Revised NAIC ALAE and ULAE Definitions A C laims P erspective

1. (A&O) (DCC) Revised NAIC ALAE and ULAE DefinitionsAClaims Perspective by Richard Carris, CPCU, CIPA, CLU, CFE, APA, AIC, ARM Casualty Actuarial Society Meeting: Casualty Loss Reserve Seminar Session: NAIC Redefinitions of Loss Adjustment Expense Venue: New Orleans, LA Date: September 11, 2001 Time: 10:30 AM to 11:59 AM Contact: richard.carris@ey.com or (212) 773-1215

2. CAS Presentation

3. Traditional ALAE = Allocated Loss Adjustment Expense = Allocated Loss Expense (in Sch P) = New or Revised ALAE = Defense and Cost Containment (“DCC”) = (in name only but not components) CAS = Claim Adjustment Services (Interim Period) Whereby CAS = Defense, Litigation and Medical Cost containment Services <DCC but> Traditional ALAE. Used for Discussion Purposes by NAIC. Trigger = 1/1/98 Keys on ALAE for the LAE Person

4. Traditional ULAE = Unallocated Loss Adjustment Expense = Unallocated Loss Expense(in Sch P) New or Revised ULAE = Adjusting and Other (“A&O”) (in name only but not components) Traditional LAE = ALAE + ULAE New or Revised LAE = DCC + A&O Trigger = 1/1/98 Keys on ULAE for the LAE Person

5. Old NAIC Definitions of ALAE and ULAE • Old ALAE - Allocate whatever can be allocated. (Expense identified with a specific claim) • Old ULAE - Everything else. Chapter 11 - Loss Adjustment Expenses of the Accounting Practices and Procedures Manual Defense, litigation and medical cost containment not previously specified.

6. New ALAE (DCC)* Per NAIC 6/24/97 Draft • Specifically, Allocated Loss Adjustment Expense (new ALAE) includes the following items: • Surveillance expenses; • Fixed amounts for medical cost containment expenses; • Litigation management expenses;

7. New ALAE (DCC) Per NAIC 6/24/97 Draft • Loss adjustment expenses for participation in voluntary and involuntary market pools if reported by accident year; • Fees or salaries for appraisers, private investigators, hearing representatives, reinspectors and fraud investigators, if working in defense of a claim, and fees or salaries for rehabilitation nurses, if such cost is not included in losses;

8. New ALAE (DCC) Per NAIC 6/24/97 Draft • Attorney fees incurred owing to a duty to defend, even when other coverage does not exist; and • The cost of engaging experts. • The foregoing list is not intended to be all inclusive.

9. New ULAE (A&O)* Per NAIC 6/24/97 Draft • Unallocated Loss Adjustment Expenses are those expenses other than allocated expenses. New ULAE includes the following items: • Fees of adjusters and settling agents; • Loss adjustment expenses for participation in voluntary and involuntary market pools if reported by calendar year; *Effective 1/1/98

10. New ULAE (A&O) Per NAIC 6/24/97 Draft • Attorney fees incurred in the determination of coverage, including litigation between the insurer and the policyholder; and • Fees or salaries for appraisers, private investigators, hearing representatives, reinspectors and fraud investigators, if working in the capacity of an adjuster. • The foregoing list is not intended to be all inclusive.

11. Who Is An Adjuster? (For ULAE) • And although not defined, the term adjuster is broad enough to include claim examiners, claim investigators, claim representative, claim supervisors, appraisers, reinspectors and other titles that any one company may use. It is not really the title, but the claims adjusting function.

12. Theme • It no longer matters whether an insurer uses its own employees or independent contractors. The concept of internal adjuster or external adjuster is gone.

13. Exhibit I NAIC Change (Cheat Sheet) MAJOR EXPENSE OLD ALAE/ULAE NEW ALAE/ULAE METHOD METHOD <1998 > 1998 _ Inside Legal Counsel * ULAE or ALAE ALAE but mostly ULAE +Overhead loading Outside Adjusters and ALAE or ULAE ULAE Appraisers but mostly ALAE Insider Adjuster and ULAE or ALAE and Appraisers but mostly ULAE ULAE * For Duty to Defend

14. Exhibit I NAIC Change (cont’d) (Cheat Sheet) MAJOR EXPENSE OLD ALAE/ULAE NEW ALAE/ULAE METHOD METHOD <1998 > 1998 Outside Experts ALAE or ULAE ALAE but mostly ALAE Inside Experts ULAE or ALAE ALAE but mostly ULAE Attorney Engaging in ALAE or ULAE ULAE Adjusting Work

15. Question and Answer Session with Richard Roth, JD, FCAS 1. Dick, what was the reason for the redefinition of LAE effective January 1, 1998? 2. Was this an industry motivated redefinition or one thought about by the CATF of the NAIC? 3. How many years prior to the implementation of the new LAE definitions was the CATF considering this redefinition? 4. How were the terms DCC and A&O (post 1/1/98) ultimately determined?

