IMIA Conference 2011 Amsterdam IMIA Working Group Paper 73 (11) - how to reserve an Engineering portfolio with its specific characteristics September 2011
Working Group Contributors 28.05.2009 2 Jürg Buff (PartnerRe) Zürich (Chairman) José Blanco (PartnerRe) Zürich Pascal Bourquin (PartnerRe) Zürich Matia Cazzaniga (ZFS) Zürich Brad Dalton (Vero) Sydney Alain Favre (AXIS Re) Zürich Andy Hottinger (AXIS Re) Zürich Hari Radhakrishnan (HDFC Ergo) Mumbai Jean-Marc Rossé (Nationale Suisse) Basel Anne Sheehy (XL Insurance) Zürich Marina Zyuganova (Renaissance) Moscow Oscar Treceno (Nationale Suisse) Basel (Sponsor)
Working Group Paper Content 28.05.2009 3 Introduction Definitions terms Premium terms methods Development triangles Expected claims technique Bornhuetter-Ferguson method Others Appropriate earning methodology for an engineering portfolio Importance of an appropriate earning methodology Considerations on construction engineering policies iro exposure evolution From the exposure to an earning pattern Application to a master policy / reinsurance treaty (portfolio of policies)
Intention of the paper 28.05.2009 4 The paper gives underwriters insight into the actuarial world of how to reserve an engineering portfolio with its specific characteristics. The objective of the group is not to give recommendations to insurers how to reserve claims of engineering portfolios, but provides understanding and ideas in practice and theory. The paper describes some of the standard reserving concepts and emphasizes about accurately measuring earned premium in particular for medium to long tail business (CAR/EAR) The aim of the paper is as well to promote a closer interaction between underwriting and actuarial functions for Engineering business affaires.
Why is correct and accurate reserving important? 28.05.2009 5 Policy holders expect claims to be paid INSURED CLAIM PREMIUM INSURER The moment at which the claims are paid doesn't correspond to the one at which the premiums are received Therefore the insurance company has to take into account these future liabilities (claims liabilities) setting up appropriate reserves in the balance sheet in the appropriate period Owners/Shareholders don t like volatility in results Under-reserving leads to higher profits in the short-run and reduced profits in future
Why is correct and accurate reserving important? 28.05.2009 6 Supervisory Authorities Requirements in order to assure claims payments to protect consumers and avoid insolvency of insurers US-GAAP - Basic Principles (FAS 60) Premiums are recognised in the income statement (earned) in proportion to the insurance coverage provided (risk) Acquisition costs are deferred and recognised as the corresponding premiums are earned Claims are recognised when they are incurred Tax regulators Profits result in tax revenues
Balance Sheet / Income Statement 28.05.2009 7 Balance sheet Assets Liquidity Assets Receivables DAC Liabilities Claims reserves Payables UPR Premium def. reserves Capital Income statement Profits + Premium earned + Income on investment _ Losses - Paid losses - Changes in reserves - Commissions - Operational expenses = Result
Graphic Illustration of claims 28.05.2009 8 Paid Losses Loss Adjustment Expenses Outstanding Loss Reserves (OLR) Case Reserves Additional Case Reserves (ACR) Claims Loss Reserves Premium Deficiency Reserves Bulk Reserves Incurred But Not Reported (IBNR) Unpaid Loss Adjustment Expense Reserves Allocated Loss Adjustment Expense Reserves (ALAE) Unallocated Loss Adjustment Expense Reserves (ULAE) Incurred But Not Enough Reported (IBNER)
terms definitions (1) 28.05.2009 9 Paid Losses Loss Adjustment Expenses Outstanding Loss Reserves (OLR) Claims Outstanding Loss Reserves (OLR) Notified claims Reserves for specific incurred claims, which Unpaid Loss Reserves are not (yet) finally settled Loss Adjustment Expense Reserves Case Reserves Bulk Reserves Allocated Loss Adjustment Expense Reserves (ALAE) Unallocated Loss Adjustment Expense Reserves (ULAE) Additional Case Reserves (ACR) Premium Deficiency Reserves Incurred But Not Reported (IBNR) Incurred But Not Enough Reported (IBNER)
terms definitions (2) 28.05.2009 10 Paid Losses Loss Adjustment Expenses Outstanding Loss Reserves (OLR) Claims Case Reserves Additional Case Reserves (ACR) Loss Amounts reserved Reserves for individual losses in excess of outstanding loss reserves ACR are usually applied if doubts exist that Bulk Reserves the claim Unpaid can be settled within the reserve frame reported by the client Allocated Loss Adjustment Expense ACR are particularly Loss used in reinsurance Reserves (ALAE) Adjustment Expense Reserves Unallocated Loss Adjustment Expense Reserves (ULAE) Additional Case Reserves (ACR) Premium Deficiency Reserves Incurred But Not Reported (IBNR) Incurred But Not Enough Reported (IBNER)
