Pricing and reserving in the general insurance industry

Solutions developed in The SAS® System

John Hansen & Christian Larsen, Larsen & Partners Ltd

1. Introduction

The two business solutions presented in this paper have been developed by Larsen&Partners, an independent
Scandinavian actuarial consultancy based in the UK which provides SAS solutions for market leaders in the
Insurance industry.

Most insurance companies have realised that advanced analysis is of crucial importance in optimising profitability
in a highly competitive market. This paper describes in further detail two business solutions, the Actuarial Claims
Reserving System and The Rate Making System. These provide high quality and accurate estimates generated
rapidly using the most up to date computer technology delivered by the SAS Institute. The applications are based
on four SAS packages SAS/BASE® , SAS/STAT® , SAS/GRAPH® and SAS/AF® (FRAME).
The basic issue that the Reserving system addresses is estimation of the future payments concerning claims incurred
in a specific period in the past. The system deals with the following questions:

How many claims have occurred that have not yet been reported to the company ?
What is the claim amount for these claims ?
What is the claim amount concerning claims reported but not settled yet ?
Of what size are the uncertainty/margins regarding these estimates ?

The basic issue that the Rate Making system addresses is optimising the premium rates concerning a specific
portfolio based on the policy and claim file. The system deals with the following problems:

How to create risk analysis and identification of important rating criteria/factors ?

How to identify profit and loss segments of statistical and financial significance ?
How to estimate the net present value (NPV) of a portfolio with a specific rating matrix ?
What is the relationship between price and lapses ?
How to create a Business Plan ?

2. Actuarial Claims Reserving System

This application projects and controls the company's claims reserves. It is a package that allows for a high degree of
customisation to individual companies' requirements. The system can handle the original transaction data directly
without any prior data manipulation such as summarising/triangulation. The advantage is improved cost efficiency,
reduced dependency on resources from the IT department and increased flexibility. Data can be cleaned and claims
capped, excluded or adjusted as required before summarisation/triangulation.

The system includes the best current practice such as a Chain Ladder module as well as more advanced reserving
methods. In addition to the forecasting of a point estimate for the outstanding claims reserve or IBNR-reserve the
package includes calculation of security margins by using Bootstrap technique which is the latest Resampling
method. Consequently margins related to each risk group can be estimated. The system also handles the calculation
of security margins subject to Cross Funding assumptions.

Some basic elements are outlined below:

Data exploration. The system permits the user to explore data by chosen variables and to generate relevant
triangles by, for example, transaction or claim code. In addition the system enables the user to view and subtract or
exclude data, such as large claims or zero-claims.

Triangulation. When the data has been selected, the accident period for which the reserves are to be estimated is
selected. The data is then grouped automatically by accident and development period according to the selected
period unit i.e. month, quarter, half-year or year. The figures can also be calculated on an accumulated basis.
Graphical descriptions and triangles can be printed. An example of a triangle is shown below:

Development Period
ACC. 1 2 3 4 5 6 7 8 9 Observed
PERIOD Payments
1985 83 8 43 43 7 1 185
1986 31 46 60 47 76 9 269
1987 52 71 192 69 68 30 482
1988 5 59 124 139 80 89 497
1989 22 71 142 167 209 610
1990 10 74 126 101 311
1991 24 72 123 219
1992 11 62 72
1993 26 26

The Chain Ladder/Link Ratio method. The Chain Ladder algorithm with the Original Weightings as described in
The Institute of Actuaries Reserving Manual (UK) is the natural starting point. However, other weighting principles
can be selected. The IBNR-Reserve and Outstanding Claims Reserve is immediately projected. The system
calculates the Outstanding Reserve regarding Notified Claims and compares it to the company's current Case
Reserve.
The model assumption can be examined graphically and if necessary the assumption can be refined. Statistics
regarding the stability (or lack of) in the speed of claims handling are calculated and displayed graphically.

