P/C RATEMAKING

AND LOSS
RESERVING
by Robert Brown and Leon
Gottlieb

CHAPTER 3: LOSS RESERVING

The financial condition of an insurance

company can not be adequately assessed
without sound loss reserve estimates.
-- CAS Chapter 5

HCPI106-7/2003
 2

I. Introduction
1. Ratemaking and Loss Reserving are two most
important P&C actuarial jobs
2. Qualified actuary must attest to adequacy of year-end
reserves (by law)
a. to protect policyholders
b. to allow distribution of reported profits
c. to indicate level of solvency to potential investors (may
be conservative)
d. to provide ultimate claims estimates to pricing actuary
 3

II. How Outstanding Claims

Payments Arise
1. There can be several delays in the claims-
payment process
a. between accident incurral and reporting
b. between reporting and recording in head
office
c. between claim file opened and final dollar
paid (i.e., growth or decline on known claims)
2. Large claims tend to settle last
3. Try to model future claim payment patterns based
on past patterns
 4

A Hypothetical Claim

10/15
Claim
Event

2013 2014 2015 2016 2017

Loss
Reserve
Carried $0
12/31
 5

A Hypothetical Claim MM/DD/YY

12/20/14
Claim
Reported to
Agent, but
Not Yet
10/15
Recorded
Claim
by Insurer
Event

2013 2014 2015 2016 2017

Loss
Reserve
Carried $0 $0
12/31
 6

A Hypothetical Claim MM/DD/YY

09/09/15
12/20/14
Pay $3,000
Claim
Medical
Reported to
Expenses;
Agent, but
Offer
Not Yet
10/15 01/07/15 $15,000
Recorded
Claim Claim Settlement
by Insurer
Event Recorded

2013 2014 2015 2016 2017

Loss
Reserve
Carried $0 $0 $20,000
12/31
 7

A Hypothetical Claim MM/DD/YY

09/09/15
12/20/14
Pay $3,000
Claim
Medical
Reported to
Expenses;
Agent, but
Offer
Not Yet
10/15 02/02/16
01/07/15 $15,000
Recorded
Claim Offer Refused;
Claim Settlement
by Insurer
Event Recorded Go to Court

2013 2014 2015 2016 2017

Loss
Reserve
Carried $0 $0 $20,000 $40,000
12/31
 8

A Hypothetical Claim MM/DD/YY

09/09/15
12/20/14
Pay $3,000
Claim
Medical
Reported to
Expenses;
Agent, but
Offer
Not Yet
10/15 02/02/16
01/07/15 $15,000 10/06/17
Recorded
Claim Offer Refused;
Claim Settlement Court
by Insurer
Event Recorded Go to Court Decision; Pay
$32,000

2013 2014 2015 2016 2017

Loss
Reserve
Carried $0 $0 $20,000 $40,000 $0
12/31
 9

A Hypothetical Claim MM/DD/YY

12/20/14 09/09/16
Claim Reported Pay $3,000
to Agent, but Medical
Not Recorded Expenses; Offer
by Insurer $15,000
10/15/13 01/07/15 Settlement
02/02/16 10/06/17
Claim Claim Offer Refused; Court
Event Recorded Go to Court Decision; Pay
$32,000

2013 2014 2015 2016 2017

Loss
Reserve
Carried $0 $0 $20,000 $40,000 $0
12/31
 10

A Hypothetical Claim 12/31

$43,000
$40
10/06
12/31
$30 $35,000
$23,000

$20
09/09
$10 $3,000

$0 2013 2014 2015 2016 2017

History of the Incurred Loss Development for the hypothetical claim

 11

A Real HK case
 12

III. Definition of Terms

A. Basic Elements
1. Claim frequency distribution developed from recent experience data

(Aside: a loss may not result in a claim)