terms definitions (3) 28.05.2009 11 Claims Incurred But Not Reported (IBNR) Losses At the end Paid of a certain Loss period, the insurer Adjustment Expenses (as well as the insured) may not be aware of certain events (covered), which may have adverse financial consequences Case Reserves The insurance company has to take into account these future liabilities (claims liabilities) setting up appropriate reserves in the balance sheet Unpaid Loss Reserves Loss Adjustment Expense Reserves Bulk Reserves Allocated Loss Adjustment Expense Reserves (ALAE) Unallocated Loss Adjustment Expense Reserves (ULAE) Outstanding Loss Reserves (OLR) Additional Case Reserves (ACR) Premium Deficiency Reserves Incurred But Not Reported (IBNR) Incurred But Not Enough Reported (IBNER)
terms definitions (4) 28.05.2009 12 Paid Losses Loss Adjustment Expenses Outstanding Loss Reserves (OLR) Claims Incurred But Not Enough Reported Case Reserves (IBNER) Outstanding Reserves may be systematically underestimated, in this Loss case the reinsurance Reserves puts IBNER on top Unpaid Loss Adjustment Expense Reserves Bulk Reserves Allocated Loss Adjustment Expense Reserves (ALAE) Unallocated Loss Adjustment Expense Reserves (ULAE) Additional Case Reserves (ACR) Premium Deficiency Reserves Incurred But Not Reported (IBNR) Incurred But Not Enough Reported (IBNER)
Claims Development Example of CAR/EAR Portfolio UWY 2001 / Cumulated View 28.05.2009 13 25,000,000 20,000,000 15,000,000 10,000,000 IBNR Closeing ACR Outstanding Losses Paid Losses 5,000,000 0 2001 2002 2003 2004 2005 2006 2007 2008 2009
Premium terms definitions 28.05.2009 14 Written Premium - Premiums for all policies sold during an underwriting period - Sum of all premium amounts stated on the policies written for one portfolio during a defined period (e.g. UWY) Accounted or Booked Premium - Booked premiums during a specific accounting period Earned Premium - Premium recorded as revenue during a specific accounting period - The earned premium is risk/exposure based. It represents the consumed part of the risk of a portfolio Unearned premium reserves (UPR) - Premium written for future financial periods and carried over to the next period s financial statements. This is essentially the difference between written but not yet earned premium
28.05.2009 15 Premium Development Example of CAR/EAR Portfolio UWY 2001 40,000,000 35,000,000 30,000,000 Premium 25,000,000 20,000,000 15,000,000 10,000,000 Written (Ultimate) Premium Booked Premium Earned Premium 5,000,000 0
Methods 28.05.2009 16 Methods described in the paper Chain Ladder Method Expected claims technique Bornhuetter-Ferguson Method Other methods Benktander Cap Cod Data Development triangles In the following discussion we will use as our example, data on reported claims. Similar analyses can be performed on paid claims, case outstanding, reported claim counts, etc. For most reserve analyses, at the very least, triangles for both paid claims, and reported claims will be examined.
Triangles - Reported claims 28.05.2009 17 Accident Year Development Year 1 2 3 4 2007 100 140 145 145 2008 90 100 105 2009 145 220 2010 120 Portfolio assumptions: Consistent claim processing Claims types stable mix Stable policy limits Accident Year Development Year 1-2 2-3 3-4 2007 1.40 1.04 1.00 2008 1.11 1.05 2009 1.52 Development Year 1-2 2-3 3-4 1.37 1.04 1.00 Age to age factors Loss development factors
Methods - Chain Ladder 28.05.2009 18 Development Year 1-2 2-3 3-4 1.37 1.04 1.00 Accident Year Development Year 1 2 3 4 2007 100 140 145 145 2008 90 100 105 105 2009 145 220 229 229 2010 120 165 172 172 Ultimate Loss IBNR 145 145-145 = 0 105 105-105 = 0 229 229-220 = 9 172 172-120 = 52
Methods Chain Ladder 28.05.2009 19 with the Chain-Ladder technique: Takes into account actual claims experience No other assumptions needed Purely multiplicative method + Pros + - Cons - Large volume of historical claims experience needed Very sensitive to substantial variations (large losses) Insurers to stay in a stable environment (constant speed in claims closure and payment)
Other Methods 28.05.2009 20 Expected claims technique Need an a priori expectation regarding the loss ratio Expected Loss = Premium x a priori LR Bornhuetter-Ferguson combination of the Chain Ladder and the expected claims technique Other methods Benktander Cape code
Which projection method should be used? 28.05.2009 21 Each method has advantages and disadvantages There is no method that will deliver the correct estimate of ultimate losses in an automatic fashion The most critical issues associated with all the methods being the relevance of historical reporting and/or paid patterns to the period of interest A thorough understanding of the characteristics of the portfolio underlying the reported claims is critical and increases the confidence in the results produced by the projection methods. Engineering specific: In the case of project business (CAR/EAR) the risk exposure needs to be measured and understood, as this is the base of the claims experience over the period.
