1. CARe Meeting Pricing Excess US Workers Compensation July 16, 2007 Jose Couret London Underwriting Center

2. 1 Outline  Terminology  Exposure Rating  Experience Rating  Impact of Benefit Changes  Questions

3. Terminology

4. 3 Terminology Workers Compensation  Workers Compensation Policy –Coverage A Workers Compensation –Coverage B Employers Liability  Workers compensation coverage is statutory; benefits are unlimited.  Employers Liability Losses generally make up less than 1% of the loss dollars (excluding F-classes and Maritime Classes). –Not separately rated –Limited, but increased limits available

5. 4 Terminology State Versus Federal Benefits  Benefits are state-specific; however, some classes are subject to the Federal Act.  “F-Class”: longshoremen, harbor workers, etc.  http://www.dol.gov/esa/owcp/dlhwc/lstable.htm http://www.dol.gov/esa/owcp/dlhwc/lstable.htm  Federal benefits tend to be higher –Maximum weekly indemnity benefit is higher for F classes. –Currently, wage replacement is capped at $1,114.44 /week –Wages relatively high  Federal benefits subject to escalation  Ratio of loss assessments to pure loss is much higher. –Important if assessments are part of UNL  Other acts: Merchant Marine Act (Jones Act) / FELA, FECA

6. 5 Terminology Premium  Manual Premium=Payroll in Hundreds x Manual Rate –Exceptions (e.g. per capita classes)  Standard Premium includes experience modification but is prior to the application of adjustments such as retrospective rating plan adjustments, schedule rating, and premium discounts. –Note: Unit Statistical Plan definition may vary.  Net Premium is used to refer to the premium actually charged – as opposed to the manual premium or modified premium. Does not mean net of reinsurance in this context.  “Industry rate changes” sometimes refer to changes in bureau rates or standard premium. During a soft market the “industry rate changes” may be flat while actual prices are plummeting.

7. 6 Terminology Premium On-Level Factor Net Premium On-Level Factor (AY) = Standard Premium On-Level Factor (AY) x Ratio of Net to Standard (Future) / by Ratio of Net to Standard (AY)

8. Exposure Rating

9. 8 Exposure Rating Discussion  Exposure rating is essentially a two-step process –step 1: come up with a ground-up loss ratio or loss by state and hazard group –step 2: allocate ground-up expected losses by layer  Within a given state, the manual rates are grossed up to the same permissible loss ratio—so the expected loss ratio (to manual premium) is state-specific, not hazard group specific.  The percent allocation of loss by layer varies by HG, the more severe hazard groups having the higher excess loss costs.  Rating bureaus provide excess loss factors that specify the percent of ground-up loss in excess of a given percentage. –NCCI (20K/year) –WCIRBonline.org (California)  LERs –Other Independent Rating Bureaus

10. 9 Exposure Rating Useful Data Sources (NCCI)  Annual Statistical Bulletin –Must have!  NCCI Calendar-Accident Year Underwriting Results (by State) –Free download at NCCI.com –Latest accident year now available is 2005 –Source of default loss ratios by state  Need to adjust for subsequent rate level changes and trend  NCCI State Advisory Forum Presentations –Free downloads at NCCI.com –Great source of rate adequacy information –“crucial information with workers compensation system stakeholders”  NCCI “Status of Rate Revision” –$500/year –Latest bureau rate level information for NCCI states

11. 10 Exposure Rating Discussion  A key element of the excess percentage is the frequency of loss by injury type. Fatalities and permanent disabilities cost more than other injury types; so when they have high relative frequency, more of the claims cost arises from large losses.  Relative Frequency = claim count for the injury type divided by the claim count for temporary total.  Relative frequency for the more serious injury types should increase as one moves from a lower hazard group to a higher hazard group. –Fatal –Permanent Total –Major Permanent Partial

12. 11 Exposure Rating An ELF is a Weighted Average of the ELFs by Injury Type

13. 12 Exposure Rating Variation in Excess Loss Costs – Within and Between Hazard Groups Sample State, $4m XS $1M

14. 13 Exposure Rating Rating by Class Versus Rating by Hazard Group  Hazard group approach accurate for most treaty business, since most books are sufficiently diversified within hazard groups.  Hazard group approach is probably not sufficiently refined for facultative pricing or specialty books.