The Chain Ladder method can be based on the Number of Claims, The Average Cost per Claim, The Amount Paid
or on the Incurred Claim Amount. The results of a Chain-Ladder analysis are outlined below, showing the
outstanding claims reserves in the lower triangle:

Development Period
ACC. 1 2 3 4 5 6 7 8 9 Observed Total Total
PERIOD Payments Reserve Estimated
Payment
1985 83 8 43 43 7 1 185 0 185
1986 31 46 60 47 76 9 2 269 2 271
1987 52 71 192 69 68 30 15 3 482 18 500
1988 5 59 124 139 80 89 98 18 4 497 120 618
1989 22 71 142 167 209 143 148 28 6 610 325 935
1990 10 74 126 101 97 95 99 19 4 311 313 624
1991 24 72 123 190 127 125 130 24 5 219 601 820
1992 11 62 94 144 96 95 99 19 4 72 550 623
1993 26 112 179 275 184 181 188 35 7 26 1161 1187
ALL 98 502 890 1337 929 887 911 174 37 2671 3091 5762

Using graphical methods, it is easy to see whether this methodology is sufficient or more advanced statistical
techniques should be used.
Advanced Reserving Methods/Stochastic Modelling Methods. The Chain Ladder model involves a parameter for
each accident and development period and the large number of parameters often leads to unstable projections,
especially for the most recent accident periods. Decreasing the number of parameters by introducing families of
run-off distributions such as Exponential Distributions improves the stability and quality of the fit. The Curve
Fitting facilities in the system include Uniform, Beta, Exponential, Gamma/Hoerl, Craighead/Weibull, Extreme
Value and Pareto curves and mixed curves. A further method of decreasing the number of parameters is to
introduce assumptions concerning constant claim inflation and/or seasonal effects. The Bornhuetter-Ferguson
model and more robust Loss-Ratio models are also included in the package. It possible to estimate the parameters in
these advanced models using the NLIN procedure available in SAS/STAT®.

Uncertainty Estimation/Bootstrap. To a certain degree the observations are random. A specific claim is for
example £10.000 but it could also have been £11.000. The Reserve is estimated on the basis of the observations and
therefore the randomness in the observations is inherited by randomness in the estimated reserve. This type of
uncertainty is known as the Estimation Uncertainty. The projected Outstanding Claims Reserve includes no
margins for this randomness and consequently the estimate cannot be described as 'prudent' or 'secure'. However,
using the Bootstrap technique/Resampling, the variability (or distribution) of the reserve is calculated, including
estimates for a 'prudent' and a 'secure' reserve/margin. Furthermore this distribution can be smoothed by curve
fitting. An example is outlined below.
Cross Funding. In practice the variability of the claims reserve for a specific group of business may be less
important to management than the variability in the company's overall claims reserve and often an estimate for the
total reserve including a prudent or sufficient margin is required by the management. The problem is that such
margins are over estimated by using the simple sum of margins. However, under the 'Cross Funding Assumption'
where the outcome of the future amount of payments on different groups of business are independent of each other,
the estimates for the total portfolio can be calculated using a simulation method. Often the total Outstanding Claims
Reserve can be reduced when taking the assumption of independence into consideration. Please find an example
below.

Group of Business Adequate Prudent Prudent Secure Secure

Reserve Reserve Margin Reserve Margin
75% 95%
likelihood likelihood
HOUSEHOLD £2450K £2622K £172K £2889K £439K
LIABILITY £3091K £3518K £427K £4198K £1107K

Total, simple sum £5541K £6140K £599K £7087K £1546K

Total, Cross Funding £5541K £6080K £539K £6623K £1082K

Presentation of results. The system automatically generates Reserving reports and Cross Funding reports for the
management as well as technical actuarial documentation reports. These reports can be modified and designed to
the specific needs of the company. The figure below is a graphical example from a management report:
3. The Rate Making System
The better performing companies in the years ahead will be those who have the best data bases and who combine
traditional underwriting with the new advanced statistical analysis of the data. By omitting the analysis and the
required premium adjustments, companies run the risk of losing profitable policies and attracting the unprofitable
ones.

The system (RMS) has been developed to support the Underwriter, Marketing Department and Actuary in
determining pricing changes in Motor, Building and Contents and other business groups. An additional facility
provides competitor analysis, and the financial consequences of adjusting premium rates can be estimated.

The process of determining accurate premium rates can be a lengthy and cumbersome procedure involving IT
departments, programmers, statisticians and underwriters. The use of RMS dramatically simplifies the process and
the relevant risk analysis can be carried out in a matter of days.
RMS uses the company's claims and policy data to identify profit and loss segments. The significance of the Criteria
and interactions are analysed and the correlation between the Criteria and the risk is quantified. New potential
criteria such as Lifestyle Rating Criteria can be analysed and the effects quantified.
Taking the company's assumption of profit rate and costs into consideration model rates are generated from break
even premiums. The financial consequence of introducing new rates is predicted incorporating price elasticity.
The Business Planning module provides forecasts of Written Premium, Incurred Claims, Expenses, U/W Profit,
Interest and Trading Profit.

