Value-Added Loss Reserving
for General Insurance-- Loss Reserving Actuaries in the New Epoch

Robert Conger, FCAS, FCIA, MAAA, Hon FIA
October 17, 2007

© 2007 Towers Perrin

Value-Added Loss Reserving
Discussion Topics

 A Different Approach to Loss Reserving
 What?
 Why?
 Who?
 When?
 How?

 Deliverables© 2007 Towers Perrin

1Different Approach: What?
The Pillars of Value-Added Reserving (VAR) Traditional:
 Data Æ Actuarial Methods ÆLoss Reserve Indication

OperationalLinkages

 The Pillars of Value-Added Reserving
 Significant, two-way operational focus
 The best tools and techniques

EffectiveTools andTechniques

VAR

Range
Analysis

EffectiveCommunications— Actuarial methods— Benchmarking
 Evaluation and quantification ofreserve uncertainty
 Communication of findings andimplications

2© 2007 Towers Perrin

Different Approach: What?
Operational Linkage
 Value-Added Reserving uses input from all of a company’sfunctional areas

Underwriting
EffectivenessPricing
EffectivenessMarketing
Effectiveness© 2007 Towers Perrin

Claim
Effectiveness

Loss
Reserve

Reinsurance
Effectiveness

Risk Management
Effectiveness3

Different Approach: What?
Best Tools and Techniques

 Proven effectiveness Historical track record; hindsighttesting Responsiveness to environmental

and operational circumstancesand changes
 Operational information guides thechoice of methods, adjustments tohistorical data, parameters,weights
 Benchmarks

4© 2007 Towers Perrin

Different Approach: What?
Range Analysis
Actuarial Pricing and Reserving Problem

The “funnelof doubt”

Actuarial projections
Case estimates
Paid1996

1997

1998

1999

2000 2001

2002

2003

2004

2005

2006 2007

2008

2009

 Reserving analysis is not just about looking backwards!

© 2007 Towers Perrin

5Different Approach: What?
Effective Communications

 Traditional Reserve Analysis: Lack of adequate communication withFinancial
Statement

non-actuarial functions
 Sometimes viewed as a mysterious
process
 Reserving results and implications
not fully understood by themanagement team  might misssome significant business issues andopportunities

Reserve
Actuary

Myth:Actuary = Fortune
Teller?
IT / Data Dept
© 2007 Towers Perrin

6

Different Approach: Why?
Higher Expectations – Internal Audiences Management decision requires more quantifiable information fromreserving actuaries
 Environmental and operational changes created new challenges tothe traditional actuarial reserving methods
 New tools are needed to satisfy more complex and competitive

business environment Peer pressure from key competitors Need to understand uncertainty© 2007 Towers Perrin

7Different Approach: Why?
Higher Expectations – External AudiencesRegulators Asian Example: Malaysia Insurance Regulator (BNM) recently
introduced new RBC requirement, which requires the company toestimate the reserve liability at 75% percentile confidence level

SEC

 Require public companies to discuss reserve uncertainty in 10-K
filings

RatingAgencies

 Capital adequacy analyses reflect reserve shortfalls and reserverisks Prudent management is expected to consider more than just thebest estimateInvestor

 Management is expected to demonstrate understanding andeffective control of risks

ActuarialProfession

 Raising the performance bar – especially regarding ranges andcommunications

8© 2007 Towers Perrin

Different Approach: Who will get involved?
 Value-Added Reserving

Management/
Decision Making

 Adequate communications

with operational
functions areemphasized in VAR
 Reserving function should
provide key input tosenior management’s
decision making process

Underwriting

Pricing

Claim

Reserve
Actuary

Marketing

Reinsurance

Risk Management

IT / Data Dept
© 2007 Towers Perrin

9Different Approach: When?
Traditional Reserving

Value-Added Reserving

 Regularly (annual or Regularly (annual orquarter) to fulfill theneed of financial
statementsquarter) to fulfill theneed of financial
statements
 Supplemental

information and insights
to enrich the basic
actuarial results
 Ongoing monitoring ofresults vs expectations
 Ad hoc analysis tosupport requirements ofmanagement’s decision
making10© 2007 Towers Perrin

Different Approach: How?
Document Operational Changes: Claim Log
Claim Log
Natureofchange

Dates
initiatedandcompleted

Reasonforchange

Targeteffect andactuarial
impactDetailsofchange

Observed
effects

Lines ofbusiness
affected

Percentage
of business
affected The types of changes to track include:

Claim New markets/exposures/types ofclaims/limits
 Case reserving
 Express claim settlement initiative Claim department organization andprocedures
 Management/staffing/vendor selection orprocess Settlement authority

 Legal environment or processes

 Problems (e.g., claim handling backlog)

 IT changes

Similarly, document issues and changes in other operational units© 2007 Towers Perrin

11Different Approach: How?
Best Tools and Techniques
Actuarial Methods

Reflect Operational Insights

 Subject the methods used

 Choice of actuarial methods
to “hindsight” testing Interpretation/adjustment of Keep the more accurate
historical data
methods
 Discard or adjust the less  Choice of parameters
accurate ones
 Introduce new methods
 Continuous improvement
 Diagnostic analyses of thedata
 Test for key trends andshifts
 Use efficient approaches

Benchmarking Most actuarial analyses

benefit from having robust
benchmarking data
 Rate/price monitoring Loss ratios
 Trend rates
 Reporting and payment
patterns
 Other Multiple levels can be used
 Industry
 Peer companies
 Economic datafor interim (e.g., monthly orquarterly) updates
Peer Review© 2007 Towers Perrin

