Casualty Loss Reserve Seminar September 2004

1. Casualty Loss Reserve Seminar September 2004 Solvency Surveillance- What is Working and What is Not Ron Dahlquist, FCAS, MAAA California Dept. of Insurance

2. What isn’t working: The Actuarial Opinion • Actuarial Opinions and supporting reports least reliable when company is in financial difficulty • Multiple insolvencies of CA WC specialty companies • Companies with excessive exposure to construction defect claims • Some multiple lines carriers • Great majority of all insolvent or impaired companies (and all of the insolvent CA WC specialty companies) had clean actuarial opinions at previous year end • Only one company I can recall that self-identified an insolvency to CDI • Reserve deficiencies the proximate cause of nearly all recent insolvencies • Insurance Department examiners, financial analysts cannot rely on actuarial opinions to identify inadequately reserved companies • Actuarial opinions don’t provide comfort that apparently healthy companies are truly healthy

3. Support for Actuarial Opinions • Actuarial Reports supporting Opinions characterized by (overly) optimistic assumptions • Examples: • California Workers Compensation • Bornhuetter-Ferguson application, with new and discontinued programs • Problem areas, e.g. construction defect

4. Support for Actuarial Opinions-California Workers Compensation (1) • Characteristics of CA WC experience, development statistics: • Severe medical inflation • Marked, long-term slowdown in settlement rates • Marked, long-term upward trend in age-to-age development patterns (both paid and incurred)

5. Support for Actuarial Opinions-California Workers Compensation(2) • Actuarial Opinion analyses: • Ignore incurred development method, citing apparent reserve strengthening • Do not adequately test reserve strengthening assumption • Do not perform Berquist-Sherman adjustment for change in case reserve adequacy • Rely on paid development method (almost) exclusively • Do not test settlement rate for changes • Do not perform Berquist-Sherman adjustment for change in settlement rate, citing prevalence of partial payments • Do not make alternative adjustments to treat problem • Use three-year averages of age-to-age factors, or longer-term averages, despite strong upward trend in actual age-to-age factors • Cite expectations that development must moderate on its own (it can’t stay high forever) • Ignore causal links to closing rate, high inflation

6. California Workers Compensation (3)WCIRB Pure Premium Rate Analysis Track Record • Analysis more aggressive than Appointed Actuaries rendering opinions on subsequently insolvent companies • Relied exclusively on paid development method • Trended loss development factors • Trending used for last several filings • Seen as aggressive • Past estimates of ultimate loss have proven to be far short of subsequent estimates • Recent estimates show less adverse development

9. Characteristics of CA WC Experience

10. Characteristics of CA WC Experience

11. California Workers CompensationConclusions • Trending the medical development factors was the right thing to do in last year’s analysis • Paid loss development factors continue to increase • Closing rate continues to decline- with possible exception of AY 2003 • Choice of three-year (or longer) average factors: • Appears to have been overly optimistic last year • Still appears to be overly optimistic for pre-reform analyses • No apparent support for assumption that development will revert to older, lower levels without effects of reforms • Incurred development method should be given weight; paid development can’t seem to catch up

12. Bornhuetter-Ferguson Expected Loss Ratios • We have seen the following: • Credit given to company “improvements” in operations, without solid evidence to back up assumptions • Optimistic trends assumed • Optimistic development assumptions used • Too much weight given to immature years, which may not be appropriately developed • Too little weight given to more mature years • Adverse experience in some years discounted • Adverse experience in similar programs discounted

13. Problem Segments of Business • Failure to identify, isolate, and separately analyze problem segments (i.e. construction defect) has been the apparent cause of several insolvencies • Proper questioning of underwriting and claims personnel can usually identify these • Failure of due diligence • Some companies better than others at this

14. Observations and Conclusions • My personal opinion: • In situations of potential financial difficulty, actuarial opinions and supporting reports usually give impression that Appointed Actuary has taken role of company advocate rather than impartial estimator of company’s reserve adequacy • Emphasis seems to be on presenting reasons why reserves could be reasonable, rather than on what an appropriate reserve level would be • This becomes an obstacle for the regulator to overcome, not an aid to evaluating companies • This has implications for the value of the Actuarial Opinion and the public perception of the profession

15. Signs of Advocacy • Analyses are not conservative • Reasons for fiscal conservatism: • Time needed for results to be known • Surprises tend to be adverse rather than favorable • cost of underestimation not the same as cost of overestimation- delays or prevents corrective action • Analyses don’t make proper use of available methods • Provide rationales why methods that yield higher estimates may be distorted- yet don’t apply standard adjustments to remove distortions • Provide rationales why methods that yield lower estimates, but are clearly distorted, may apply- again, don’t apply standard adjustments or adjust in any way • Analyses don’t seem to react to consistent pattern of underestimation • Methods should be made more responsive to current conditions in this case • We see this responsiveness in ratemaking analyses but not in reserving

16. Successes • Internal financial modeling has provided early identification of some problem companies • Skeptical internal approach has also provided early identification and led to close monitoring • This has reduced the cost of some insolvencies, may have prevented others • Flexible approach to troubled companies has allowed: • Some to obtain outside capital or be acquired • others to transfer books of business and go into orderly runoff • Has avoided some insolvencies, reduced the costs of others