3.1 Basic problems in premium calculation

There are three essential problems in connection to premium calculation:

1. randomness in the data

2. the extent to which information concerning the past is applicable when making conclusions about the
future

3. price elasticity

The problem of randomness is a question of defining a suitable statistical model which describes the distribution of
data. The system includes factor models with standard error distributions such as Poisson, Gamma etc. These
models which are implemented using the GENMOD procedure available in SAS/STAT® usually describe the
insurance data adequately. However, the NLIN procedure is used when further limitations on the parameter space
are needed, for example when the claim frequency or average claim is assumed to depend linearly on the policy
holder's age.

The second problem, that of representation, is dealt with by the introduction of the calendar period as a criteria.

The third problem is to estimate the customer's reaction when premium changes are introduced. The system
includes facilities to estimate the relationship between premium level and lapse ratio. This relationship can be taken
into consideration when estimating the Net Present Value of a portfolio or a policy.

3.2 Basic features of the RMS system

Data base handling

• easy access to data
• handles transaction data or summarised data
• viewing, exploration and management of data
• subtraction or exclusion of data, such as large claims
• capping claims
Modelling
• the analysis assesses and allows for time trends
• risk analysis by riskcode
• finds best model using financial or statistical significance
• conditional fit
• the system quantifies the relationship between lapse ratio and price
• it compares premium rates with those of competitors

Presentation of results
• formatted technical reports and summaries generated automatically
• graphical examination of model assumption
• graphical presentation of results

3.3 Areas of focus

The system focuses on the following areas:

Identification of risk criteria

The statistical or, more importantly the financial significance of the examined Criteria and Levels can be analysed
simultaneously and randomness eliminated. The statistical models used are the Generalised Linear Models which
are implemented using the GENMOD procedure in SAS/STAT®. An example is Vehicle classification and No
Claim Discount in Motor Insurance, Accident History and Lifestyle Rating Factors. The system is not confined to
personal line premium rating. The correlation between the Rating Criteria and Claim Frequency, the Average Claim
and the Loss Rates are estimated. The significance of a specific Criteria or the interaction between two Criteria is
calculated automatically by the system.

Identification of profit and loss segments of financial or statistical significance.

The system provides management information such as loss ratio and profit concerning subsegments defined by the
relevant Criteria/Levels. In addition estimated loss ratio and profit can be calculated on subsegments. The problems
connected with summaries of large data sets, e.g. the time involved and space used to produce them, have been
reduced dramatically.

Estimating the consequences of a new rating matrix.

Taking the company's assumption of costs and profit allocation into consideration, model rates are generated from
the break even premiums. The financial consequence of introducing the model rates or any other pricing strategy is
predicted. Model rates can be estimated under assumptions of changing the insurance cover or the value of excess.
Also the financial implication of 'redlining' a specific sub portfolio is estimated.

Competitor analysis and identification of profitable niche strategies.

Comparing premium rates with competitors' and highlighting segments where profit margins are inexpedient.

How to create a Business Plan.

Based on analyses of the claim frequency, claim costs, lapses, incepts, price elasticity and cash flow, the Business
Planning module provides forecasts of Written Premium, Incurred Claims, Expenses, U/W Profit, Interest and
Trading Profit. The number of Lapses, Inceptions and Renewals can also be estimated. The projections for a
specific period selected by the user can be made on a Daily, Monthly, Quarterly or Yearly basis.

3.4 The application

CRITERIA - Manipulating class variables and formats

The criteria/class variables for the analysis are selected by clicking on the variables. The dimensions, i.e. the
number of different levels for the variables are shown and also the current format related to the variable.

A format can now be associated/generated in four different ways:

 1. Generation of a new format by joining levels together.

2. A format can also be selected from the list of already existing formats. By clicking on 'FORMAT' a
list of available formats will be shown.
3. Generation of a new format for a numeric variable can also be made by grouping the data into
intervals of approximately the same size (measured by exposure or number of policies) by increasing
value of the variable.

4. A format can be defined externally.

Example of creating a format for joining levels together: All levels for criteria MAXAGE below 30 are gathered in
one group : 30- , and all levels above 55 are grouped in : 55+. This is done by clicking on the levels in an extended
table.