Engineering specific characteristic 28.05.2009 22 Renewable business underlying exposure remains approximately uniform throughout the policy period as value at risk and operational matters stay constant (Property) reserving techniques like Chain Ladder are suitable Project business underlying exposure increases over the multi year policy period as value at risk and covers are not constant Changing exposure should be considered in age-to-age factors with some direct relation to the premium earning pattern used for the specific class of business Improving the reliability of Engineering lines reserves needs a separate analysis of renewable and project accounts according to their exposure over the period.
What is an appropriate earning curve? 28.05.2009 23 Fixed exposure (MB, EEI, Property) Exposure increasing (CAR/EAR) Risk exposure Risk exposure Linear exposure Policy period => a pro-rata temporis (proportional) earning curve is appropriate Policy period => a pro-rata temporis (proportional) earning curve is not appropriate
What is an appropriate earning curve? 28.05.2009 24 Exposure increasing (value at risk) Exposure increasing (policy cover) Risk exposure Risk exposure Actual exposure Linear exposure Arrival of high value equipment Policy period = project period Linear exposure Site preparations and foundations Actual exposure Policy period = project period Testing
From the exposure to an earning pattern 28.05.2009 25 Illustration: - 3 years construction policy - exposure during the 1 st year is 100, 200 in the 2 nd and 400 in the 3 rd - premium generated: 105 What is an appropriate earning pattern? Case 1: pro rata temporis earning Exposure 400 200 100 Year Earned Premium 1 2 3 35 35 35 Case 2: earning according to exposure by year Exposure 400 200 100 Year Earned Premium 1/7 1/7 1/7 1/7 1/7 1/7 1/7 1 2 3 15 30 60 The time to earn the premium considered but not the fact that the exposure is increasing year by year => NOT SATISFACTORY Time and exposure evolution considered => MORE APPROPRIATE?
From the exposure to an earning pattern 28.05.2009 26
From the exposure to an earning pattern 28.05.2009 27 The calculation of non-pro rata earning patterns depends highly on the evolution of the exposure => we need the evolution of the exposure at any point of time during a project: Project bars chart giving milestones? Project status monitoring surveys? These ways have their constraints and limits => make some assumptions directly on the earning pattern
28.05.2009 28 Assumptions directly on the earning pattern Possible earning pattern for construction insurance Assuming that after 2/3 of the construction period we have earned 50% of the premium % earned
More characteristics to consider? 28.05.2009 29 Possible earning pattern for construction insurance considering some features Assuming that 10% of the premium is earned in the maintenance period % earned Assuming that after 2/3 of the construction period we have earned 1/3 of the premium
Application to a master policy / reinsurance treaty 28.05.2009 30 Build a combined curve with the following assumptions: % of the portfolio which is made out of renewable business % of the portfolio made out of project/construction policies: average duration of the construction period of the underlying policies average duration of the maintenance period of the underlying policies % of the underlying policies have an ALOP cover
Conclusion 28.05.2009 31 Claims reserves for losses not yet paid can significantly impact insurance and reinsurance companies balance sheet and profit & loss account. Insurers currently use several methods to determine reserves. A combination of different techniques are used to come to a sound opinion on the amount and adequacy of reserves needed. A thorough understanding of underlying portfolio characteristics in relation to reported claims is critical especially for construction business with exposure pattern varying over a multi-year period. Reliability of claims development projections and estimates mostly depends on data volume and accuracy. Data made available to actuaries should be extracted from IT systems designed to capture key information preventively agreed with experienced underwriting functions.
Enough reserves?