Section 2.2

Question 1

Define Retained Risk

Answer 1

Retained risk in property and casualty insurance refers to the amount of risk that an entity decides to keep instead of transferring it to an insurance company. It means that the entity takes financial responsibility for potential losses or liabilities without relying on insurance coverage. Retained risk can be managed through strategies like self-insurance, reserves, or captive insurance companies.

Colloquially, the terms “retained risk” and “self-insurance” refer to the same thing.

AAA Retained Risk

Question 2

Define ‘guaranteed cost policy’

Answer 2

a policy where an entity transfers all liability to an insurer for a fixed premium

AAA Retained Risk

Question 3

Define ‘retrospectively rated policy’

Answer 3

• a policy where an entity transfers all liability to an insurer based on actual loss experience
• the final premium depends on an audited exposure base and loss experience

AAA Retained Risk

Question 4

Define ‘captive’

Answer 4

• affiliated insurance companies that can assume some or all of an entity’s liability
• captives are subject to less stringent regulation than admitted carriers
  (and can directly insure or reinsure the entity’s insurer)

AAA Retained Risk

Question 5

Define ‘direct policy’ in relation to captive

Answer 5

a policy purchased directly from an affiliated captive insurer
(typically used for coverages that would otherwise be self-insured)

AAA Retained Risk

Question 6

Define ‘fronting arrangement’

Answer 6

an arrangement where an entity, having purchased a guaranteed cost policy, can transfer risk back to its captive
(with the commercial insurer acting as a “fronting” company for excess losses)

AAA Retained Risk

Question 7

Define ‘trust’ and briefly describe how it is use in insurance

Answer 7

• a financial arrangement where funds or assets are set aside to cover potential losses
• commonly used to finance professional liability exposures
  (and provide coverage to affiliated entities on a direct basis)

AAA Retained Risk

Question 8

Define ‘deductible reimbursement’

Answer 8

• a policy written by a captive that directly reimburses the entity for its deductible obligations
  (it covers the entity’s obligations to the insurer but not to claimants)

AAA Retained Risk

Question 9

Identify the contexts where a ‘retained risk’ actuarial analysis is generally used.

Answer 9

Adequacy of Accruals for Financial Reporting
Internal Financial Reporting and Cost Allocation
Regulatory Filing for a Qualified Self-Insurance Designation

AAA Retained Risk

Question 10

Actuaries often receive requests to calculate the projected financial accrual for self-insured or retained liabilities. The actuarial estimates can be used by company management in what 2 ways?

Answer 10

1. to directly record the accrual amount
2. to validate the reasonableness of management estimates

AAA Retained Risk

Question 11

Identify items included in these accruals for retained liabilities.

Answer 11

• provisions for: deductibles
• provisions for: self-insured exposure
• provisions for: potential retrospective premium amounts

AAA Retained Risk

Question 12

Identify key considerations when comparing an actuarial estimate to a company’s ledger.

Answer 12

• net or gross of insurance recoverables
• discounting
• combined accruals that include other insurance-related balances

The first 2 bullet points above are covered in here in Odomirok chapters 22-23 and don’t require any further discussion.

Regarding the 3rd bullet point on combined accruals:

The presence of combined accruals in financial statements can pose challenges when comparing them to actuarial estimates. In some cases, the financial statement accruals may include items like third-party administrator fees that are not accounted for in actuarial calculations. This makes it difficult to directly compare the results of the actuarial analysis with the financial statement entry.
The key idea is the concept of timing and its impact on the comparison between actuarial estimates and financial statements. The timing differences in payments, billing cycles, and the treatment of prepaid balances or amounts due to third-party administrators and excess insurers are discussed, emphasizing the need for adjustments and documentation to address these timing issues.

AAA Retained Risk

Question 13

What are combined accruals?

Answer 13

financial entries that include multiple related accruals, where only a portion is considered in the actuarial analysis

AAA Retained Risk

Question 14

What challenges can arise when comparing actuarial analysis with financial statement accruals?

Answer 14

financial statement accruals may contain items that are not accounted for in the actuarial calculation
(making direct comparisons difficult)

Example: Third-Party Administrator (TPA) fees

AAA Retained Risk

Question 15

What timing-related issues arise with prepaid balances or amounts due to TPAs and/or excess insurers?

