CASUALTY ACTUARIAL SOCIETY COURSE ON PROFESSIONALISM – CANADA Case Study #3 THE CASE OF THE SOPHISTICATED INSURANCE BUYER INTRODUCTION This case study revolves around “large account pricing” for commercial insurance. For many lines of P&C insurance, actuaries determine what rates should be charged average members of homogeneous groups based on similar characteristics; this is referred to as manual ratemaking. [CAS Basic Ratemaking, Werner and Modlin] In Basic Ratemaking, Werner and Modlin discuss adjustments that are often needed for commercial lines pricing: For many commercial insurance products, the creation of homogenous groups for ratemaking purposes is not feasible, and without adjustment, individual risk experience can be expected to vary widely around the average group rate. In addition, some commercial risks are sufficiently large that their historical experience can be used in whole or in part to derive an individual rate. Consequently, commercial lines ratemaking employs special techniques that address the heterogeneity and credibility of commercial risks. In large account pricing often uses the individual entity’s own experience as the basis for determining the premium to be charged, supplementing it to the extent necessary with industry or other collateral data. Rates for large accounts are largely unregulated, as the buyer is usually assumed to be sophisticated and knowledgeable enough not to need “consumer protection”. The expense loads also often vary from manual ratemaking, because loss control, claims management, or other risk management services are often part of the insurance solution offered to the entity or are performed by the entity itself. To a much greater extent than in other ratemaking work, the choice of data used in large account pricing and the types of adjustments made to that data are left to actuarial judgment. The insured entity often employs its own risk manager (who may or may not have an actuarial background) or contracts for the services of one through an insurance brokerage firm. As part of the insurance purchasing process, the risk manager or broker may want to negotiate the data and/or methodological choices made by the pricing actuary. He or she may also hire or contract another actuary to perform a similar study with the same data to compare and contrast it with the work of the insurance company’s actuary. Thus, the professionalism of both the insurance company pricing actuary as well as the independent actuary becomes integral to the business process, potentially giving rise to situations such as the one in this case study. CASUALTY ACTUARIAL SOCIETY COURSE ON PROFESSIONALISM – CANADA Case Study #3 THE CASE OF THE SOPHISTICATED INSURANCE BUYER Page 1 You are responsible for pricing a large and profitable General Liability renewal that your company, The Feelings Mutual Insurance Company (the Company), has written for five years. The final price quote will be the responsibility of your boss, the Chief Underwriting Officer (CUO). The risk is primarily Premise and Operations and is written within a Comprehensive General Liability policy with a policy limit of $1 million. Your company also writes a $10 million limit Umbrella policy for this insured, which has been loss free. The insured, Ronnell McDonnell Douglass (RMD), is represented by their Risk Manager, who has a number of (non-actuarial) insurance designations and considers himself to be very knowledgeable about insurance pricing. Every year the Risk Manager reminds you that he believes your price is too high. You know he has stayed with the Company because of your top-notch loss control and claims services, but you are not certain of the dollar value he puts on these services. You develop the basic limit portion of the rate for RMD’s primary policy (i.e., the $1 million limits policy) based on RMD’s own claims and exposure experience. Because RMD’s excess loss experience is not credible, you determine the price for the excess policy by multiplying the rate underlying the primary policy by the appropriate rating bureau increased limits factor (ILF) for the layer $10 million excess $1 million, which is consistent with the Company’s published internal procedures. The Risk Manager insists that the rating bureau ILF is not appropriate for RMD. He goes on to say that RMD is a “frequency” risk with minimal “severity” potential, where the rating bureau data includes both frequency and severity risks. He supports this statement by referring to RMD’s actual loss experience, and insists that the one large loss RMD had was simply poor luck and should not happen again. To exacerbate the situation, the indicated rate has increased 10% this year because you increased your underwriting profit requirements to reflect the sustained environment of weak interest rates; your overall target ROE, as established by senior management, has not changed. The Risk Manager states that a competitor, The Fly Bye Night Insurance Company (Fly Bye Night), who has taken many of your better risks and seems to be targeting your book, has quoted a price 25% below the quoted renewal price for the total account at the same coverage terms. He goes on to say that Fly Bye Night has used the same interest rate assumption in pricing that you used last year (which is three points higher than your current value), and Fly Bye Night used RMD’s actual large loss experience in CASUALTY ACTUARIAL SOCIETY COURSE ON PROFESSIONALISM – CANADA Case Study #3 THE CASE OF THE SOPHISTICATED INSURANCE BUYER Page 2 determining their quoted price. He feels this proves that he is right about the rating bureau ILF’s and you are wrong. The Risk Manager says the Company will lose the account, including the Umbrella, if you do not lower the price to meet Fly Bye Night’s quote. If you are submitting the pricing suggestion to the CUO, what pricing suggestion do you make? Questions: 1. What are the issues relating to Standards of Practice? 