range on loss reserve, which you can do for a number of lines of insurance, you should have a lot of confidence. Again -- if you're reserving products or medical malpractice, it's very difficult to get a handle on what the reserves levels should be, especially for the current accident year. So you have to spend a lot of time seeing what your loss ratios were in the past, how your pricing philosophy has changed, your underwriting philosophy and how the mix of business has changed by state. That's all that Susan and I had to cover. questions from the audience. But we'd appreciate 18.

19 QUESTION AND ANSWER SESSION: Q: In Exhibit 23, you indicate the application of professional judgement, and I come from the accounting profession and am not really that familiar with the standards in the actuarial profession. I was wondering if there was any guidance in the area of for example, documenting the assumptions and methodologies that are used and the sensitivity analysis that should be formed. Mr. Brown: There has not been a lot of documentation on that in the past. The Casualty Actuarial Society has published a Statement of Principles regarding Loss Reserves. The purpose of the statement is to identify principles applicable to evaluate reserves. I have a copy of it and I'm sure a number of other actuaries here do also. As far as reasonability, it is very important to look at history and how other carriers are doing. You can see a reserve amount that is clearly unreasonable. Now there is obviously a large range by line of reasonable loss ratios. For example in medical malpractice, if you're writing occurrence coverage, I'd be very surprised if a loss ratio of below 60 percent was reasonable. Because of the investment income included in pricing that coverage, you're probably pricing to an 80 percent loss ratio or higher. So if you come up with a 60 percent loss ratio, you have to ask yourself is that reasonable -- and I think the answer is probably no because of competition. But that's one of the things that actuaries have to deal with all the time; it's very difficult, especially for the current accident year -- to get a handle on what's a reasonable estimate and what isn't. You can also, check reasonableness by using several reserving methods. The most important thing is to document your work. If your loss estimates turn out to be deficient and a state regulator comes to you or upper management, it's very important to document everything that you've done so they can look through it and say "yeah that was a reasonable assumption" at the time. So you did your job, it's just that some events were unforeseen. For example; no one can anticipate changes in the legal climate. Q: I have a question for Brian. You mentioned severity several times, and usually when I think of severity I think of something very severe. What does it mean? Mr. Brown: Severity is defined as the average claim size. One very important loss reserving method multiplies severity, which is the average amount you're going to pay on claims that close, times frequency, which is the average claim per exposure time exposures. 19.

20 The frequency in auto liability is how many claims per car you expect, so if you multiply severity times frequency times exposures, you're going to have an estimate of what your ultimate losses will be. This type of approach -- and I'm sure they have other sessions on that -- is one good method when you're looking at long tail lines. You can project using straight development, say, until accident year 1984 and then use a severity trend and frequency trend and your known exposures so you can project ultimate losses. Q: Brian, you mentioned some trouble you might have communicating results to non-actuaries, especially that results may not be as good as anticipated. Mr. Brown: It's important for underwriters and accountants to understand what actuaries do and vice versa. I think the real point I was trying to make is that for a number of lines of insurance, an individual exposure does not have a lot of credibility -- and basically what I mean by that is just because somebody has an accident doesn't mean that they are a bad driver - it just may be chance. Therefore I don't think we should see a huge swing in loss ratios due to a tightening of underwriting policy -- except in some very specific cases. If your underwriting department said they plan to eliminate all marginal risks, how much would this impact loss ratios? Unless more exclusions are put on the policy and the price remains the same or unless most losses are produced by one type of risk, I don't think that eliminating marginal risks will reduce your loss ratio a lot (more than 20%). If the underwriters were doing their job in the past, and I'm sure most were, there shouldn't be many marginal risks on the books. Price adequacy probably has the greatest effect on loss ratios. Ms. Miller: Yeah, I think communication between underwriting and actuarial is essential because otherwise, you end up with a general distrust, one for the other. I heard an underwriter say once, IBNR meant to him "interesting but not relevant". Well, it is relevant to underwriters, especially when results cause bonuses, etc. So the more underwriters understand about IBNR, the better -- and the more we understand about the changes they have made in their book of business, mix of business, what kind of risks they're looking for or what kind of risks they're staying away from, the better job we can do. Q: What proportion of a company's reserves would you expect to be case reserves, vs. development on known claims, vs. IBNR, etc. Ms. Miller: Well, that's a good question. It really depends very much on the lines of business written for example, IBNR for any given accident year would be a relatively large percentage of the total loss reserve for a line of business where you expect the claims to take a long time to come in, like products liability. IBNR would be a much smaller percentage of the total reserve for a line of business like auto physical damage. 20.