CS-18: THE ACTUARIAL ROLE IN THE AUDIT Brian E. Johnson, ACAS, MAAA Senior Underwriter.

CS-18: THE ACTUARIAL ROLE IN THE AUDITBrian E. Johnson, ACAS, MAAA

Senior Underwriter

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Antitrust NoticeAntitrust Notice

The Casualty Actuarial Society is committed to adhering strictly to The Casualty Actuarial Society is committed to adhering strictly to the letter and spirit of the antitrust laws. Seminars conducted the letter and spirit of the antitrust laws. Seminars conducted under the auspices of the CAS are designed solely to provide a under the auspices of the CAS are designed solely to provide a forum for the expression of various points of view on topics forum for the expression of various points of view on topics described in the programs or agendas for such meetings.described in the programs or agendas for such meetings.

Under no circumstances shall CAS seminars be used as a means Under no circumstances shall CAS seminars be used as a means for competing companies or firms to reach any understanding – for competing companies or firms to reach any understanding – expressed or implied – that restricts competition or in any way expressed or implied – that restricts competition or in any way impairs the ability of members to exercise independent business impairs the ability of members to exercise independent business judgment regarding matters affecting competition.judgment regarding matters affecting competition.

It is the responsibility of all seminar participants to be aware of It is the responsibility of all seminar participants to be aware of antitrust regulations, to prevent any written or verbal discussions antitrust regulations, to prevent any written or verbal discussions that appear to violate these laws, and to adhere in every respect that appear to violate these laws, and to adhere in every respect to the CAS antitrust compliance policy.to the CAS antitrust compliance policy.

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The Deal Team

Traditionally the deal team was lead by the UW or Account Exec and the Actuary was just called upon to “crunch” the numbers

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Data/Structure

LossCost

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The Deal Team

Only looking at the submission could lead to a misinterpretation of what is going on at the company

By looking at the UW files actuaries can quite often interpolate information wrt the submission that is not evident

In addition you will quite often be able to extract anecdotal evidence that may not otherwise be available in the company’s system (information not captured)

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The Deal Team

Some examples of anecdotal information that can be obtained from the UW files include:

– Trends in usage of pricing components (credits/debits, IRPM mods, adjusted ILFs, a-rates, class codes, etc)

– Effects of minimum premium not otherwise captured in rate change

– UWs consideration of the specificities of a risk which lead to pricing decisions (or lack thereof)

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The Deal Team

The actuary should also sit in meetings with a cross section of insurance professionals i.e. UWs and claims. This will allow the actuary to hear about important changes to the company and relate them to things they may see in the data.

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Case Study – A Tale of Two Actuaries

Two actuaries (at different companies) Alpha and Beta both received a submission from Pandorum Insurance Company who is looking to buy a quota share on their umbrella business.

Alpha decides that he is too busy to participate on the UW/Claims review. Instead he sends a couple of questions back to Pandorum’s actuary to confirm his understanding of the data in the submission

Beta attended The Actuarial Role in the Audit at the CARe meeting and very wisely decides it is well worth his time to attend the audit.

First we will look at a few aspects of the submission and then see how each actuary utilizes them in their analysis

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One exhibit that was of interest to both actuaries was the historical and projected limits distribution

According to the submission, Pandorum had made a concerted effort to move up into higher layers (away from the lead position) to layers that they perceive to be more adequate.

The exhibit is as follows:

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2007 Distribution

AttachmentLimit >$1M-$5M >$5M-$10M >$10M-$15M >$15M-$20M >$20M-$25M >$25M-$50M Total % of Total

≤ $1M 190,825 0 0 0 0 0 190,825 0.70%>$1M -$2M 172,971 0 0 0 0 0 172,971 0.64%>$2M -$3M 238,791 255,740 0 0 0 0 494,531 1.82%>$3M -$4M 1,346,194 21,884 210,958 30,637 0 0 1,609,673 5.92%>$4M -$5M 2,010,549 382,964 600,467 144,345 73,967 45,956 3,258,247 11.99%

>$5M -$10M 7,876,439 3,161,927 1,656,427 1,023,931 258,227 124,299 14,101,250 51.90%>$10M -$15M 405,381 388,650 1,233,300 1,823,161 568,760 0 4,419,253 16.27%>$15M - $20M 54,271 0 1,380,065 152,509 113,970 0 1,700,816 6.26%>$20M - $25M 127,801 355,040 250,874 440,341 47,006 0 1,221,062 4.49%

