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

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 How You Can Help

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

A View to A Cycle

A View to A Cycle

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

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

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

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

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

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

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”

The Model – Casual(ty) Loop Diagram

The Model – Structures

The Model – Structures

The Model – Structures

The Model – Structures

The Model – Structures

The Model – Structures

The Model – Structures

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

The Model – PID Control

The Model – PID Control

The Model – PID Control

The Model – Behavior Displays Decaying Oscillation to Step Input

The Model – Casual(ty) Loop Diagram

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

The Model – Casual(ty) Loop Diagram

The Model – Behavior Loop Gain Very Important

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