15. 14 Exposure Rating Use of Payroll in Exposure Rating  Are ground-up loss ratio picks reasonable?  Rates/Loss Costs for NCCI states are available in electronic format. –Cost for non-affiliates is $22K/year –Available (free) for many independent states on bureau web sites. –Also available through SilverPlume  Apply bureau loss cost rates to account’s payroll distribution by state and class. – Result should be consistent with loss ratio assumption. –Bureau loss cost rates typically are not pure loss –include allocated and unallocated loss adjustment expense and, sometimes, loss-based assessments.  Use of payroll weights as a proxy for expected loss weights in exposure rating understates excess loss costs since the average rate increases with hazard group.

16. 15 Exposure Rating Maximum Any One Live (MAOL)  Overwhelming majority of serious workers compensation occurrences involve a single claimant.  Bureau statistical plans collect data on multi-claim occurrences impacting the same policy. Do not pick up clash between different policies that may be in the reinsurance treaty.  Surprisingly little difference between bureau per claim and per occurrence excess loss factors. Not intended to incorporate terrorism or certain “non-ratable” exposures.  Construction classes have higher incidence of multi-claim occurrences (anecdotal).  What fraction of the $5M XS $5M layer loss is eliminated by a $5M MAOL?

17. 16 Exposure Rating Miscellaneous  Coding of premium to “governing class” (the class with the most payroll) may distort exposure rating. –A single policy may have exposure in multiple classes. –Should be manual or standard premium by state and class  Excess Loss Factors are produced by rating bureaus for Retrospective Rating, not reinsurance pricing. –Non-ratable classes with catastrophic experience not assigned a hazard group. –Example: 0766 is non-ratable component of 4766 “EXPLOSIVES OR AMMUNITION MFG.”  Ratio of ALAE to loss should reflect company experience.  California bureau (WCIRB.com) plan has nine hazard groups. A mapping to four hazard groups is available; however, these are NOT equivalent to NCCI hazard groups.

18. Experience Rating

19. 18 Experience Rating Excess Loss Reporting Patterns  Key driver: company case reserving practices with respect to medical inflation –Do medical case reserves incorporate a medical inflation assumption? –Company discounting practice  Does the company have a Catastrophic Claims Unit?  Practice of settling fatal claims at present value reduces exposure in excess layers.  Fatal and pt claims close for less than the carried reserve even if reserves are inadequate.

20. 19 Experience Rating Ratio of Undiscounted to Discounted Annuities

21. 20 Experience Rating Excess Loss Reporting Patterns  At the May 11, 2007 AIS Research Workshop, NCCI released a study of excess loss and claim count reporting patterns based on Call 31.  https://www.ncci.com/ncci/media/pdf/AIS_2007_Excess_Loss_Develop ment.pdf https://www.ncci.com/ncci/media/pdf/AIS_2007_Excess_Loss_Develop ment.pdf  https://www.ncci.com/ncci/media/pdf/AIS_2007_WC_Appendix.pdf https://www.ncci.com/ncci/media/pdf/AIS_2007_WC_Appendix.pdf  Statutory excess of various attachment points.  Can be used in combination with ELFs to derive development patterns for limited layers: Layer LDF = (ELF@AP – ELF@(AP+L)) ) (ELF@AP/LDF@AP - ELF@(AP+L)/LDF@(AP+L)  Easy to build a spreadsheet tool to derive patterns for any layer.