Total 12,423,223 4,566,205 5,332,092 3,614,923 1,061,930 170,255 27,168,628 100.00%% of Total 45.73% 16.81% 19.63% 13.31% 3.91% 0.63%

2008 Distribution


≤ $1M 155,248 0 0 0 0 0 155,248 0.61%>$1M -$2M 140,722 0 0 0 0 0 140,722 0.55%>$2M -$3M 194,271 286,702 0 0 0 0 480,972 1.90%>$3M -$4M 1,095,208 24,533 214,363 29,704 0 0 1,363,808 5.38%>$4M -$5M 1,635,701 429,328 610,157 139,950 72,191 46,400 2,933,726 11.57%

>$5M -$10M 6,407,949 3,544,730 1,683,156 992,760 252,027 125,500 13,006,121 47.87%>$10M -$15M 329,802 435,703 1,253,202 1,767,659 555,103 0 4,341,468 17.12%>$15M - $20M 44,153 0 1,402,335 147,866 111,233 0 1,705,587 6.73%>$20M - $25M 103,973 398,024 254,922 426,936 45,877 0 1,229,733 4.85%

Total 10,107,027 5,119,019 5,418,134 3,504,876 1,036,431 171,899 25,357,386 100.00%% of Total 39.86% 20.19% 21.37% 13.82% 4.09% 0.68%

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Projected 2010 Distribution


≤ $1M 84,092 0 0 0 0 0 84,092 0.39%>$1M -$2M 76,224 0 0 0 0 0 76,224 0.35%>$2M -$3M 105,230 348,625 0 0 0 0 453,855 2.09%>$3M -$4M 593,237 29,832 221,171 27,839 0 0 872,079 4.01%>$4M -$5M 886,004 522,056 629,536 131,162 68,639 47,287 2,284,683 10.51%

>$5M -$10M 3,470,969 4,310,337 1,736,614 930,417 239,626 127,901 10,815,864 49.76%>$10M -$15M 178,642 529,808 1,293,004 1,656,656 527,789 0 4,185,899 19.26%>$15M - $20M 23,916 0 1,446,874 138,581 105,760 0 1,715,131 7.89%>$20M - $25M 56,319 483,991 263,019 400,126 43,620 0 1,247,074 5.74%

Total 5,474,634 6,224,648 5,590,217 3,284,781 985,434 175,188 21,734,902 100.00%% of Total 25.19% 28.64% 25.72% 15.11% 4.53% 0.81%

2009 Distribution


≤ $1M 119,670 0 0 0 0 0 119,670 0.51%>$1M -$2M 108,473 0 0 0 0 0 108,473 0.46%>$2M -$3M 149,750 317,663 0 0 0 0 467,413 1.99%>$3M -$4M 844,223 27,182 217,767 28,772 0 0 1,117,944 4.75%>$4M -$5M 1,260,852 475,692 619,846 135,556 70,415 46,843 2,609,204 11.08%

>$5M -$10M 4,939,459 3,927,533 1,709,885 961,589 245,826 126,700 11,910,993 43.84%>$10M -$15M 254,222 482,755 1,273,103 1,712,158 541,446 0 4,263,684 18.11%>$15M - $20M 34,035 0 1,424,604 143,223 108,497 0 1,710,359 7.26%>$20M - $25M 80,146 441,007 258,971 413,531 44,749 0 1,238,404 5.26%

Total 7,790,830 5,671,834 5,504,175 3,394,828 1,010,933 173,544 23,546,144 100.00%% of Total 33.09% 24.09% 23.38% 14.42% 4.29% 0.74%

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In addition the submission has the following rate change summary

ExposureAdjusted

TY Rate Chng2003 12.42%2004 8.54%2005 2.00%2006 -7.53%2007 -9.24%2008 2.00%2009 7.50%2010 7.00%

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Both actuaries notice that there is in fact a shifting in the attachment point to higher layers.

In addition, they also notice that they are also writing higher limits.

Both actuaries ask if there has been a shifting in the class of business commensurate with the shifting in the limits/attachment distribution (the old adage that people who buy higher limits need them)

The response back is that they are writing the same kinds of risk and that there has been no shift in the hazard group

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Both actuaries also notice that the Pandorum seems to have achieved much bigger rate changes in the soft market than their competitors.