Answer 15

payments made but not yet reimbursed (by company to TPA) result in higher accruals
advance payments lead to lower accruals

AAA Retained Risk

Question 16

How do companies address timing differences in accruals related to TPAs and excess insurers?

Answer 16

• adjust accruals
• carry a separate timing accrual
• treat the timing difference as immaterial ← this is the simplest option if it applies!

AAA Retained Risk

Question 17

What timing issues can arise with claims paid by the entity but not yet reimbursed by an excess insurance carrier?

Answer 17

when claims are paid but not yet reimbursed by excess insurance carriers

AAA Retained Risk

Question 18

What timing discrepancies can occur with retrospectively rated and large deductible policies?

Answer 18

timing gaps between claim payments and premium payments

AAA Retained Risk

Question 19

Internal Financial Reporting and Cost Allocation Description

Answer 19

Actuarial indications help company management track financial performance and goals internally. However, limited data availability may pose challenges for actuaries when allocating reserves to subcomponents.

AAA Retained Risk

Question 20

What is the general requirement for a company applying for a Qualified Self-Insurance Designation?

Answer 20

an actuarial report and certification along with its application package

AAA Retained Risk

Question 21

Who should provide the actuarial opinion for a self-insured application?

Answer 21

a member in good standing of the Casualty Actuarial Society

AAA Retained Risk

Question 22

What should the actuarial opinion include for a self-insurance application?

Answer 22

actuarially appropriate reserves based on reserves estimated from the program’s inception to the valuation date

AAA Retained Risk

Question 23

What additional elements should the actuarial opinion include?

Answer 23

• identifying information about the actuary
• scope of the opinion
• description of the estimation method
• exhibit showing the methodology
• data source information
• data reconciliation
• explanation of any data checking, verification, or auditing

AAA Retained Risk

Question 24

What 3 important dates does ASOP 43 talk about?

Answer 24

accounting date
valuation date
review date

AAA Retained Risk

Question 25

How does price optimization compare to traditional ratemaking techniques?

Answer 25

price optimization is a process that uses
- big data (data mining of insurance & non-insurance personal information where permitted by law)
- advanced statistical modeling

price optimization makes granular adjustments to indicated rates (specific risk classifications, or even individual insureds)

Traditionally, actuarial adjustments to indicated rates were judgmental and applied only on a broad level

NAIC Price Op

Question 26

State the 4 principles in the CAS “Statement of Principles Regarding Property and Casualty Insurance Ratemaking”

Answer 26

Principle 1: A rate is an estimate of the expected value of future costs.
Principle 2: A rate provides for all costs associated with the transfer of risk.
Principle 3: A rate provides for the costs associated with an individual risk transfer.
Principle 4 :A rate is reasonable and not excessive, inadequate or unfairly discriminatory if it is an actuarially sound estimate of the expected value of all future costs associated with an individual risk transfer.

NAIC Price Op

Question 27

Define price optimization as it is used in this NAIC Whitepaper

Answer 27

the process of maximizing or minimizing a business metric
uses sophisticated tools and models to quantify business considerations

Also want to note that the paper is related to personal lines (thanks for letting me interupt)

NAIC Price Op

Question 28

Define cost-based rate

Answer 28

this is just the traditional actuarially derived rate based on loss costs, LAE, and other expenses

NAIC Price Op

Question 29

Define price elasticity of demand

Answer 29

the change in quantity demanded versus the price

high elasticity ==> consumers will shop around even if prices only go up a little (savvy consumers!)

low elasticity ==> price doesn’t have much effect on demand (you can jack the prices but consumers won’t shop around)

NAIC Price Op

Question 30

Define the terms ratebook optimization, individual price optimization, hybrid optimization

Answer 30

ratebook optimization
→ adjust factors in a cost-based rating structure using a demand model
individual price optimization
→ build a pricing structure based on both cost and demand
hybrid optimization
→ insert a new rate factor based on demand (into an existing rate cost-based structure)

 These definitions highlight the critical concepts of traditional or cost-based pricing, and the demand model of price optimization. If there is only 1 thing you remember from this reading, that's the thing! (Price optimization can be based on metrics other than demand but the demand model is one that's very often used so that's my own personal hook for understanding it.)

