2. THE INCREDIBLE SHRINKING RESIDUAL MARKET Session: WCP/PA-37 Presented by: Tom Daley, ACAS, MAAA, NCCI John Winkleman, Jr., FCAS, AIPSO Richard Amundson, FCAS, MN DOC

3. © 2000 National Council on Compensation Insurance, Inc. WORKERS COMPENSATION Presented By: Tom Daley

4. © 2000 National Council on Compensation Insurance, Inc. OUTLINE Historical Perspective How did it get so large? Impact on the marketplace What caused the shrinkage? Ratemaking implications How will we keep it from growing again?

5. ® © 2000 National Council on Compensation Insurance, Inc. RESIDUAL MARKET ESTIMATED ULTIMATE PREMIUMS AS OF 9/30/1999 * Excludes Maine Residual Market Pool

6. © 2000 National Council on Compensation Insurance, Inc. HOW DID IT GROW SO LARGE? Inadequate rates Poor underwriting results Overly generous benefits Lack of cost containment Excessive fraud

7. ® © 2000 National Council on Compensation Insurance, Inc. RESIDUAL MARKET UNDERWRITING GAIN/LOSS AS OF 9/30/1999 * Excluding Maine ** Excluding Maine and New Mexico # Excluding New Mexico

8. © 2000 National Council on Compensation Insurance, Inc. IMPACT ON THE MARKETPLACE Carriers stop writing WC AR plans grow Rates increase Employers costs rise Movement towards self-insurance

9. © 2000 National Council on Compensation Insurance, Inc. WHAT CAUSED THE SHRINKAGE? Residual Market pricing programs Reform at all levels New state funds Residual Market reform Increased competition/capacity

10. © 2000 National Council on Compensation Insurance, Inc. WHAT CAUSED THE SHRINKAGE Residual Market pricing programs: Produced additional premium ARAP, Differentials, Surcharges Removal of premium discounts Other programs: Take-out credit program Safety incentive programs

11. © 2000 National Council on Compensation Insurance, Inc. WHAT CAUSED THE SHRINKAGE? Creation of New State Funds 1992LA, RI 1993ME 1994FL (JUA) 1995KY, MO 1997HI

12. © 2000 National Council on Compensation Insurance, Inc. WHAT CAUSED THE SHRINKAGE? Reform at all levels: Employers:  Increased safety awareness  Embraced RTW programs Regulators:  Tightened up statutes governing benefits  Reduced attorney involvement Insurers:  Better loss control  Improved claims management  Increased penetration of managed care

13. © 2000 National Council on Compensation Insurance, Inc. WHAT CAUSED THE SHRINKAGE? Residual Market Reform: Direct assignment option available Servicing Carrier bid process Contributed to reduced underwriting losses

14. ® © 2000 National Council on Compensation Insurance, Inc. RESIDUAL MARKET COMBINED RATIOS AS OF 9/30/1999 * Excludes Maine Residual Market Pool

15. © 2000 National Council on Compensation Insurance, Inc. NCCI RATEMAKING IN TODAY’S ASSIGNED RISK MARKET Two general approaches for overall indication: 1. Use total market data (most states) 2. Use AR data only (a few states)

16. Residual Market Depopulation Policy Year 93 vs. Policy Year 99 All NCCI States

17. © 2000 National Council on Compensation Insurance, Inc. NCCI ASSIGNED RISK RATEMAKING Biggest challenges facing NCCI: Volatility of assigned risk data Increasing expense provisions as % of premium Maintaining Servicing Carrier capacity Affordability vs. subsidies (break-even pricing)

18. © 2000 National Council on Compensation Insurance, Inc. HOW WILL NCCI KEEP RESIDUAL MARKETS SMALL? Strive for rate adequacy Retain pricing programs in AR market Help prevent erosion to reforms Long term goals: Maintain a target goal of underwriting loss to voluntary premium ratio <1.0% JUA initiative, with National Administration

19. PRIVATE PASSENGER RATEMAKING ASSIGNED RISK John Winkleman, Jr. AIPSO

20. RATEMAKING METHODOLOGY BASED ON SIZE OF PREMIUM  TOTAL PREMIUM < $1.0M  BASED ON COMPARISON TO NON- STD MARKET  TOTAL PREMIUM > $1.0M  BASED ON PROSPECTIVE RATING

24. Residual Market Pricing Richard Amundson CAS Ratemaking Seminar March 9, 2000 San Diego

25. A Paradox An assigned risk plan (ARP) whose rates are suppressed may have stable loss ratios even in the face of inflation. An ARP whose rates increase based on its own experience may fail to improve its loss ratios.

