Brehm Chapter 5

Question 1

Describe the four stages of underwriting cycle for a single LOB

Answer 1

• 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 (eg. 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

Question 2

For each stage, state whether the primary driver is competition, data lags or both

Answer 2

• Emergence: dynamics driven by competition
• control: dynamics driven by data lags
• Breakdown: dynamics driven by competition and data lags
• Reorganization: dynamics driven by competition

Question 3

Describe how data lags might influence the underwriting cycle

Answer 3

• 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

Question 4

Describe how competition might influence the underwriting cycle

Answer 4

• 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

Question 5

Three examples of economic drivers that affect insurance profitability

Answer 5

• 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

Question 6

Two quantities that could be used as the dependent variable in an underwriting cycle model

Answer 6

Loss ratio or combined ratio

Question 7

Four quantities that could be used as independent variables in an underwriting cycle model

Answer 7

historical combined ratio, reserves, inflation and GNP

Question 8

Four sources of competitor intelligence that could be used to inform an UW cycle model

Answer 8

customer surveys, trade publications, news scanning and rate filings

Question 9

Three styles of modeling the UW cycle

Answer 9

Soft, behavioural and technical

Question 10

With the three styles of modeling in the UW cycle, describe and compare the three dimensions they vary by.

Answer 10

• Dimension 1: data quantity, variety and complexity: soft>behavioural>technical
• Dimension 2: Recognition of human factors: soft>behavioural>technical
• Dimension 3: Mathematical formalism and rigor: technical>behavioural>soft

Question 11

Describe three soft approaches to modeling the UW cycle

Answer 11

• 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 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 summaries, participants can change their answers or articulate their reasons for disagreeing. Process is repeated until consensus is reached
• Competitor analysis: attempts to discern the states, motives and likely behaviour of individual competing firms. It starts with a database of competitor information, key financials, news items and behavioural metrics. For predicting turns in the UW cycle, the goal is observing usually profitable or distressed financial conditions over a large number of firms (has the state of the market changed?)

Question 12

Describe how scenarios and the delphi method feed off of each other

Answer 12

dephi process can create a set of scenarios and scenarios can form the input to a dephi assessment about the likelihood of each scenario

Question 13

describe two types of technical models that can be built to model the UW cycle.

Answer 13

• Basic autoregressive time series: eg. let Xt represent the industry combined ratio for a LOB in year t
• General factor model: Xt moves around a moving average Zt. Z is not observable. These models are more difficult to fit than an AR model and may require more sophisticated fitting techniques

Question 14

Describe the supply curve

Answer 14

• supply curve slopes up and to the right because the price must increase to attract more supply to the market. When competition is strong and/or technological advances reduce firm expenses, the initial line shifts sown and to the right (the competitive limit line). when available capital is restricted (ie. natural catastrophe), the initial line shifts up and to the left (the post-shock line)

Question 15

Describe the Demand curve

Answer 15

• sloes down and to the right because the price must decrease in order to sell more products. When the industry capital increases, there is a general increase in capital “quality” (more capital means default probability is lower for a firm). Thus, the line shifts up and to the right (the capital rich line). When available capital is restricted, demand reduces and the line shifts down and to the left (the post-shock line)

Question 16

Describe the supply and demand curves in equilibrium in the following two states: initial and post-shock

Answer 16

• intersection of supply and demand determines the equilibrium price. When capital is restricted, the supply and demand curves shift, creating a new equilibrium (price increases)

Question 17

Describe the Gron Curve

Answer 17

• Gron seta a minimum price. Up to a certain quantity, companies sell products at this price. At some point, a capacity threshold is reached and companies must raise the price to take on more business (need more risk capital to support more business). Eventually the price (i.e. the premium) reaches a point where it can adequately fund the business. When capital is restricted, the capacity threshold is reached sooner (the post shock line)

Question 18

Describe how capital flows in and out of a firm as profit changed

Answer 18

When profit is low (ie operating losses), capital is used to pay claims. Over time, this leads to exiting the market and/or insolvencies. When profit is “normal”, retained earnings add to the capital stock and firms pay out capital in the form of dividends to shareholders. At some point, profit hits a threshold where external capital infusion occurs (capital infusion tends to happen when capacity is limited and profit expectations are high) This capital funds existing firms and new entrants into the market. It’s also important to note that the precise location, shape and level of the threshold is random

Question 19

Provide four questions that must be answered before an econometric model can be built

Answer 19

• 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 curve?
• how do the supply and demand curves jointly determine price and quantity?
• how does profitability affect external capital flows?

Question 20

Once an econometric model is built, describe how it can be used to create an empirical distribution of possible future market equilibrium prices

Answer 20

• econometric 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 and empirical distribution of possible future equilibrium prices

Question 21

Describe Econometric modeling

Answer 21

• Econometric (or behavioural) modeling exists between soft modeling and technical modeling. The components have meaningful interpretations motivated by economic and behavioural theory
• most econometric models revolve around supply and demand

Question 22

Three themes in the theories as to what drives underwriting cycle. Provide example of each

Answer 22

• institutional factors: historical data is projected for future pricing and there are regulatory and reporting delays. These all create time lags that hep drive the cycle. eg. Historical, immature losses are used to estimate rate changes and go into effect in the future. There’s also a delay with regulatory approval
• competition: competition helps drive the cycle due to insurers lowering rates to unprofitable levels for market share leading to crisis and price correction eg. competitors may try to aggressively grow by reducing prices for a line of business. Over time, after too much pain of unprofitable business, there’s a price correction
• Supply and demand: the underwriting cycle is driven by shocks that increase or decrease capacity, which impacts supply and the price of insurance eg. a catastrophe reduces capital supply in the industry causing prices to rise.

Question 23

Describe the three approaches to modeling the underwriting cycle

Answer 23

• soft: focuses on gathering a wide variety of data about the market and competitor intelligence. This analysis is used to identify or predict a turn in the UW cycle. This approach recognizes human factors and the complexity of the underwriting cycle
• Behavioural modeling (econometric) lies in the middle of soft and technical approaches. The supply and demand of insurance and capital flows are modeled.
• technical approach: models the UW cycle as a time series, such as an autoregressive model. Once the model is fit, future values can be simulated