Enterprise Risk Management
for P&C Insurance Companies
Shaun S. Wang
Robert T. Faber
1
Agenda
 ERM Research Project
 Summary of Research Findings
 Underwriting Psychology
 Our Proposed Actions
2006-9-29
2
ERM Research Project
 Co-sponsored by



Casualty Actuarial Society
Risk Management Section (SOA & CAS)
ERM Institute International, Ltd
 Researcher Team



2006-9-29
Shaun Wang (actuary, scholar)
Bob Faber (executive, senior underwriter)
Assisted by Project Oversight Team chaired by
John Kollar (ISO)
3
Objectives & Time line
 Objectives:


2006-9-29
Propose a fresh
ERM Theory that is
applicable to all
sectors
Make ERM
operational for P&C
insurers
 Time Line



Feb 16, started
June 15, exposure
draft
August 1, completed
4
The Concept of Risk Dynamics
 The big Universe consists of
 many projects (risks and opportunities),
 external players (customers, competitors),
 external forces (financial, regulatory)
 An enterprise sits within the big universe
 selected projects, internal players & internal
forces
 “risk dynamics” refers to the interactions of
forces and players within and without the
enterprise.
2006-9-29
5
We define ERM as
 studies of the system of risk dynamics of the
enterprise, including interactions among
internal and external risk dynamics, and how
players’ actions (including the risk
management practices) can influence the
behaviors of the risk dynamics, with the
ultimate goal of improving the performance
and resiliency of the system.
2006-9-29
6
Element of ERM Framework
1) Analyze the business model
2) Define the scope of business operations,
3) Identify operating constraints by regulators
and rating agencies,
4) Measure sensitivity to external and internal
forces,
5) Develop business or risk strategies to
interact with the various forces
6) Monitor the dynamics
2006-9-29
7
P&C Insurer Risk Dynamics -- Players
Regulator
Competitor
Stock Analyst
Rating
Agency
Board of
Directors
Marketing &
Underwriting
Pricing
CEO; CFO;
CIO; CRO
Claims &
Reserving
Investment
I.T., H.R.
Accounting
2006-9-29
8
Net Effect of Diversification
Benefit/Penalty
 It depends on the nature of business model,
& how you conduct the business


2006-9-29
Personal Lines: diversification essential for
managing catastrophe exposure
Commercial Lines: we observed dramatic
differences in financial performance among
companies with different underwriting/pricing
practices
9
Empirical Studies
 A sample of 29 insurance companies:
1) Small Companies (14 companies)
2) Jumbo Regional (7 companies)
3) Large National (8 companies)
 Focused on WC and GL


2006-9-29
use gross loss ratios
use gross loss triangles
10
2006-9-29
LN: logP=17.6
LN: logP=17.1
LN: logP=16.8
LN: logP=16.5
LN: logP=16.4
LN: logP=16.2
LN: logP=16.0
LN: logP=15.0
JR: logP=15.0
JR: logP=14.9
JR: logP=14.6
JR: logP=14.5
JR: logP=14.3
JR: logP=12.3
JR: logP=12.1
SC: logP=13.9
Deviation of Loss Ratio
SC: logP=13.3
SC: logP=12.9
SC: logP=12.8
SC: logP=12.7
SC: logP=12.1
SC: logP=11.9
SC: logP=11.8
SC: logP=11.6
SC: logP=11.5
SC: logP=11.4
SC: logP=10.4
Mean and Deviation of Loss Ratio in
relation to Size of Written Premium - WC
Workers's Compensation:
Small Companies, Jumbo Regional, Large National
100%
Mean Loss Ratio
Linear (Deviation of Loss Ratio)
80%
Linear (Mean Loss Ratio)
60%
40%
20%
0%
Type of Company & Logarithm of Written Premium during 1985 - 2003
11
Mean and Deviation of Loss Ratio in
relation to Size of Written Premium - GL
General Liability: Average and Stdev of Loss Ratio By Company
Small Companies, Jumbo Regional, and Large National
120%
Deviation of Loss Ratio
Mean Loss Ratio
100%
Linear (Mean Loss Ratio)
80%
Linear (Deviation of Loss Ratio)
60%
40%
20%
LN: logP=16.4
LN: logP=16.2
LN: logP=15.6
LN: logP=15.6
LN: logP=15.3
LN: logP=15.1
LN: logP=15.0
LN: logP=15.0
JR: logP=14.8
JR: logP=14.7
JR: logP=14.1
JR: logP=13.4
JR: logP=13.1
JR: logP=13.0
JR: logP=12.8
SC: logP=12.3
SC: logP=12.1
SC: logP=11.8
SC: logP=11.7
SC: logP=11.6
SC: logP=11.6
SC: logP=11.5
SC: logP=11.4
SC: logP=11.0
SC: logP=10.2
SC: logP=10.0
SC: logP=9.93
0%
Type of Company & Logarithm of Written Premium (1985-2003)
2006-9-29
12
Summary Result by Company Type
Workers Compensation: Loss Ratios By Company Type
90%
80%
Average (Mean
Loss Ratio)
70%
60%
Average(Deviation
of Loss Ratio)
50%
40%
30%
20%
10%
0%
Small Companies
2006-9-29
Jumbo Regional
Large National
13
Loss Reserve Practices
 For a selected company and 1997 accident
year, we observe booked loss ratios at
12/31/1997, 12/31/1998, up to 12/31/2004.
 Loss Development for Accident Year 1997 =
{Estimated Incurred Loss as of 12/31/2004 } –
{Initial Incurred Loss Ratio of12/31/1997 }
2006-9-29
14
Workers Compensation Loss
Development
Worker's Compensation Reserve Development:
Difference in Updated Loss Ratio and Initial Loss Ratio
0.25
0.20
Large Companies
0.15
Small Companies
0.10
Jumbo Regionals
0.05
0.00
-0.05
-0.10
-0.15
-0.20
-0.25
-0.30
1992
2006-9-29
1993
1994
1995
1996
1997
1998
1999
2000
15
General Liability Loss Development
Other Liability (Occurrence) Reserve Development:
Difference in Updated Loss Ratio and Initial Loss Ratio
0.40
Large Companies
0.30
Small Companies
0.20
Jumbo Regionals
0.10
0.00
-0.10
-0.20
-0.30
1990
2006-9-29
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
16
Back Testing of the Chain-Ladder
Development Method
 For each company and a given line of
business (WC or GL), we use the loss triangle
data up to the end of year 2000 as input.
 Applied the Chain-Ladder method to project
future development to end of 2004.
 Compared the projected losses with the
actual observed losses by the end of 2004.
2006-9-29
17
Large National Companies
Liberty Mutual WC Loss Development
Actual vs. Projected Losses as of 12/2004
Continental WC Loss Development
Actual vs. Projected Losses as of 12/2004
2,000,000
4,000,000
1,600,000
3,000,000
1,200,000
2,000,000
800,000
400,000
Accident Year
2006-9-29
Projected Loss
2000
1999
1998
1997
1996
1995
0
1994
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
0
Actual Loss
1992
Projected Loss
1991
Actual Loss
1993
1,000,000
Accident Year
18
Small & Regional
Central WC Loss Development
Actual vs. Projected as of
12/31/2004
West Bend WC Loss Development
Actual vs. Projected as of 12/31/2004
Accident Year
2006-9-29
2000
1999
1998
1997
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
0
1996
5,000
Projected Loss
1994
10,000
1993
Projected Loss
1992
15,000
Actual Loss
1991
20,000
Actual Loss
1995
80,000
70,000
60,000
50,000
40,000
30,000
20,000
10,000
0
25,000
Accident Year
19
Number of Insurer Upgrades vs. Downgrades,
1993 to 2003 (Source: Standard & Poor’s)
20
18
Upgrades
16
Downgrades
14
12
10
8
6
4
2
0
1993
2006-9-29
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
20
Leading Indicators vs Lagging
Indicators
 Reserves can only be a lagging indicator.
-at 12 months, are almost never in an adverse position to
precipitate big change
-24-36 months at best for true indications
 Rate change indications on renewal are adequate only if:
-constant policy form (SIRs, deductibles, limits, etc)
dominates the book of business and
-policies are rated on a true exposure basis, and
-new business constitutes a small percentage of
premium.
 By 1997, most companies were rate monitoring and were still
surprised by the depth of unmeasured rate decreases for 19981999.
2006-9-29
21
Underwriting Psychology
 Underwriting psychology is more important to understand than