26. An Actuarial Explanation With rates constant, influx of better risks improves ARP’s book of business, offsetting inflation. When rates increase, departure of good risks hurts book, offsetting improvement due to higher rates. If ARP bases prices on its own experience, use of a contingency factor adds to price of each policy like a profit margin. Best business leaves, driving prices of remaining policies to unaffordable levels.

27. A Second Paradox The voluntary market charges for the same coverages as ARP but in addition charges for profit because of its risk. ARP has no charge for risk. With no contingency factor, ARP has a rate advantage. It can pick up market share, improve its book, and destroy the voluntary market. Maybe ARP should use a contingency factor.

28. What is the truth? Will break-even pricing cause ARP to grow or cause it to shrink? Does ARP need a contingency factor or not? The Scales Fall From Our Eyes Both these scenarios can happen: ARP may grow or ARP may shrink. Break-even pricing is inherently unstable. To achieve goals normally desired, ARP should base rates on voluntary market rates, not on its own experience.

29. A Model of Residual Market Pricing Some assumptions ARP sets prices to break even based on its own experience. ARP’s profit or loss is allocated to the voluntary market. Insurance is mandatory; 2 choices: voluntary or ARP. An insured buys from market with lowest price. Expenses are proportional to loss and will be ignored.

30. An Instructive Example Insurer needs $100 surplus for $200 yr-end loss. Insurer earns 5% risk-free on invested assets. Insurer needs a 15% return on equity. Extreme case 1: ARP has 0 percent market share. Insurer collects $200 in premium, invests it & the $100 of surplus. Insurer earns $15 during the year. Year-end: insurer pays $200, has $100 plus $15 from investments.

31. Extreme case 2: ARP has 100 percent market share.  Insurer has no voluntary premium, but retains responsibility for ARP’s losses.  Insurer still needs $100 in surplus: all the risks that surplus protects against are still around and still borne by insurer.  Insurer has same risk as in case 1, same investment as in case 1, so needs same return. ARP must charge full $200 in order to generate same return. Regardless of ARP market share, the full $100 surplus is needed and the full $200 premium is needed.

33. A Natural Limit: Assigned Risk Must Charge Strictly More Than Market Average L= average expected loss per policy R= ARP price per policy V= voluntary market average price n= total number of insureds m= number of ARP insureds nL= total premium needed mR= premium collected by ARP (n-m)V= premium collected by voluntary market Insurer pricing problem: find premium, V, which attracts customers ( V V  (nL-mR) / (n-m)  nR-mR > nL-mR  nR > nL  R > L If R  L, there is no solution to pricing problem.

34. The Elusive Search For Equilibrium If R > L, what happens when ARP reviews rates? ARP overcharged insureds with expected losses between R’ and R and undercharged insureds with expected losses > R. Net effect is undercharge, but analysis will not necessarily indicate rate increase. ARP doesn’t include profit in its analysis. ARP may charge enough to pay claims: analysis on non-profit basis may show need for rate reduction. Whether analysis will show need for increase or decrease is function of distribution of expected losses. Only sure way to remain in equilibrium is to ignore indications.