NAIC Price Op

Question 31

Define constrained optimization

Answer 31

setting minimum & maximum limits on a model’s output (Ex: min = current price, max = cost-based indication)

note that unconstrained optimization does not impose these limits

NAIC Price Op

Question 32

Describe the main differences between traditional ratemaking and price optimization

Answer 32

difference 1:
traditional: applied at class level
price optimized: can be applied to individual policies
difference 2:
traditional: uses cost-based pricing
price optimized: incorporates non-cost-based considerations like propensity to shop around
difference 3:
traditional: deviations from indicated rates are subjective
price optimized: deviations from indicated rates are based on quantitative models

NAIC Price Op

Question 33

Identify other miscellaneous differences between traditional ratemaking and price optimization

Answer 33

Traditional ratemaking (including a component for actuarial judgment) will assign the same price to identical risks, but price optimization may assign different prices

Traditional ratemaking (including a component for actuarial judgment) is generally accepted by regulators whereas price optimization may not be acceptable (more on this later)

NAIC Price Op

Question 34

Identify benefits and drawbacks of price optimization

Answer 34

BENEFITS
paragraph 35
- doesn’t unfairly discriminate (low-income customers are more likely to shop around and not be penalized by non-cost-based increases)
- provides more accurate pricing (neither inadequate nor excessive)

paragraph 37
- if optimization is applied on a ratebook level, it is not unfairly discriminatory
- note that individual optimization may be unfairly discriminatory

DRAWBACKS
paragraph 31
- regulators don’t have the data to independently verify rates based on price optimization

paragraph 32
- the models (often GLMs) can produce large individual rate swings (can be controlled by using constrained optimization however)

paragraph 34
- no evidence of improved stability from using price optimization (effect on long-term costs is inconclusive)

paragraph 38
- concern that ratemaking ASOPs may be violated (if rates are unfairly discriminatory)

NAIC Price Op

Question 35

Identify 3 things that a rate filing cannot be

Answer 35

a rate filing cannot be: inadequate, excessive, unfairly discriminatory

NAIC Price Op

Question 36

Identify possible regulatory responses to price optimization rating plans

Answer 36

paragraph 42a
* determine permissibility with respect to state laws

paragraph 42b
* define regulatory constraints (min/max rate swings, methods apply only to rate classes of at least a certain size)

paragraph 42f
* transparency: require full explanation of…
==> DAM - Data / Methods / Assumptions
==> rate differences between customers with identical risk profiles (if any)

NAIC Price Op

Question 37

Identify disclosures a regulator may require when price optimization is used in a rate filing

Answer 37

• rate adjustments that are not cost-based (may include judgmental adjustments)
• whether price optimization was used (Ex: demand models)
• which rating factors are affected by price optimization and their quantitative impact
• whether customers with the same risk profile have different rates
• data sources and models that affected the rate charged in any way

NAIC Price Op

Question 38

Identify recommendations of the Task Force on Price Optimization regarding pricing methodology

Answer 38

• rates should be cost-based
• rates should comply with state law
• customers with identical risk profiles should be charged the same rate (aside from temporary differences - due to transition rules for example)

NAIC Price Op

Question 39

Identify rating considerations that the Task Force on Price Optimization believes are unfairly discriminatory

Answer 39

• price elasticity of demand
• propensity to shop for insurance
• retention adjustment at an individual level
• a policyholder’s propensity to ask questions or file complaints

NAIC Price Op

Question 40

Identify recommendations of the Task Force on Price Optimization regarding state regulatory practices

Answer 40

• issue bulletin addressing use of non-cost-based methods
• enhance disclosure requirements for rate filings
• ensure compliance with state laws and actuarial principles by analyzing insurers’ rating models

NAIC Price Op

Question 41

Define and briefly describe the concept of a Risk Retention Group (RRG)

Answer 41

• a RRG is a liability insurance company owned by its members
• members are a group of similar business that have pooled their risks
• medical malpractice is the most common line of business for a RRG

NAIC RRG

Question 42

How is a RRG formed and how does it operate?

