1. Cycles In Casualty: Balancing Loops in the Insurance Industry
Kawika Pierson
MIT Sloan PhD Candidate

2. Presentation Outline The Insurance Industry Past Research The Model
Economics
Control Theory
System Dynamics
The Model
Boundary
Causal Loop Diagram
Important Structures
PID Control
Behavior
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3. The Insurance Industry
Basic Idea
Two Sides to the Business
Insurance
Investing
Insurance Cycle – What is Cycling?
Underwriting Loss Ratio or Combined Loss Ratio
Loss Ratio – Adjustments/Premiums
Expense Ratio – Expenses/Premiums
Combined Ratio – Loss + Expense = (A + E) / P

4. A View to A Cycle

5. A View to A Cycle

6. The Insurance Industry
Insurance Cycle – What Causes It?
Industry View:
“The next stage is precipitated by a catastrophe or similar significant loss, for example Hurricane Andrew or the attacks on the World Trade Center.” – “The Insurance Cycle” wikipedia
Academic View:
“Using quarterly data from 1974 through 1990, we provide evidence of a long-run link between the general economy and the underwriting performance as measured by the combined ratio.” – Grace and Hotchkiss, 1995 J o Risk and Insurance
“Fluctuations in the supply of property-liability insurance may be exacerbated by regulation.” Winter, 1991 Economic Inquiry

7. Past Research in Economics
Early 1980’s through Mid 90’s
Three Main Schools of Thought
Cycle Caused by Interest Rate Fluctuations
Doherty and Kang (1988) – Insurance Prices Change in Lagged Response to Interest Rates
Grace and Hotchkiss (1995) – “External Impacts on the Property-Liability Insurance Cycle”
Cycle Caused by Limits to the Supply of Insurance
Winter (1988, 1991, 1994), Gron (1989, 1994)
Cycle Caused by Feedback Processes
Brockett and Witt (1982) – Loss expectations from the past inform current premiums, causing autocorrelation

8. Past Research in Control Theory
If a Cycle Exists we Will Create a Lagged Negative Feedback Loop to Explain It
Balzer and Benjamin 1980 – “Dynamic Response of Insurance Systems with Delayed Profit/Loss Sharing Feedback…” Journal of the Institute of Actuaries
Zimbidis and Haberman 2001 – “The Combined Effect of Delay and Feedback on the Insurance Pricing Process: a Control Theory Approach” Insurance: Mathematics and Economics

9. Past Research in System Dynamics
The Claims Game and Hanover Insurance
“claims management, quality and costs”
Quality = Claim Adjustment Quality
Daniel H. Kim
Learning Laboratories
Peter Senge – “The Fifth Discipline”
Moissis 1989 Masters Thesis (Sterman)
Focuses on Determining Decision Rules
Cavaleri and Sterman (1997) “Towards evaluation of systems thinking interventions: a case study”
Improved Manager’s Mental Models

10. Past Research in System Dynamics
Insurance Cycle…
Are There Really no SD Articles on the Insurance Cycle?
Thomas Beck
Co-President of Swiss SD Society
Works for Large Swiss Reinsurer
No Published Articles on Insurance Cycle

11. The Model – Boundary Endogenous Variables Exogenous Variables Premiums
Underwriting Quality (Risk)
Claims
Employees
Administrative Costs
Exogenous Variables
Desired Profit Margin
Size of the Total Market
Some Components of Administrative Costs

12. The Model – Boundary Many Feedbacks Excluded
Size of the Insurance Market
Investments and Interest Rates
Free Capital’s Influence on Underwriting
Effect of Time Pressure on Claim Settlement
Competitive Effects on Profit Margins
Random Claim Incidence
Employee Productivity
Is this Too Far Towards “Negative Loop w/ Delay”

13. The Model – Casual(ty) Loop Diagram

14. The Model – Structures

15. The Model – Structures

16. The Model – Structures

17. The Model – Structures

18. The Model – Structures

19. The Model – Structures

20. The Model – Structures

21. The Model – PID Control Translating Equations to SD isn’t Always Easy
Proportional Control = Standard Structure
Integral Control = No Steady State Error
Reasonable that People Use IC
Derivative Control = Less Overshoot
Less Likely that People Use DC

22. The Model – PID Control

23. The Model – PID Control

24. The Model – PID Control

26. The Model – Behavior
Displays Decaying Oscillation to Step Input

27. The Model – Casual(ty) Loop Diagram

28. The Model – Behavior
Instability A Function of Largest Source of Costs

29. The Model – Casual(ty) Loop Diagram

30. The Model – Behavior
Loop Gain Very Important

31. The Model – Potential Solutions
Derivative Control of Premiums?
Careful Tuning Is Necessary
Managerial Implementation
Industry Wide Application
Why Do Quality Standards Change?
Can This Loop Be Cut
Life Insurance
The Kalmanuclear Option?
Optimal LINEAR Filter
Just Build a Really Good Model Instead