They both ask to confirm that these are actual exposure adjusted rate changes and not premium increases.

The response is that these rate change have been adjusted for increases and decreases in the exposure.

The response also goes on to say that the rate change is calculated as part of the UW process. Details can be found in each UW file.

Alpha (who is a very busy man) accepts this explanation and moves forward with his analysis. Beta makes a note to confirm the process while looking at UW files.

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While reviewing files Beta notes how the rate change was calculated in several files. Here is one example what he sees:

Vault101 Construction CompanyRate Change Calculation

Expiring premium: 55,000Renewal Premium: 62,500

Expiring Sales: 1,500,000Renewal Sales: 1,650,000Expiring Limit: 5,000,000

Renewing Limit: 10,000,000Calculated Rate Change: 3.3%

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Beta immediately notices that the “rate change” does not account for the expanding limit.

He does a quick adjustment to reflect the difference in limit and sees for this particular account the change in rate is not +3.3% but instead a -1.7%.

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Beta sets up a meeting to talk to the Chief Pricing Actuary and the Senior VP of Underwriting.

Beta asks about the rate change calculation in the files compared to what was in the submission. In addition he also asks about any changes going forward that may not be reflected in the data.

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Pandorum’s actuary confirms that the rate increase does not reflect change in limit. Since their retention ratio is in the high 90’s and historically the limits didn’t change much the system was not created with that kind of complexity.

He goes on to say it is on ITs list of enhancements for their pricing/underwriting system.

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When asked about company changes the SVP of UW comments that due to Agent feedback they are going reduce their minimum premium per mill from $1,500 to $1,250 for 75% of their classes.

Given the higher average attachment and propensity to hit minimum premiums more frequently, Beta asks if they have tried to estimate the change in rate due to the lowering of the minimum

They both comment that this kind of information is not currently captured in their pricing system but that it is on IT’s list of future enhancements.

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Beta and his UW audit team get through 35 files. Beta is able to use the data captured in these files to make subjective adjustments to the rate change to account for the decrease in the minimum.

In addition, he also uses the change in limits/attachment distribution and Pandorum’s ILF tables to adjust the rate change history.

Even though the minimum premiums per million are decreasing Beta feels as though there is some additional rate lift provided by the mins.

Using data from the sample of files reviewed Beta estimates the net rate lift due to minimums.

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He runs his adjustments by Pandorum’s actuary for ensure they are somewhat reasonable. The actuary agrees the adjustments make senses.

Here is a comparison of the unadjusted and adjusted rate changes.

Original Rate Changes Adjusted Rate ChangesExposureAdjusted Expo Adj. Avg

TY Rate Chng TY Rate Chng2003 12.42% 2003 12.42%2004 8.54% 2004 8.19%2005 2.00% 2005 1.86%2006 -7.53% 2006 -9.71%2007 -9.24% 2007 -11.03%2008 2.00% 2008 -8.75%2009 7.50% 2009 4.17%2010 7.00% *2010 4.00%

2010 adjusted for min reduction

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Understanding the Big Picture

In addition to a better understanding of the data, the actuary may also gain additional insight to other changes at the company that should be reflected in the loss cost selection.

For example, quite often companies will stop writing certain classes or lines of business that have been historically unprofitable for them.

In order to determine how much “credit” can be given for these kinds of changes the actuary must have a very thorough understanding of the changes in the UW guidelines and how they are being implemented by the desk UW’s.

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While understanding rate changes on renewals is an important step towards estimating loss cost, it is also important to understand the marginal effect on rate levels of writing new business.

If company ABC’s average rate change on their renewal book is say -3%, the business that was non-renewed (written new by company XYZ) is written at a rate decrease bigger than -3%.

By that same token, when ABC writes a new piece of business, there may be a difference in the average rate adequacy of the new business versus the renewal book.

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The actuary can gather statistics from the files which will allow them to estimate the adequacy of premiums of new business versus renewed business.

Things to look for and compare include: average rate level by class of business, average unit rate per vehicle, difference in discretionary mods, difference in take-up factors in the case of umbrella business

While estimating the new business rate effect is not exact it should be considered especially in cases where the company is growing and there is a material amount of new business.

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CS-18: THE ACTUARIAL ROLE IN THE AUDIT Brian E. Johnson, ACAS, MAAA Senior Underwriter.

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