16. Question and Answer Session with Richard Roth, JD, FCAS 5. Besides space issues (22 characters formerly for Allocated Loss Expense and 24 characters formerly for Unallocated Loss Expense) in the annual statement blank heading of Sch P, what was the rational or constraints in selecting new terms? 6. What changes, if any, have there been in the actual implementation of the redefinition from the June 24, 1997 CATF draft on the topic?

17. Question and Answer Session with Richard Roth, JD, FCAS 7. Are you aware of methods insurers have employed to adjust to the change? If so, can you explain? 8. Are you aware of changes, if any, made by ISO and NCCI regarding their definition of ALAE (ALE prior to 1/1/98 and DCC thereafter)? 9. Can you say yet if this change is expense neutral? If not, how has the ALAE/LAE (DCC/DCC + A&O) ratio changed? Would this vary by company?

18. Question and Answer Session with Richard Roth, JD, FCAS 10. Do you think the NAIC change has achieved its objective? 11. Would you ever see the NAIC going back to the pre-January 1st 1998 definitions of LAE? 12. Did anyone study the cost to the insurance industry of implementation of DCC and A&O as compared with traditional ALAE and ULAE?

19. Question and Answer Session with Richard Roth, JD, FCAS 13. Do you know what the NAIC is doing differently with the new data vs. the old data? 14. How is the NAIC monitoring implementation of compliance with DCC and A&O? 15. By the way, has the NAIC ever determined what is a settling agent? (Source: NAIC Draft June 24, 1997).

20. Question and Answer Session with Richard Roth, JD, FCAS 16. Have you learned of insurers or reserving actuaries that are pleased with the change? 17. Do you have any feedback that you would like to provide to the members in attendance at the session on November 14, 2000? Thanks as always for your help on our favorite topic.

21. Exhibit IIRevised Definition of ALAE and ULAE EXAMPLE Coded as ULAE ? (A&O) Coded as ALAE ? (DCC) Salaries of fraud investigators, private investigators, appraisers, hearing representatives and reinspectors. Yes, if working in the capacity of an adjuster. No, if working in defense of a claim. Yes, if working in defense of a claim. No, if working in the capacity of an adjuster. Surveillance Expenses No Yes Fees of Professionals No Yes Salaries and expenses of inside adjusters and fees and expenses of outside adjusters. Yes No Source: NAIC June 24, 1997 Draft and various conversations with Richard J. Roth, Jr. of the California Insurance Department.

22. Exhibit II (cont’d)Revised Definition of ALAE and ULAE EXAMPLE Coded as ULAE ? (A&O) Coded as ALAE ? (DCC) All independent adjuster expenses Yes No All staff adjuster expenses Yes No Attorney fees Yes,for coverage evaluation and litigation between the insurer and insured. (i.e., D.J. costs). Also, Yes, for any adjustment type of activity. Yes, for expenses incurred under the broad duty to defend concept, even if no duty to indemnify. Does not include any adjuster type of expense. (Include an overhead loading). Selected medical cost containment expenses No Yes Source: NAIC June 24, 1997 Draft and various conversations with Richard J. Roth,Jr. of the California Insurance Department.

23. Exhibit II (cont’d)Revised Definition of ALAE and ULAE EXAMPLE Coded as ULAE ? (A&O) Coded as ALAE ? (DCC) Litigation management expenses including legal bill review No Yes Loss adjustment expenses for participation in voluntary and involuntary market pools Yes, if reported by calendar year Yes, if reported by accident year Outside Expert fees (accountants, physicians, engineers, architects, etc.) No Yes Inside Expert fees No Yes Claim adjuster expenses Yes No Source: NAIC June 24, 1997 Draft and various conversations with Richard J. Roth,Jr. of the California Insurance Department.

24. Exhibit II (cont’d)Revised Definition of ALAE and ULAE Coded as ULAE ? (A&O) EXAMPLE Coded as ALAE ? (DCC) Internal or external defense and litigation No Yes Medical cost containment expenses Yes No Usual Adjuster Expense Yes No Unusual Adjuster Expense No Yes Expenses not cited above Yes Yes Source: NAIC June 24, 1997 Draft and various conversations with Richard J. Roth,Jr. of the California Insurance Department.

