Understanding Discounting and Risk Adjustment in Property/Casualty Claim Liabilities

1. Casualty Actuarial SocietyPractical discounting and risk adjustment issuesrelating to property/casualty claim liabilitiesResearch conducted by PricewaterhouseCoopersPresented by Sam Gutterman, FCAS, FSA, MAAAIASB Board – February 15, 2005PwCPwC

2. Outline • Project objectives & specifications • Measurement approaches • Findings • Significant issues

3. Research objectives • Given a set of fair value principles, evaluate the effect of discounting and risk adjustment on loss and loss adjustment expense (LAE) claim liabilities of US property/casualty insurance companies • Identify significant issues associated with discounting and risk adjustment in loss and LAE claim liabilities

4. Measurement objectives • Active markets for claim liabilities do not exist • Entity-specific experience was used • Claim liability measurement components • Undiscounted estimate of future payments • Assumed undiscounted losses were estimated appropriately • Discount for time value of money • Margin for risk and uncertainty (“Market Value Margin” / “MVM”) • Did not reflect correlation across lines of business • No adjustment for own credit risk other than in aggregate cost of capital

5. Research specifications • Used publicly available entity-specific loss data only • Schedule P from US regulatory Annual Statements • Lines of business studied • Personal Auto Liability (shorter tail, although in some countries this coverage would be considered long tail) • Workers Compensation (long tail – stable) • Medical Malpractice, claims-made (long tail – volatile) • Evaluated ten companies for each line of business

6. Measurement approaches Liability elements studied and measurement approaches evaluated • Discount factor models • Duration • Matched to yield curve • MVM models • Development (Mack) method using standard deviations • Stochastic simulation using standard deviations • Stochastic simulation using percentile distribution • Return on capital

7. Measurement calibration • Calibrated to the Cost of Capital Method at calendar year-end 2002 • Capital equal to US regulatory minimum Risk Based Capital requirement • 10% target rate of return on capital for each company • Arithmetic average of calibrations for 3 companies • 1 large, 1 medium, 1 small

8. Findings – discounting

9. Findings – discounting • Given a payment pattern, well-defined approaches are available • In general, no significant differences between duration and matching approaches were identified • Discounted results are affected by • Interest rate fluctuations • Shape of the yield curve • Expected payment pattern and tail (time until claim resolution) • Significant uncertainty can be associated with payment patterns • In most cases, will be less than for amount of ultimate losses • Will require additional calculations, but generally not onerous

10. MVM by company (increasing by size)Personal Auto Liability

11. MVM by company (increasing by size)Workers Compensation

12. MVM by method for one company Personal Auto Liability

13. MVM by method for one company Workers Compensation

14. MVM by company for one method Personal Auto Liability

15. MVM by company sizePersonal Auto Liability

16. Discounting & MVM by company Workers Compensation

17. Findings – MVM measurement • Indications for MVMs varied, sometimes significantly • By method, for a given company and year-end • Over time, for a given company and MVM method • The ranking of size of MVMs by method tended to vary over time • No method was consistently the highest nor the lowest • For smaller companies, MVMs tended to be larger (when measured as a percentage of claim liabilities)

18. Findings – effect on claims liabilities • Personal Auto Liability • FV claim liabilities were generally greater than undiscounted/non-risk adjusted claim liabilities • Workers Compensation • FV claim liabilities were generally less than or close to the undiscounted/non-risk adjusted claim liabilities • Medical Malpractice claims-made • We did not consider the results of our testing to be meaningful, as there was too much statistical variation in results • Impact of moving to fair value of claim liabilities tended to be greater (due to larger MVMs) for smaller companies Based on the model calibrations

19. Findings – effect on incurred losses • Current accident year incurred Fair Value losses were generally greater than undiscounted/non-risk adjusted losses • Relativities affected by calibration benchmark applied • Accident year FV liability development benchmark would not be zero • Due to relative changes in discount and MVM • Leveraged effect of changes in claim liability would likely increase volatility of incurred losses

20. Significant issuesModeling measurement • Real data issues • Measures of variation • Releasing constraint of acceptance of booked claim liabilities as expected (unbiased) ultimate amount of losses will affect • Expected payment and claim notification patterns • Variability of experience in relation to expectations • Variation from the tail/prior accident year bucket • Affected by study period, level of aggregation and degree of homogeneity of claims selected • Risk and variation inherent in certain claim liabilities are not be easy to analyze quantitatively (e.g. asbestos and environmental)

21. Significant issuesMVM estimation • Variety of approaches exist, but no single approach currently preferred or accepted • Further professional research, guidance and education needed regarding acceptable methods and calibration procedures for calculating MVMs to obtain consistent and comparable results • Single industry guideline for all lines of business and companies unlikely to be appropriate • Calibration of MVM models • Challenging • Can significantly affect the results

22. Significant issuesFinancial statement presentation • Based on currently available approaches, non-additivity of MVMs requires judgmental allocation among • Accident years • Lines of business • Business units • Accident year development disclosures may be confusing • Development of prior claim liabilities would not necessarily be benchmarked to zero • Component analysis of one-year development of prior year-end claim liabilities quite complicated • Solution might be triangular analysis shown on an undiscounted, non-risk adjusted basis

23. Assessment of P&C actuarial methods