12

Different Approach: How?
Range Analysis
 Define “Range”
 Range of best estimates Range of normal variance around a mean
 Range of most likely outcomes Range of possible outcomes Analysis methods
 Compare results of the various deterministic methods
 Scenario testing: e.g. alternative medical inflation rates
 Hindcast testing: historical performance of consistently-applied method
 Stochastic methods that are calibrated based on observed variability inyour historical data Industry-based benchmarks regarding inherent variability
 Link potential environmental, operational, or behavioral factors to theireffects© 2007 Towers Perrin13

Different Approach: How?
Distinct Types of Risk

Total Risk

Process Risk

Parameter Risk

Model Risk

Roll of fair die,equal chance ofone to six

Roll of loaded die,no longer sure ofprobabilities

Roll of trick die notnumbered one to six,
not sure what is oneach side

Decreases with volume
ActualOutcomeConstant with volume
True
Expected
OutcomeModel Estimateof Expected
Outcome14© 2007 Towers Perrin

Different Approach: How?

Claim Variability Analysis
Common stochastic reserving methods
Mack Method

Produces a measure of the variability of the projected unpaid
claims by examining the variability of the historical loss
development factors

Bootstrapping
MethodProduces a distribution of unpaid claims by simulation;differences between actual historical loss development andidealized development based on selected loss development
factors are treated as sampling errors

Practical Method Incorporates judgments about loss development factors andultimate loss ratios; produces a distribution of claim liabilities
via simulation
ChristofidesMethod© 2007 Towers Perrin

Fits regression model to incremental loss development
triangle; regression equation has both accident year anddevelopment year parameters

15Value-Added Loss Reserving
Discussion Topics

 A Different Approach to Loss Reserving
 Deliverables
 Loss reserve indications
 Claim variability
 Standard of materiality
 Loss reserve implications
 Operational insights
 Input to the Enterprise Risk Management process© 2007 Towers Perrin

16Deliverables
Loss Reserve Indications
 Best estimate
 Comparison to other actuary’s results
 For example, internal actuary vs. external actuary
 Comparison to management’s booked loss reserve Changes from last year’s projections
 And why?
 Gross and net of reinsurance Loss, Loss adjustment expenses
 Results by business segment, line of business, years© 2007 Towers Perrin

17Deliverables
Claim Variability
 Anticipating “negative surprises”
 Rigorous range analysis allows assessment of the probability of“worse than expected” results
 Identify circumstances likely to produce “surprises”
 Allows for risk management interventions
 More effective results monitoring Distinguish truly exceptional results from random noise More effective early recognition of problem areas18© 2007 Towers Perrin

Deliverables
Standard of Materiality
Management’s View
H0α
= 25%
2μ0

Independent Actuary’s View
H1β = 50%

 In this illustration, there issignificant overlap betweenmanagement’s view andthe external actuary’s viewof the underlying
distribution
 Differences in estimates ofultimate liabilities are likely
to represent “noise”

μ1© 2007 Towers Perrin

19Deliverables
Alternative scenario – “Not Reasonable” Opinion
Management’s View
H0

α= 25%
2μ0

Independent Actuary’s View
H1

β = 50% In this illustration,differences between theactuary’s estimate andmanagement’s estimate
are statistically significant
 Differences in estimates ofultimate liabilities representa real difference of opinion
 The Statement of ActuarialOpinion may need to be“inadequate”
μ1© 2007 Towers Perrin

20

Deliverables
Loss Reserve Implications

 Adequacy of booked provisions
 Profitability of various segments of business Trends
 Claim management effectiveness Areas for future refinement and more analysis
 Reinsurance effectiveness© 2007 Towers Perrin

21Deliverables
Input to Enterprise Risk Management (ERM) Process

0%
Percent Change in
Economic Capital

Economic Capital covers the downside
scenarios in all but the most extreme scenarios-100%

Policyholder/depositor security risk
relates to insolvency and non-performanceCumulative Probability22© 2007 Towers Perrin

Deliverables
Operational Insights: Hypothetical Operational Summary
OpportunityforImprovement

Area

Comments/Observations
 Case reserve strengthening appears to have occurred

Claims Average settlements also increased
 Appears to be more than severity trend
 May be related to recent changes in authority levels
 Higher case reserves driving higher settlements

Underwriting/Pricing

 Recent years’ loss ratios do not track with company

Reinsurance Recent years’ ceded ratios very favorable for two coverages

expectations
 Estimates show higher loss ratios than expected Price monitoring system not capturing price cuts
 Quality/mix of business may have slipped Line of business X has high and volatile loss ratio(WC and GL), and improving
 May be an opportunity to discuss possible revision in terms

LowMedium© 2007 Towers Perrin

High23

Suggested Readings
1. Considerations Regarding Standards of Materiality in Estimates of Outstanding

2.
3.

4.

5.

Liabilities, Bardis E., Gwilliam C., Malhotra A.
http://www.casact.org/pubs/forum/06fforum/5.pdf
Measuring the Variability of Chain Ladder Reserve Estimates, Mack T.
http://www.casact.org/pubs/forum/94spforum/94spf101.pdf
Analytic and Bootstrap Estimates of Prediction Errors in Claims Reserving,
England P. and Verrall R.
http://www.sciencedirect.com/
Value-added Reserving, Ghezzi T.
http://www.towersperrin.com/tp/getwebcachedoc?webc=TILL/USA/2005/200511/Ghezzi.pdf
Statement of Actuarial Principles Regarding Property and Casualty Loss andLoss Adjustment Expense Reserves
http://www.casact.org/standards/princip/sppcloss.pdf© 2007 Towers Perrin

24bob.conger@towersperrin.com
www.towersperrin.com/tillinghast+001–312–201–5617© 2007 Towers Perrin

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