27. Considerations of LAE • NAIC • ISO • NCCI • State Bureaus • GAAP • Operational - Allocating expenses to their source makes good economics and is proper cost accounting, regardless of the regulatory requirement.

28. Exhibit III-Pre/Post Observations NEW ALAE/ULAE (Practice) OLD ALAE/ULAE (Practice) ALAE Inside Legal ALAE ULAE ULAE Outside Adjusters ULAE Inside Legal ALAE Outside Adjusters • = Overlap Other Expenses • = Overlap

29. Exhibit IVOther Benefits of the Change: An Increase in Demand for Casualty Actuaries Price S1* P2 P1 D2 D1 Quantity Demanded Q1 Q2

30. Exhibit V - Net ONE EXAMPLE OLD NEW NET Change to ALAE ALAE ALAE as % of LAE Inside Legal Mostly Out In + Loading + X % Factor Independent Mostly In Out - y % Adjuster Net + if x% > y% - if x%< y% no ^ if x%=y%

31. Analytic Geometry of Two Dimensions EXAMPLE Month of Development ACC YR Year 12 24 36 48 60 72 84 96 108 x1 X X X X X X X X X x2 X X X X X X X X x3 X X X X X X X x4 X X X X X X x5 X X X X X x6 X X X X x7 X X X x8 X X x9 X Month of Development Year 12 24 48 60 72 84 96 108 x1 X X X X X X X X x2 X X X X X X X x3 X X X X X X x4 X X X X X x5 X X X X x6 X X X x7 X X x8 X X x9 X ACC YR 2 Triangles =

32. = 1 Claims File EXAMPLE • If one can do triangles, with double the effort, one can do rectangles (the claims file). Year 1 24 36 48 60 72 84 96 108 x1 X X X X X X X X X x2 X X X X X X X X x3 X X X X X X X x4 X X X X X X x5 X X X X X x6 X X X X x7 X X X x8 X X x9 X Year 1 24 36 48 60 72 84 96 108 x1 X X X X X X X X X x2 X X X X X X X X x3 X X X X X X X x4 X X X X X X x5 X X X X X x6 X X X X x7 X X X x8 X X x9 X

33. Economic Benefits of Transforming Traditional ULAE into ALAE • Proper Analysis of Profitability • Reinsurance Recoverables • Agents’ Contingent Commissions • Additional Premiums via Loss-Sensitive Insurance Programs • Subrogation and Salvage Actions See The Claims Magic Show Article

34. LAE Trend X X =? Confusion Sept. 11, 2001 11:00 AM ~ ~ Actuarial ACAS FCAS 1997 1998 1999 2000Student Time

35. Next Speaker ... “This new definition of ALAE/ULAE is not retroactive. However, prospectively the change could be implemented on a calendar year or an accident year basis. On a calendar year basis, the expenses in the new and older accident years have the new definition as they develop in the loss and expense triangles. On an accident year basis, the expenses in the new accident years have the new definition and the expenses in the older accident years have the old definition. It is optional to the company which way to do it. There is a split among companies as to which is easier. The actuary should be able to handle either way as long as it is known which choice was made.” Source: NAIC

36. “The email version of this discussion for the CAS topic NAIC Redefinitions of LAE could not include various hard copy attachments that the speaker had included in the handout. If you wish to have these attachments please contact Richard Carris at Ernst & Young LLP, phone (212) 773-1215, or email him at richard.carris@ey.com.