35. Table 1 (1)(2)(3)(4)(5)(6) If ARP writes all risks with losses greater than x ------------------------------------------------------------------------------ xP[X = x]voluntaryARP ratevoluntary 1: ARP gains x market rate( for all )market rate-1: ARP loses x for x for x + 1 0: equilibrium ------------------------------------------------------------------------- 20 0.1030.7123.8132.251 21 0.10 25.98 24.29 27.211 22 0.10 25.03 24.76 26.161 23 0.10 25.02 25.24 26.110 24 0.10 25.40 25.71 26.460 25 0.10 25.97 26.19 27.010 26 0.10 26.65 26.67 27.670 27 0.10 27.39 27.14 28.401 28 0.10 28.18 27.62 29.191 29 0.10 29.00 -------- 24.5 = average expected loss = E[X]

36. Figure 2 Market Rates With ARP Pricing To Break Even

37. Table 2 (1)(2)(3)(4)(5)(6) If ARP writes all risks with losses greater than x ------------------------------------------------------------------------------ xP[X = x]voluntaryARP ratevoluntary 1: ARP gains x market rate( for all )market rate-1: ARP loses x for x for x + 1 0: equilibrium ------------------------------------------------------------------------- 20 0.0028429.5723.35451.051 21 0.0095 115.79 23.38 121.301 22 0.0316 47.96 23.46 50.141 23 0.1053 29.86 23.65 31.161 24 0.3508 25.23 24.21 26.281 25 0.3508 25.23 25.14 26.241 26 0.1053 26.06 26.04 27.071 27 0.0316 27.02 26.89 28.021 28 0.0095 28.01 27.62 29.001 29 0.0028 29.00 -------- 24.5 = average expected loss = E[X]

38. Table 3 (1)(2)(3)(4)(5)(6) If ARP writes all risks with losses greater than x ------------------------------------------------------------------------------ xP[X = x]voluntaryARP ratevoluntary 1: ARP gains x market rate( for all )market rate-1: ARP loses x for x for x + 1 0: equilibrium ------------------------------------------------------------------------- 1 0.06463.713.747.420 2 0.1769 2.76 4.17 4.13-1 3 0.2424 3.32 4.79 4.43-1 4 0.2214 4.16 5.52 5.20-1 5 0.1516 5.08 6.32 6.10-1 6 0.0831 6.04 7.16 7.05-1 7 0.0379 7.02 8.02 8.02-1 8 0.0149 8.01 8.85 9.010 9 0.0051 9.00 9.52 10.000 10 0.0021 10.00 -------- 3.74 = average expected loss = E[X]

39. Table 4 (1)(2)(3)(4)(5)(6) If ARP writes all risks with losses greater than x ------------------------------------------------------------------------------ xP[X = x]voluntaryARP ratevoluntary 1: ARP gains x market rate( for all )market rate-1: ARP loses x for x for x + 1 0: equilibrium ------------------------------------------------------------------------- 1 0.54001.122.712.23-1 2 0.2484 2.07 3.66 3.11-1 3 0.1143 3.05 4.61 4.07-1 4 0.0526 4.03 5.56 5.04-1 5 0.0242 5.02 6.49 6.02-1 6 0.0111 6.01 7.40 7.01-1 7 0.0051 7.01 8.26 8.01-1 8 0.0024 8.00 9.01 9.00-1 9 0.0011 9.00 9.52 10.000 10 0.0009 10.00 -------- 1.85 = average expected loss = E[X]

40. How To Set ARP Rates If consensus is in favor of keeping and controlling residual market, break-even pricing is poor tool. Assuming that ARP will exist, that it should not be too burdensome on voluntary market and that it should not have wild swings in market share, then there is a reasonable solution to rate problem: Base ARP rates on industrywide experience, consistently higher than what a typical insurer would need to charge in voluntary market.

41. Setting Specific Goals Guidelines:  Bigger the voluntary market the better.  Residual market should not be unaffordable.  Expected assessment of residual mkt losses on voluntary mkt insureds not excessive.  Rate changes should not be abrupt.

42. Possible goals for residual market:  Market share under 1%.  Rates under 150% of voluntary.  Expected assessment under 0.5%.  Annual rate changes < 10% (relative to voluntary market) during catch-up period. Using Goals To Set Prices Residual market can set prices as multiple of voluntary market and measure success directly from goals. Example of Specific Goals

43. Final Thoughts Residual markets don’t usually get into trouble from basing rates on their own experience, but rather from suppressing rates and ignoring the effects. Basing ARP rates directly on ARP experience may seem the obvious solution to such a problem, but it is an unreliable solution. A better solution is to base the rates on the overall market experience, at a level consistently above the rest of the market.