underwriting philosophy.
Most underwriters think frequency more than severity. It is more
tangible.
Most underwriters have not been in the position long enough to
live with their tail. The adverse development always belongs to
others.
Especially in larger companies, underwriting is not a career path,
management is.
It is much easier to cut the rate on new business than on
renewals. (You didn’t screw up the rating last year)
Underwriters learn the unwritten rule early: No matter what
management says, those with the bigger books of business
get rewarded. Premium is measured by underwriter, loss
ratio and development is not.
2006-9-29
22
Price Monitoring
 True price monitoring can only take place
when anchored firmly on a rate for the
exposure base, attaching at first dollar.
 The goal of price monitoring is to project the
loss ratio range. This can only occur if the
proper rate level per exposure unit is known.
 Failing that goal, projecting the direction and
magnitude of the change still has value.
 What has a higher priority with company
management: expense ratio or price monitors
2006-9-29
23
Terms and Conditions
 Experience rating by its very nature, using
valued claims, can have a market or insured
driven bias.
 Deductible and Self Insured Retention
valuations have to take place exactly in
accordance with price monitoring techniques.
 Changes in coverage have to be quantified, if
only by estimate.
2006-9-29
24
Quantification of Risk
 Risk level increases significantly as the attachment
point rises. Deductibles and SIRs remove the more
predictable part of the risk.
 Risk knowledge decreases as risk size increases. It
is harder to establish exposure bases and there are
more variables to balance.
 Balance of knowledge shifts to the buyer as size
increases, increasing risk.
 Risk level increases with the inexperience of the
underwriter on the book. (Note we did not say
inexperience of the underwriter)
2006-9-29
25
Monitoring Process
 Establish base rates per exposure units to be





measured against. This does not fully recognize risk
quality, but creates a hard base line.
Measure renewals creating a history.
Force identical quantification of all terms variation
(composite rates, deductibles, SIRs, etc) against
these base rates.
Measure new business against the same standards
Even when using experience rating as a methodology,
measure the resulting rate against the same basis.
Take tracking of rate level change to desk level.
2006-9-29
26
Correcting the Decision-Making
Process
 Effective price monitoring has to occur at the
same location as effective underwriting; the
underwriter’s desk.
 Price monitoring needs to become a real part
of the evaluation process for rating agencies
and analysts. (Remember the grading chart)
 Senior management and analyst emphasis
on top line premium growth and expense
control is often at odds with effective price
monitoring.
2006-9-29
27
ERM Implementation
 First line of defense
starts at the deskunderwriter
 Track exposure data
 Track pricing data
 Integrate pricing /
underwriting/ claims /
reserving
2006-9-29
Pricing
Reserving
ERM
For P&C
Companies
Claims
Underwriting
28
Contact
Shaun Wang, swang@ermii.org, 678-5249222
2. Bob Faber, robert.faber@risklighthouse.com,
847-428-2533
1.
29