Brehm 5 CF Only Flashcards
a) Describe the four stages of the underwriting cycle for a single LOB. b) For each stage, state whether the primary driver is competition, data lags or both. c) Describe how data lags might influence the underwriting cycle. d) Describe how competition might influence the underwriting cycle.
Part a: ⇧ Emergence – when a new LOB arises, data is thin, demand grows quickly and pricing is erratic. Price wars set in as competitors enter the market. Eventually, a sudden price correction occurs and weak competitors leave the market. A period of profitability follows, which brings in more competitors and “restarts” the cycle ⇧ Control – stabilization of the LOB is eventually gained through collective coercive control (ex. restricting entry, standardizing insurance products, stabilizing market shares, etc.). Rating bureaus and state DOIs regulate price changes ⇧ Breakdown – due to technological and societal changes, new types of competitors enter the market and take business away. This causes a breakdown in the control regime ⇧ Reorganization – this is a return to the conditions of the “emergence” phase, as a new version of the old LOB emerges Part b: ⇧ Emergence – dynamics driven by competition ⇧ Control – dynamics driven by data lags ⇧ Breakdown – dynamics driven by competition and data lags ⇧ Reorganization – dynamics driven by competition Part c: ⇧ Since insurance pricing involves forecasting based on historical results, there are time lags between the compilation of the historical data and the implementation of the new rates. One theory is that these time lags lead to poor extrapolation by actuaries during the ratemaking process. Due to the lags, historical data may suggest that further rate increases are needed when rates have actually returned to adequate levels Part d: ⇧ Not all competitors have the same view of the future. Inexperienced firms may have poorer loss forecasts than mature firms. As a result, inexperienced firms may drop prices based on poor forecasts. This eventually pushes the market toward lower rates
Provide three examples of economic drivers that affect insurance profitability.
⇧ Insurance profitability is linked to investment income ⇧ The cost of capital is linked to the wider economy ⇧ Expected losses in some LOBs are affected by inflation
a) Provide two quantities that could be used as the dependent variable in an underwriting cycle model. b) Provide four quantities that could be used as independent variables in an underwriting cycle model.
Part a: ⇧ Potential dependent variables include loss ratio and combined ratio Part b: ⇧ Potential independent variables include the historical combined ratio, reserves, inflation, and GNP
Provide four sources of competitor intelligence that could be used to inform an underwriting cycle model.
⇧ Sources of information include customer surveys, trade publications, news scanning and rate filings
a) Identify three styles of modeling the underwriting cycle. b) The styles identified in part a. vary by three dimensions. Briefly describe the three dimensions. For each dimension, state how each style compares.
Part a: ⇧ Soft approaches, behavioral modeling and technical modeling Part b: ⇧ Dimension 1 – data quantity, variety and complexity: soft > behavioral > technical ⇧ Dimension 2 – recognition of human factors: soft > behavioral > technical ⇧ Dimension 3 – mathematical formalism and rigor: technical > behavioral > soft
Describe three soft approaches to modeling the underwriting cycle.
⇧ Scenarios – A scenario is a detailed written statement describing a possible future state of the world. Multiple scenarios are used to define a space of possible future outcomes. Once this space has been defined, firms can organize their thinking about the future and how they might respond to these scenarios. These scenarios are different from “simulations”, which are more numerous and processed by computers rather than humans ⇧ Delphi method – the Delphi method is a method of obtaining expert consensus on an issue. Experts are given background information and asked for their opinions in a questionnaire. The answers are aggregated and then summaries are given back to the participants. Based on the summaries, participants can changes their answers or articulate their reasons for disagreeing. This process is repeated until consensus is reached ⇧ Competitor analysis – competitor analysis attempts to discern the states, motives and likely behavior of individual competing firms. It starts with a database of competitor information, key financials, news items and behavioral metrics. For predicting turns in the underwriting cycle, the goal is observing unusually profitable or distressed financial conditions over a large number of firms (basically, has the state of the market changed)
Briefly describe how scenarios and the Delphi method feed off of each other.
⇧ A Delphi process can create a set of scenarios and scenarios can form the input to a Delphi assessment about the likelihood of each scenario
a) Provide four questions that must be answered before an econometric model can be built. b) Once an econometric model is built, describe how it can be used to create an empirical distribution of possible future market equilibrium prices.
Part a: ⇧ How do economic factors (ex. interest rates, inflation, cost of capital) influence the supply and demand curves? ⇧ How does capital influence the supply and demand curves? ⇧ How do the supply and demand curves jointly determine price and quantity? ⇧ How does profitability affect external capital flows? Part b: ⇧ An econometric model is comprised of various components such as supply curves, demand curves, capital flows, inflation, etc. Each component influences the equilibrium price in specific ways. Various component changes can be simulated to create an empirical distribution of possible future equilibrium prices
Describe two types of technical models that can be built to model the underwriting cycle. For each model, provide the underlying equations that drive the model.
a) Draw basic supply curves in the following three states: initial, post-shock and competitive limit. Explain the curves in words.
b) Draw basic demand curves in the following three states: initial, post-shock and capital-rich. Explain the curves in words.
Draw basic supply and demand curves in equilibrium in the following two states: initial and postshock. Explain the curves in words.
Draw Gron supply curves in the following two states: initial and post-shock. Explain the curves in words.
Draw a graph that illustrates how capital flows in and out of a firm as profit changes. For each segment of the graph, explain what is happening in words.