2. What alternatives are open to you and your company? 3. What actuarial guides, standards or principles apply here? 4. What action would you take? Facilitators’ topics to address: General Approach If asked, suggest to the Group, that the impact of the change in your interest rate assumption is approximately 10%. In other words, without this change there would be no change in the indicated rate. The difficulty if this situation is that you have a responsibility to your Company to make the best business decision possible, under the circumstances, and you also have a responsibility to perform your actuarial duties in a manner consistent with the standards of your Actuarial Standards Board. In theory these two responsibilities do not conflict, but they might in practice. 1. What are the issues? Issues are similar to some extent as that noted for Case Study #2 – in Canada, there is the issue of best estimates (see notes from prior case study) – important issue of when acting (and calculating) as an actuary and when making business decisions – documentation is absolutely critical a. What is a reasonable range of rates? This can only be determined by performing a sensitivity analysis, using a reasonable range of values for each parameter. The focus of the discussion should be on how to determine a reasonable range and what do to if the competitor’s rate is outside this range. b. Can you justify using the same interest rate that was used last year? c. Can you justify deviating from the rating bureau ILFs iii) in general? iv) for this insured? d. How do you measure excess loss credibility? e. What if you believe it is reasonable to deviate from the rating bureau ILFs in this situation, even though Company policy does not condone it? What is the expected ROE if you meet your competitor’s quote (25% below expiring)? Is this an acceptable result to your Company for this risk? f. Should the profitability of the umbrella policy affect your estimate of a reasonable range of rates? g. Are you permitted to make a “business decision”? 2. What alternatives are open to you? Some alternatives from a business perspective are: i. stick to your guns. ii. offer to compromise at the expiring rate. iii. meet the competitor’s quote. iv. offer the minimum rate you would be comfortable with, based on a sensitivity analysis. Which of these alternatives are supportable from an actuarial perspective? 3. What actuarial guides, standards, or principles apply here? CAS Code of Professional Conduct/CIA Rules of Professional Conduct Rules/Code of Professional Conduct (CIA Rule/CAS Precept): Professional Integrity (Rule 1/Precept 1) Qualifications Standards (Rule 2/Precept 2) Standards of Practice (Rule 3/Precept 3) Disclosure (Rule 4/Precept 4) Conflict of Interest (Rule 5/Precept 7) Control of Work Product (Rule 6/Precept 8) Confidentiality (Rule 7/Precept 9) Courtesy and Cooperation (Rule 8/Precept 10) Advertising (Rule 9/Precept 11) Titles and Designations (Rule 10/Precept 12) Collateral Obligations (Rules 11, 12, 13) CIA Standards of Practice 2600 Ratemaking: Property/Casualty Insurance Ratemaking The actuary should select appropriate methods, techniques and assumptions recognizing that such elements depend on the circumstances of the case and that a variety of actuarial methods may be appropriate to derive an indicated rate.” CAS Statement of Principals Regarding Property and Casualty Insurance Ratemaking: Principle 1: A rate is an estimate of the expected value of future costs Principle 2: A rate provides for all costs associated with the transfer of risk. When the experience of an individual risk does not provide a credible basis for estimating these costs, it is appropriate to consider the aggregate experience of similar risks. Principle 4: A rate is reasonable and not excessive, inadequate, or unfairly discriminatory if it is an actuarially sound estimate of the expected value of all future costs associated with an individual risk transfer. Considerations: Individual Risk Rating – When an individual risk’s experience is sufficiently credible, the premium for that risk should be modified to reflect the individual experience. Consideration should be given to the impact of individual risk rating plans on the overall experience. CIA Standards of Practice – 1000 General Standards and 2000 Standards of Practice – Practice-Specific Standards for Insurance The Standards apply in all situations and some with particular relevance to this case include: 1500 – The work 1510 Approximation 1530 Data 1560 Documentation 1700 – Assumptions o 1720 Selection of assumptions o 1730 Appropriate assumptions 1800 – Reporting 4. What action would you take? There are a couple of possibilities: a. Does your “reasonable range of rates” include the competitor’s quote? If so, perhaps you can justify, from an actuarial perspective, lowering your price. b. You might discuss the possibility of a “business decision” to lower your price with a superior. Your responsibility is to clearly document your work, the resulting indicated rate, and the range of reasonable rates. You are also responsible for communicating these results to all involved individuals in your Company, along with your estimate of expected profitability at the indicated rate versus the competitor’s quoted rate. This does not preclude the possibility of a business decision to meet the competitor’s quote, although your role and input into such a decision should be documented, especially if you disagree with the decision from an actuarial perspective.