Managing Overconfidence
Douglas J. Collins, FCAS, MAAA
doug.collins@towersperrin.com
Tillinghast London (Tel: 44 (0)207 170 2162)
CAE Zurich – 23 April 2004
Many factors contribute
to errors (and bias!) in pricing and underwriting
Common Sources of Pricing
and Underwriting Error/Bias (Micro)
Inadequate internal [historical] data upon which to
develop estimates (e.g., old, incomplete or
inaccurate data; inadequate/inappropriate sample)
Systemic Sources of Pricing
and Underwriting Error/Bias (Macro)
Long feedback loop
No skin in the game
Inability to collect and synthesize all relevant
sources of data within the organization
Lack of reliable information about external market
conditions and trends (e.g., inflation, tort costs)
Excessive concern for “competitive pressures”
Lack of adequate oversight over pricing decisions
Lack of “metaknowledge” — reinforces inherent
overconfidence when making estimates, forecasts
and predictions
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The results of a recent Tillinghast
“Confidence Quiz” illustrate the prevalence of
overconfidence
Tillinghast Confidence Quiz
The Quiz
Objective: To test respondents
understanding of the limits of their
knowledge
Raw Scores of Online Respondents
Number of Respondents
0
29
1
Respondents were asked to answer ten
questions related to their general
knowledge of the global
property/casualty industry
For each answer, respondents were
asked to provide a range that offered a
90% confidence interval that they would
answer correctly
67
2
56
3
69
4
44
5
44
6
28
7
18
8
Ideally (i.e., if “well calibrated”),
respondents should have gotten nine
out of ten questions correct
12
9
10
7
0
Note: based on 374 respondents as of 4/5/04.
Profile of respondents: 86% work in P/C industry; 73% are actuaries.
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3
The best way to manage overconfidence
is to implement a control cycle for pricing and underwriting
The Control Cycle: Retrospective Test of Pricing/Underwriting
1. Pricing and
Underwriting
Process Elements
Data required
3. Formal
Retrospective
Performance
Testing
Actuarial methods
Data accurate and
1. Define/Refine Process
adequate?
employed
Underwriting policies
and rules
3. Measure
Performance
Decision authorities
and reporting
Quality assurance
2. Implement
Process
Pricing methods
sufficiently robust?
Policies and rules
effective?
Decision authorities
appropriate?
Variances between
projected and actual
experience within
tolerances?
A control cycle for P/C pricing and underwriting entails identifying, testing and validating all of the
assumptions that underlie the projection of future loss costs used to price and underwrite the business
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While improving pricing/underwriting
requires a sustained commitment over time,
three near-term steps will jump start the process
Retrospective Analysis
Analyze relevant sample of pricing and underwriting results
to identify/pinpoint specific causes and sources of error
Define (or refine) and institutionalize an ongoing
Process Design/Refinement
Case-study Training
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process of continuous improvement (i.e., control
cycle) for pricing and underwriting
Incorporate insights from retrospective
analysis to address key challenges and
deficiencies
Develop/institute case-study oriented
training modules for underwriters and pricing
actuaries to provide practical experience
and rapid feedback
Base training materials on past business
where results are already known
5
Managing overconfidence in pricing and
underwriting
Pricing Element
Best
Estimate
Standard
Deviation
90% Confidence
Low
High
Historical experience not fully credible
957
5.0%
897
1,020
Historical experience not fully mature
191
20.0%
146
242
1,149
6.7%
1,052
1,249
138
50.0%
67
226
10
200.0%
1
23
1,297
12.0%
1,105
1,500
610
33.0%
383
874
1,906
17.3%
1,508
2,340
-20.9%
22.7%
Subtotal Ultimate Historical Loss Costs
Frequency and severity changes
Mix of business or underlying exposure changes
Subtotal Projected Future (Attritional) Loss Costs
Non-attritional loss elements
Total Projected Expected Future Loss Costs
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6
0