37. Resume

38. Richard Carris, CPCU, CLU, CFE, CIPA, APA, ARM, AICErnst & Young LLP - 787 Seventh AvenueNew York, New York 10019 • Richard Carris has more than 20 years of property/casualty experience in the areas of claims, premium auditing, risk management and surety operations. Mr. Carris has been with Ernst & Young for 10 years and is based in the firm’s New York City office. He has worked extensively in most areas of property and casualty insurance claims, has experience with auditing the variable exposure base of various insurance products and has structured and reviewed dozens of large construction wrap-ups with a construction value combined of over $50 billion. • Prior to becoming an insurance claims and risk management consultant, Mr. Carris had varied experience in claims and claim management positions at a major property & casualty insurance company. These functions included experience and oversight with the claim phases of investigation, evaluation, negotiation and settlement. While with Ernst & Young for the past decade, Mr. Carris has reviewed thousands of claims in the areas of workers’ compensation, general, professional and automobile liabilities, automobile physical damage, property & business interruption and surety lines of business. Mr. Carris has developed subrogation benchmarks for various lines of business that have become P/C industry standards for the measurement of the effectiveness of an insurance company’s recovery program. • In addition to his property and casualty claims experience, Mr. Carris has experience in commercial lines brokerage with a national insurance broker and was a risk management consultant for four years with an international Engineering & Construction (“E&C”) firm. • Mr. Carris holds a Bachelor of Science degree in Economics from the University of Florida (1979) and a M.B.A. degree in Finance from Pace University (1987). Mr. Carris also holds the following professional designations: Chartered Property Casualty Underwriter (CPCU), Chartered Life Underwriter (CLU), Certified Fraud Examiner (CFE), Certified Insurance Premium Auditor (CIPA), Associate in Premium Auditing (APA), Associate in Claims (AIC) and Associate in Risk Management (ARM). • Mr. Carris is a member of the professional societies of CPCU, CLU, ChFC, CFE, NSIPA (National Society of Insurance Premium Auditors) and NASP (National Association of Subrogation Professionals). He has served for ten years as an Editorial Advisory Board Member for Risk Management magazine reviewing risk management and claim articles for publication consideration. • Mr. Carris was an Adjunct Professor of Insurance Economics for several years teaching the Part 9 CPCU course at Baruch College – City University of New York and The College of Insurance located in NYC.

39. Richard Carris, CPCU, CLU, CFE, CIPA, APA, ARM, AICErnst & Young LLP - 787 Seventh AvenueNew York, New York 10019 Risk Management Articles • The Mathematics of Retros”, The CPCU Journal, March 1993  • “Wrap-Ups Can Save on Construction Costs,” Contractor Briefing, Fall 1996 • “Controlling Construction Insurance Costs”, Ernst & Young Contractor Briefing, January 1992 • “Wrap-Up Premium Auditing,” Construction Risk Management, October, 1998 • “Partnering in a Complex Environment,” Risk Management, March 1997 • “Carris Corner,” Monthly Risk Management Column – Managing Risk for Loss Prevention and Cost Control • “National Compensation Survey of Risk Management Professionals,” Ernst & Young LLP, 1993 • “Workers’ Compensation Insurance Cost Control, Construction Insurance, Bonding, and RiskManagement, McGraw-Hill Companies, 1996 International Insurance Articles • “Insurers Are Not ART Lovers”, Global Reinsurance, January 1996 • “A Force to Contend With”, Ernst & Young Insurance Executive Report, Fall 1994 • “The Production Possibilities Curve and International Insurance,” CPCU Journal, 6/90 • “When Will the Walls Come Down?,” Ernst & Young Insurance Executive Report, Spring93 • “Global Flow of Insurance Premium,” Risk Management, October, 1995 • “New Zealand: Down Under But Out in Front,” Ernst & Young Insurance Executive Report, Summer 1997.

40. Richard Carris, CPCU, CLU, CFE, CIPA, APA, ARM, AICErnst & Young LLP - 787 Seventh AvenueNew York, New York 10019 Underwriting Articles • “Underwriting Expenses: Would You Get a Passing Grade?,” E&YInsurance Executive Report, ‘95 • “The Premium Fraud Card Game,” Ernst & Young Insurance Executive Report, Winter 1998 Insurance Claims Fraud and Claims Management Articles • “Unmasking Insurance Fraud,” Ernst & Young Insurance Executive Report, Spring 1994 • “Using Databases to Combat Insurance Fraud,”San Francisco Business, February 25, 1994 • “Insurers Can Be Smarter in the Fight Against Fraud,” North Carolina Business Journal, August 15, 1994 • “Mobilizing Against Insurance Fraud,” Rochester Business Journal, April, 1994 • “Insurance Fraud and the Industry Response,” CPCU Journal, Summer 1997. • “The Adventures of Subroman”, Ernst & Young Insurance Executive Report, Spring 1995 • “The Claims Gold Rush,” Ernst & Young Insurance Executive Report, Fall 1994 • “Digging for Gold In Claims Departments,” Best’s Review, January, 1995 • “Benchmarking Claims Performance,” Risk Management, December 1994 • “Claims Worst Practices,” Risk Management, December 1995 • “The Runaway Claims Train,” Ernst & Young Insurance Executive Report, Summer 1996 • “The Claims Magic Show,” Ernst & Young Insurance Executive Report, Spring 1997. • “2025: A Claims Odyssey,” Insurance Executive, Winter ‘98 • “Benchmarking Subrogation Performance,” NASP Subrogator, Fall 2000