RATE MAKING - The analysis

The model for the analysis (FREQUENCY AND AVERAGE CLAIM or LOSS RATE) has to be selected. If the
model FREQUENCY AND AVERAGE CLAIM is chosen, then the claim frequency and the average claim are
estimated separately. The loss rates are estimated as the product of the estimates regarding Claim Frequency and
Average Claim:

1. Claim Frequency = Number of Claims/Exposure

2. Average Claim = Claim Amount / Number of Claims

3. Loss Rate = Claim Frequency * Average Claim

The screen controls the flow through the chosen method giving access to tables and graphics when appropriate. The
colours of the buttons are used as a guide for the next selection.

FACTOR MODELS - Generalised Linear Models

Select the criteria which may have an impact on the claim frequency (or average claim) as main effects and the
potential interactions and reestimate the factors and the statistical level of significance.

The model used to estimate the INTERCEPT and the FACTORS is, that the claim frequency (or average claim) for
a specific combination of the levels is equal to the product of an intercept and factors regarding the levels. If a level
has the factor 1.123 for example, it means that the claim frequency (or average claim) for that level is 12.3% higher
than for the level with a factor equal to 1.

Criteria Level Frequency Average Claim Loss

Factor Factor Factor
INTERCEPT 0.194 1273.129 247.505
HBAND A 1.204 1.204
B 1.071 1.071
C 1.000 1.000
MAXAGE 30 1.088 1.088
35 1.051 1.051
40 0.945 0.945
45 1.144 1.144
50 1.243 1.243
55 1.000 1.000
PLAN GD 2.157 0.599 1.293
SR 1.000 1.000 1.000

The nature of the random fluctuation is initialised to be POISSON for frequency models which is the most
frequently used distribution to describe the variation in the number of claims (and GAMMA for other models, but
other error distributions can be selected).
When the model/analysis has been run the levels of the statistical significance and financial impact indicate whether
or not the model should be corrected and rerun.
The level of statistical significance expresses the probability that the criteria (or the level) has no impact on the
claim frequency (or average claim). If the statistical level of significance is 1% for example, then there is a 99%
probability that the criteria has an impact.

The financial impact of a criteria describes the impact of removing the criteria from the set of criteria. If the
financial impact of a specific criteria is 10% for example, it means that 10% of the premium would be reallocated
on the portfolio if the specific criteria was neglected. This key figure often contains more relevant information than
the statistical significance.

ADVANCED MODELS - Non-Linear Regression

If the factors for a specific numeric criteria (such as AGE or SUM INSURED) show a trend then this can be
estimated and the factors smoothed accordingly by a specific curve. The factors regarding the chosen numeric
criteria will then be reestimated using a non linear regression analysis.

This facility is not available in PROC GENMOD and PROC NLIN (Non-Linear Regression) is used to identify the
relationship.

The curve has been smoothed by an exponential curve, reducing the number of parameters and producing a curve
that in this example is constantly increasing (avoiding the decrease in the parameters for AGE around 40).

QUALITY CONTROL
Frequency / Average Claim or Loss Rate (Tables)
The exposure, the estimated and observed Loss Rate and the estimated and observed number of claims are tabulated
by criteria level or by combinations of levels.

Example of table on Criteria AREA (using PROC TABULATE and reading the output to an extended table in
FRAME):
Criteria Exposure in Number of Claim Observed MODEL
AREA years Claims Amount Loss Rate Loss Rate
A 858 236 60158 70 70
B 2054 638 204361 100 100
C 3043 933 334812 110 109
D 1905 703 271791 143 139
E 2146 750 326761 152 156
ALL 10006 3260 1197883 120 120
Model Control
The Model Control can disclose if the model, for example, under-estimates the loss rate for the low risk segments
and/or over-estimates the loss rate for the high risk segments.

For each cell, i.e. for each combination of criteria levels, the observed loss rate is plotted against the estimated loss
rate. A good model will give plots on or around the line where the observed and estimated frequency is equal. A
regression line with confidence intervals as well as the line y=x is shown.

TREND ASSUMPTIONS
It is possible to estimate the time trend and to calculate an estimate of the loss rates for a specific period in the
future. The exposure is indicated on the top of the graph to indicate the level of weight on the error and the
confidence intervals on the observed values are calculated and shown on the graph (PROC GCHART). Furthermore
a regression (using PROC REG) on the estimated figures is carried out and the result implemented in the graph
(using the ANNOTATE facilities) :
NEW PREMIUMS
When the analysis is finished and the profits and costs are decided then the new premium matrix can be generated
as shown in the following screen. It is possible to manipulate the order of the variables in the table and to have 1-4
variables shown at the same time.
Premiums Number of Bedrooms
1 2 3 4
Type of House Rate Area
1 A 70 45 116 132
B 104 66 171 196
C 119 76 195 224
D 143 92 235 269
E 167 107 275 315
2 A 41 26 68 78
B 61 39 100 115
C 70 45 115 132
D 84 54 138 158
E 98 63 162 186

When a criteria is not shown in the table a specific value must be chosen. This is done by putting all the different
levels into a list and using the SCL-function POPLIST when clicking on one of the criteria not shown in the tables.