22. 21 Experience Rating Excess Loss Reporting Patterns  Consider a layer with attachment point AP and Limit L.  The reporting pattern for statutory XS AP is a weighted average of the patterns for : 1. L XS AP 2.Statutory XS (AP +L)  Question: What if the average report lag for Statutory XS (AP +L) is shorter than that for L XS AP? (This seems to be the case in NCCI’s study.)  Answer: The average report lag for the layer L XS AP will be greater than that for Statutory XS AP  Illustration (fictitious numbers): AP=2M, L=1M –Statutory XS 2M  Report lag =7 years  ELF=7% –Statutory XS 3M  Report lag =6 years  ELF=5% –1M XS 2M  Report lag=(7% x7 – 5% x 6)/(7% - 5%) =9.5 years  ELF=2% –

23. 22 Experience Rating Speculation on Excess Development Patterns  Perhaps, the loss potential of very large claims, the kinds of claims likely to breach a $3M layer, is to some extent recognized early on. –Characterized by catastrophic medical costs  Other claims eventually –over a long period of time – creep their way into excess layers. – Not characterized by catastrophic medical costs or potential not recognized –Excess development driven in part by unwinding of the discount. –Such claims would perhaps eventually make it to $1M, but not $3M.  The report lag for the lower layer would be lengthened by these slow developing claims – but not the higher layer.  Unfortunately, development to a 22 nd report not available below $2M.

24. 23 Experience Rating Large Loss Severity Trend  Using ground-up severity trends as a proxy for “large loss” trend in experience rating seemingly has an upward bias. –NCCI estimates that differential frequency trend accounted for perhaps 2%-3% of the trend in the average cost per case. –For a discussion of this effect, see NCCI’s 2006 State of the Line Report.  In many states, indemnity benefits for PT and Fatal do not escalate. –Should consider changes in the maximum weekly benefit over the trend period.  Is inflation on attendant care more like wage inflation than medical inflation?  Second Injury Funds

25. 24 Experience Rating Large Loss Severity Trend In the above illustration, ground-up trend of 6.47% overstates the “true” large loss trend of 5%. The effect results from differential frequency trend by injury type. NOTE: For illustration only, not based on real data.

26. Impact of Benefit Changes on Shape of Size-of-Loss Distribution

27. 26 Impact of Law Amendment Factors Ground-Up Versus Excess  Law amendment factors are used to adjust historical losses to prospective benefit levels. Since rating bureaus derive these factors to estimate the impact on ground-up loss costs of a law change, we must be extremely careful when we apply these factors – sometimes unknowingly --in pricing excess business.  For example, some law amendment factors reflect a shift of losses from one injury "bucket" to another. For example, a law that restricts access to permanent total benefits by tightening the definition of "permanent total" will have the effect of shifting claims from the permanent total category to the less generous major permanent partial category. –The expected dollars of pt loss will decrease significantly as a result of such a law change while the dollars of major permanent partial indemnity loss will increase by some less-than-offsetting amount. –Overall, there will be a decrease.  It is appropriate to apply such law amendment factors to ground-up losses in pricing proportional business but perhaps incorrect for non-proportional business.

28. 27 Impact of Law Amendment Factors Ground-Up Versus Excess (Illustration)  Before Law Change –100 pt cases with an average severity of $1,000,000. –Of these, 20 were borderline pt cases with an average severity of $400,000. –The remaining 80 claims had an average severity of $1,150,000. (1,000,000 =.2 x 400,000 +.8 x 1,150,000) –700 major permanent partial cases with an average severity of $200,000.  Effect of the Law Change –Shifts the 20 borderline pt claims to major pp. –The average severity for the 20 claims will be $300,000 under the less generous pp benefits.

29. 28 Impact of Law Amendment Factors Ground-Up Versus Excess (Illustration)  The number of pt claims drops 20%.  The average severity for pt claims increases from $1,000,000 to $1,150,000 (+15%).  The dollars of PT loss decreases by 8%, from $100,000,000 to $92,000,000.  The number of major pp claims increases by 20 claims (about 2.9%).  The average severity for major pp claims increases by 1.4% (to $202,778)  The dollars of major pp loss increase by $6,000,000.  Overall, losses are decreased by $2,000,000 due to the law change.  There may be no effect excess of $1,000,000.

30. 29 Impact of Law Amendment Factors Conclusion  Reinsurers who best predict the differential impact of law changes by layer will have a competitive advantage.  Sources for Information on Law Amendment Factors –Annual Statistical Bulletin (ASB) –WCIRB has extensive information. –Other rating bureaus  GOOGLE

31. Questions