# of incurred claims
average f 
units of earned exposure
 13

III. Frequency and Severity

2. Loss distribution which models severity (S)

$ of incurred losses
(Aside: total incurred claims = claims paid-to-date + unpaid loss reserve)

average S 
# of incurred claims
 average payment per claim incurred
 14

III. Frequency and Severity

3. A rate of interest, i, or force of interest, 
4. Time to payment of claims (t): Payout Pattern
5. Also define:

Loss Cost  f  S
# of incurred claims $ of incurred losses
 
units of exposure # of incurred claims
$ of incurred losses

units of earned exposure
 pure premium or net premium
 15

A. Individual Claim File Estimate

1. Field adjuster establishing claim file upon notice of
(potential) claim
2. File info
a. Date of occurrence (accident)

b. Date of claim

c. Assigned lawyer

d. Examining physician

e. Payments-to-date
 16

A. Individual Claim File Estimate

3. Field adjuster to estimate E[future payments]
based on
a. Severity of potential loss
b. Likely time to settle (ALAE will go up)
c. Inflation between now and settlement
d. Any recent impacts of courts or legislation
e. Other pertinent info
4. Case reserves =  All individual claim file
estimates (split by line of business and accident
year)
 17

B. Gross IBNR (Reserves)

1. Gross IBNR reserve (or bulk reserve) is total of:
a. future development (+, -) on known claims
b. files that are closed but may be re-open (e.g.,
W.C.)
c. claims incurred but not reported (pure IBNR)
d. claims reported (to field adjuster) but not
recorded (in head office), RBNR
 18

C. Paid Loss Development

1. Paid age-to-age loss development:  cumulative
payments on a defined set of claims between
successive valuations (e.g., annual/quarterly)
2. Age-to-ultimate loss development:  from
defined date (or age) evaluation to ultimate
payment amount
3. Paid-loss development factor (L.D.F.) =
cumulative paid @ duration j
cumulative paid @ duration j 1

NOTE: there are no estimates in these numbers;

they are 100% known and 100% objective
 19

D. Incurred Loss Development

1. Same definition as above except you are using

incurred data
( = pd-to-date + reserve O/S estimate) future
2. Incurred L.D.F. can be < 1
a. if reserve estimates are conservative
b. because of salvage or subrogation
 20

E. Salvage and Subrogation

 Salvage: e.g., if a policyholder has a car accident and the car is
“written off,” the policyholder will receive a check for the value of
the car at the time of claim. From that point on, the car is owned
by the insurer. The right to any salvage value belongs to the
insurer, and will appear in the accounts as a recovery of costs.
 Subrogation: e.g., if a policyholder has a house fire, the insurer
pays for the house to be repaired or rebuilt within the limits of
policy. If it can be shown that the fire was caused by the
negligence of a 3rd party, the insurer has the right under
subrogation to pursue recovery in a lawsuit against the 3 rd party.
 These can lead to a less-than-one final loss-development factor.
 21

F. Loss Adjustment Expenses

1. Must reserve for future ALAE and ULAE

2. ALAE (e.g., lawyers’ fees) are usually in claim file
paid and incurred so are covered
3. ULAE (e.g., head office) are allocated at year-end
(to line of business) by formula
 22

G. Fast Track Reserves

1. Used for high freq, low severity, fast closing
lines (e.g., auto collision)
2. Head office actuary provides an average claim
size based on past experience
3. All files use this number initially
4. Final number is entered once known (e.g., claim
settled)
5. If claim file open too long, individual estimates
take over
 23

IV. Professional Considerations

1. Setting reserves is not a black box computer calculation
2. Must have intimate knowledge of company
a. all definitions (e.g. what is a claim)
b. management attitude toward settling claims (i.e. fast/slow)
c.  company’s retention limit
3. Must be cognizant of external factors
a. economic inflation
b. recent court decisions & recent legislation
4. Must set up data collection criteria
a. compromise of homogeneity and statistical credibility
5. Review accuracy of data
6. Calculate reserves using more than one method
7. Reconciliation of different answers will narrow the range of most
likely estimate
 24

V. Checking the Data

1. Methods are based on there being patterns in claims
settlement
2. Review with care any past data that do not fit pattern
3. Calendar year action will impact the “diagonals” of
the loss-development triangles (as seen later)
4. Document all modifications/adjustments (and keep on
file)
 25

VI. Loss Reserving Methods

(There are as many loss reserving methods as there are
actuaries!)