IDENTIFY PROFIT
This screen keeps information about the profitability of the business in the period under consideration. It is used to
identify profit and loss segments of financial significance.
For each combination of the levels of the criteria key figures are created and sorted by the sort-variable if this has
been selected:
PROFITIDENTIFICATION
Claim Number Actual New Profit Loss Profit per Est. Exposure
Amount of Claims Premium Premium Rati Insurance Claim in years
PREMIUM NEWPRM o Year Amount
Type of Rate
House Area
1 A 30799 111 33844 27108 3045 91 10 27108 290
B 87894 228 92065 90206 4171 95 6 90206 649
C 136095 358 152354 144097 16259 89 17 144097 945
D 116814 269 109110 113297 -7704 107 -13 113297 611
E 143041 280 119377 143710 -23664 120 -35 143710 670
2 A 29359 125 50252 32793 20893 58 37 32793 568
B 116125 410 147015 114153 30890 79 22 114153 1404
C 198717 575 254896 192487 56179 78 27 192487 2098
D 154977 434 174791 151578 19814 89 15 151578 1294
E 183720 470 195061 190806 11341 94 8 190806 1476
ALL 1197541 3260 1328767 1200235 131226 90 13 1200235 10006

WHAT IF
This is used to identify the consequences of redlining/eliminating a specific (unprofitable) sub-segment by clicking
on the segments to redline. By manipulating the table (selecting different criteria) it is possible to see if eliminating
a sub segment from the portfolio would affect other segments.
For each combination of the levels of the criteria the following key figures are created :
1. Actual Variable (Premium, Loss Ratio or Profit)
2. New Variable
3. Adjustment, i.e. the difference New Variable minus Actual Variable
4. Relative Adjustment, i.e. the relative difference between New Variable and Actual Variable
5. Exposure in years
6. Claim Amount
7. Profit per Insurance year
8. Estimated Loss Ratio i.e. Estimated Claim Amount in percentage of Reference Premium
9. Profit i.e. Reference Premium minus Claim Amount (Contribution 1)
10. Estimated Profit i.e. Reference Premium minus Estimated Claim Amount (Contribution 1)
COMPARE PREMIUM
This is used to answer questions such as:

'What is the proportion of the portfolio that will have a premium increase if the Reference Premium is
changed to The Office Premium?'

'What are the consequences of using a new rating matrix?'

Comparison of premiums is necessary to avoid some segments in the portfolio being given too high an increase or
decrease when using the new rating matrix and is also used to discover if the company is competitive. This is done
by grouping the business by the size of the difference or relative difference (using a FORMAT) between the rating
matrices as shown in the following example:

Group defined by (NEWPREM-EARNED)/EARNED.

Exposure Ref. Comp. Ref. Comp.
Premium Premium Loss Loss Claim
% EARNED NEWPREM Diff. Diff.% Ratio Ratio Amount
Group
<=-25 9078 18 5073031 3026867 -2046164 -40 50 85 2559750
<=-20 2391 5 1048744 812067 -236676 -23 60 78 634282
<=-15 2444 5 1013707 836257 -177450 -18 54 65 543225
<=-10 2613 5 1028789 900466 -128322 -12 69 79 708072
<=-5 2590 5 963681 891544 -72136 -7 50 54 483760
<=0 2562 5 911353 887751 -23602 -3 60 61 542401
<=5 2435 5 831686 852195 20508 2 62 60 511714
<=10 2394 5 774375 832023 57648 7 54 51 420585
<=15 2264 5 707295 795299 88004 12 67 59 472003
<=20 2072 4 617342 725132 107790 17 64 55 395924
<=25 1925 4 551466 675211 123745 22 52 43 288386
>25 17412 35 3943767 6224388 2280621 58 69 44 2740827
ALL 50179 100 17465235 17459200 -6035 -0 59 59 10300928

For further information please contact

Larsen & Partners Ltd

20 Prior Street
Greenwich
London SE10 8SF
UK
Tel&Fax: +44 (0) 181 858 7777

Trademarks : SAS is registered trademark of SAS Institute Inc., Cary, NC.