Answer 42

formation:
- formed using a combination of state & federal laws under the auspices of the Federal LRRA (Liability Risk Retention Act)
→ must submit a plan of operation to commissioner of domiciliary state that includes coverage, deductibles, limits, rates, classification system
- may be formed under a state’s captive or traditional insurance laws (click for the definition of captive insurer - not on syllabus)

operation
- may write business directly in states where they are registered without obtaining a license (whereas captives cannot do this)
- can be domiciled in 1 state but still do business in another state if a registration process is completed and the state’s commissioner is designated as agent for service of process
- treated as multi-state insurers and subject to NAIC accreditation standards for RRGs (NAIC standards are not discussed in this reading but you can click the link for a very brief overview of what those standards are)

NAIC RRG

Question 43

Is a RRG required to comply with the usual quarterly & annual financial filing requirements?

Answer 43

yes, and this includes but is not limited to:
- financial statements (yellow book format)
- RBC
- SAO
- MD&A (Management’s Discussion and Analysis)
- audited statements

NAIC RRG

Question 44

Identify regulatory differences between RRGs and traditional insurers

Answer 44

• many RRGs use GAAP instead of SAP
• few RRGs submit rate filings
• RRGs cannot participate in state guaranty funds

NAIC RRG

Question 45

Describe the purpose of rate regulation according to Porter

Answer 45

• to ensure financial stability of insurers
• to protect policyholders

Porter Rates

Question 46

Identify the level of regulatory scrutiny for ocean marine insurance and provide 2 reasons for your answer

Answer 46

Ocean marine covers transportation of goods in vessels crossing waters
regulatory scrutiny: low
- sophisticated buyers
- individual risks

Ok, let’s think about why these reasons for low regulatory scrutiny make sense:
==> if buyers are sophisticated, they may not need protection from outside regulatory authorities
==> if risks are highly individualized, regulation is difficult for outside authorities (may not be a productive use of the regulator’s time.)

Porter Rates

Question 47

Identify the level of regulatory scrutiny for private passenger auto insurance and provide 2 reasons for your answer

Answer 47

PPA is mandatory
regulatory scrutiny: high
- unsophisticated buyers
- uniform risks

Ok, let’s think about why these reasons for high regulatory scrutiny make sense:
==> if risks are relatively uniform, regulation is easy for outside authorities (rating methodologies are well-known and uniform across insurers)
==> if buyers are unsophisticated, they will benefit from protection by outside regulatory authorities

Porter Rates

Question 48

Identify 7 types of insurance listed by Porter and level of regulatory scrutinty

Answer 48

low scrutiny: ocean marine
low scrutiny: inland marine
low scrutiny: surety
low scrutiny: title
low scrutiny: commercial general liability
high scrutiny: PPA
high scrutiny: WC

Porter Rates

Question 49

Main Reasons for Scrutinty Level

Answer 49

==> for low scrutiny
- sophisticated buyers
- individualized risks
- thin data

==> for high scrutiny
- unsophisticated buyers
- uniform rates
- credible data
- mandatory coverage
- complex classification system
- public interest & political awareness

Porter Rates

Question 50

What is the political theory of regulation?

Answer 50

The political theory of regulation just states that regulatory scrutiny is higher when there is:

• voter interest (like PPA rates, which affect almost everyone)
• easy for policymakers to understand (this explains why the nobody gives a crap about surety insurance!)

Porter Rates

Question 51

What are Rate Advisory Organizations?

Answer 51

• statistical agents collect & report loss experience & trends
• rating bureaus prepare & submit rate filings on behalf of members

This activity would violate anti-trust and anti-competition laws in other industries but are tolerated in insurance because of benefits to consumers. If insurers did not have access to industry loss experience, their pricing may be based on less credible data. This could lead to rates being either too high or too low, both of which are bad for consumers. Now, high rates would suck, but wouldn’t consumers like it if rates were too low? Well, no. Rates that are too low might be great for a while, but they could lead to insolvency in the long-term.

Rate Advisory Organizations also provide other important services such as:

• education of the public, industry, & regulators
• actuarial services
• filing support
• development of policy forms

Porter Rates