A. Case Reserve Estimates Plus

1. To Case file estimates add Gross IBNR or
a. future development on known claims
b. files that have closed but may re-open
c. IBNR = total of pure IBNR and RBNR
2. Method is very subjective
a. may be used to hide profit and avoid tax or
b. make the year profitable
3. Could result in insolvency
 26

B. The Expected Loss Ratio Method

1. Estimate ultimate expected loss ratio = E [LR]
2. Then E [LR]   earned premium for fiscal period = E [$L,
ultimate]
3. Finally: E [Loss Reserve] = E [$L, ultimate] – [$L, pd-to-date]
4. Again, too subjective
5. May lead to illogical answers (e.g. if you have just taken a
rate decrease for purely competitive reasons)
6. At times, may be the only method available:
a. new line of business
b. gov’t regs require minimum loss ratio targets for certain
volatile lines of business (e.g. Employee Fidelity Insurance)
c. can be used in conjunction with other methods (see
Bornhuetter-Ferguson)
 27

C. The Chain-ladder or
Loss-Development Triangle Method
1. Historical data present as a triangle of paid or incurred
development
2. Create a cumulative paid or incurred triangle (Note: activity
in row labeled Accident Year Z and column labeled
development year t, took place in Calendar year Z+t)
3. Calculate age-to-age loss development factors, LDF, (or link
ratios) (see tables 3.2 and 3.3)
4. Look for patterns in these LDF
5. Use these patterns to create the missing half of the triangle
6. Advantages of using paid loss
a. purely objective, contains no reserve estimates
7. Advantages of incurred loss data
a. reserve estimate contains valuable information
 28

C. The Chain-ladder or
Loss-Development Triangle Method
8. Do both paid and incurred and reconcile the differences
(ultimately they must be the same as all incurrals become paid)
9. Part of work is data review (remember calendar-year activity
appears along diagonals of the triangle--e.g. legislative change
or management style shift)
10. Reserve = E[ultimate paid or incurred (same)] - [Pd-to-date]
11. Note: Mean LDF (as defined in text) is a volume-weighted
average (i.e. years of greater volume are give greater “weight”)
12. If there is consistent growth or decline in a column of LDF may
project the trend into future values (i.e. not use a constant)
13. A LD triangle with n rows and n-l columns, creates a statistical
model with 2n-l parameters (n-l LDF applied to n “jump-off”
points -not good modeling!)
14. Not surprising, stability is not a characteristic of the LDF method
 29

Stability is not a characteristic of the LDF!!

 Example 1: Increase by 10% the cumulative payments for
accident year 2006, development year 1, from $22,253 to
$24,478.
  The total loss reserve using 5-year average modeling
assumption would rise 4.1%
 Example 2: The Claims Department changed its claims
settlement philosophy for 2007 so that all losses were paid more
promptly.
 In fact, all of the payments along the calendar year 2007
diagonal increased by 10% (except for AY 2000, development
year 7 which has been assumed to be fully mature).
  Logically it should lead to smaller reserve, but that resulted
in a 9.2% larger reserve using the Chain-ladder method.
 30

D. The Bornhuetter-Ferguson Method (BF)

1. A combination of the E[LR] and LDF-triangle methods
2. Adds stability to LDF-triangle method and
3. Adjusts E[LR] as time provides more information
4. From p.73-4 it can be shown that from the LDF method:

E [Loss Reserve] = E [$L, ultimate] ( 1 

1
), where f ULT   f j
f ULT j

(cumulative LDF from now to )

 31

D. The Bornhuetter-Ferguson Method (BF)

5. The BF method
a. For each Acc Year row estimate E[LR] based on most recent
info
b. Then: E[$L, ultimate] = E[LR]  (Earned Premiums)
1
c. Then: E[Loss Reserve] = E[$L, ultimate] ( 1  )
f ULT
d. Hence a combination of E[LR] and LDF methods
e. BF answer will (must) lie between E[LR] answer and LDF
answer
 32
Example 3.1: You have chosen the following paid loss-
development factors to model the lower half of a
claims paid rectangle:

1/0 2/1 3/2 4/3 /4

1.41 1.22 1.16 1.08 1.04

You are setting reserves for the annual report as

of December 31, 2006. For accident year 2005 you
have claims paid-to-date lf $420,000 at report
duration 1, which is December 31, 2006. The
earned premium calculated for accident year 2005
is $1,000,000 and the expected loss ratio is .600.
For the 2005 accident year, determine the
estimated loss reserve using each of the expected
loss ratio method, the chain-ladder method, and
the Bornhuetter-Ferguson method.
 33

Example 3.2: Given

Earned Premium = $800,000
E[LR] = .680

Sum Individual Claim File Estimates ($Paid+Reserves) =

$500,000
$Pd-to-date = $300,000


�f j (on incurred claims)  1.100

 Find the Total Actuarial Reserve using:

 (a) The Loss Ratio Method;
 (b) The Chain-Ladder Method;
 (c) The Bornhuetter Ferguson Method.
 34

E. Estimates Split into Frequency & Severity

1. Requires for each Acc Year, E[# of claims]
a. this data is known very rapidly (i.e. not as much gross IBNR
on # of claims as $ Loss)
2. Given a triangle of cumulative loss payments, and a vector of
E[# claims] for each Acc Yr, you can create a triangle called
Cumulative Loss Payments per Claim Incurred (a severity
triangle)
a. usually done with “$ paid” but can be “incurreds”
b. helpful if payments adjusted for inflation and represent
constant $ values (more so in the late 1980’s)
3. Really good if you can create a triangle of Cumulative Closed
Claim Files (see table 3.9)
4. This can then be transformed into %-of-claims-closed triangle to
show the “speed of finalization” (see table 3.10)
 35

E. Estimates Split into Frequency & Severity

5. You can thus see if the company is speeding up or
slowing down settling claims
6. You can then “adjust” paid losses to a consistent %-
of-claims-closed basis (see Q3.11 and do it)
7. This is important - e.g.
a. the company decides to settle faster, but does not tell the
actuary
b. reserves should go down
c. the claims-paid data suddenly show larger LDF in the last
diagonal
d. with larger model LDF, reserves go up - Wrong!
 36

F. Summary
1. Do more than one method and reconcile differences
2. May build some level of conservatism in, depending
on the use of the results (e.g. solvency vs. pricing)
 37

VII. Discounting Loss Reserves

1. For the life side, discounting for time value is a
given
2. Historically, most P & C reserves were carried
undiscounted (hence some implicit conservatism)
3. Explicitly calculated provision for adverse
deviation is probably actuarially preferable
4. Reserves for tax purposes must now be
discounted future development on known claims
 38

VII. Discounting Loss Reserves

5. To discount
a. create lower half of triangle = future cash flow
b. assume payments are made at mid-pt of development
year
c. choose an interest rate and re-value at present value
d. note: any given discount factor, vt, will be applied
across a diagonal (Tables 3.17 and 3.18)
6. Now need an explicit provision for adverse deviations
 39

VII. Discounting Loss Reserves

7. Issues
a. is the mid-pt assumption valid especially for the first
year and last year?
b. what interest rate should I use? (answer: the net rate
being earned by the assets backing these liabilities)
asset-liability matching has not been the norm for P &
C co’s
c. it should be net of expenses
d. how does one include unrealized capital gains?
e. what are the tax implications?
 40

VII. Discounting Loss Reserves

8. Discounted loss reserves are the correct ones to use
in pricing (pricing actuary should discount back to
average date of premium receipt)
9. Discounting is becoming much more common (often
forced by tax or pricing agencies)
10. The best way to learn this stuff is to do lots of
exercises.
11. Books are always better than movies (SAP vs. GAPP) -
as well as power point slides!!