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Volume 2, Number 1


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Understanding and Evaluating Losses

Forecasting Workers Compensation Losses for the Next Policy Period

Analytical Tools to Help

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Dear Insurance and Risk Management Professional,

In previous issues of NewSolutions, I have discussed the various factors that drive the mod. Understanding the mod is important because it is a key component in determining the cost of workers compensation insurance. Another major factor in the cost of workers compensation insurance is the losses that occur during the policy period. This issue of NewSolutions discusses the evaluation of losses, which are the most significant variable in any loss financing program. For this topic, I am pleased to introduce Al Rhodes, ACAS, MAAA and president of SIGMA Actuarial Consulting Group, Inc. SIGMA is the sister company to Specific Software Solutions, LLC and the technical resource behind our Loss Forecaster II software.

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Sincerely,
Tim Coomer
President, Specific Software Solutions, LLC

Today's NewSolution:
Understanding and Evaluating Losses
by Tim Coomer and Al Rhodes

Definition of Loss Terms

Losses can be defined in three categories:

1. Incurred Loss: This is the amount at which the insurance company has established a loss (or losses) on their books.

2. Paid Loss: This is the amount that has actually been paid toward a specific claim or group of claims.

3. Loss Reserve: This is the amount that has been established as a reserve for a specific claim or group of claims. This amount is equal to the incurred loss less the paid loss.

Ultimate Incurred Loss: This is an estimate of what the loss or losses will ultimately cost. It includes an adjustment to the loss reserve for "development" in the claim(s) and incurred but not reported losses (IBNR).

Loss Development Factor: This is a factor used to project the additional expected costs for a group of claims.

Incurred But Not Reported Losses (IBNR): These are claims that have occurred but not been reported.

Forecasting Worker’s Compensation Losses
for the Next Policy Period

The forecasted loss, also called a loss pick, is established by an underwriter for a given risk through a process which might seem random to an outside observer. However, the selection of ultimate incurred losses for a given policy period is a methodology that can be easily understood and duplicated. The standard process utilized to generate a loss pick is discussed below:

1. Computation of the pure loss rate for past years – The first step in the process is to determine what the pure loss rate (today’s dollar losses / today’s dollar exposure) was for past policy periods. This consists of a few sub-steps. The incurred losses for each of the past loss periods must be multiplied by a loss development factor to account for incurred but not reported claims (IBNR) and development (unexpected increases in the reserve amount) in open claims. The loss development factor appropriate for the risk can be obtained from the underwriter or actuary. Next, the losses are trended to today’s dollars using a trending factor. The result is trended estimated ultimate incurred losses. This is compared to the exposure base (usually payroll) which is trended to today’s dollars. The ratio of trended estimated ultimate incurred losses to the exposure base is called the pure loss rate. This is usually stated as dollars of loss per $100 of payroll.

2. Selection of a pure loss rate – The next step is to select a pure loss rate based on the analysis in step one. Actuaries and underwriters utilize their judgement in this process. Some common methods are
a) use a weighted average of the past years pure loss rate;
b) use a straight average of past years pure loss rate;
c) use an straight average with the high and low rates excluded; or
d) select a rate based on judgement which takes into consideration the historical data.

3: Estimation of the coming year’s exposure – A good estimate of the exposure base for the coming policy period is required for an accurate forecast. You will want to look at anticipated changes in operations and determine a best estimate for the payroll for the coming year.

4: Computation of the loss pick – The forecasted loss (loss pick) is then computed by multiplying the selected pure loss rate by the forecasted exposure base.

This process is a standard actuarial process utilized throughout the industry. The "negotiating" between broker and underwriter occurs in the assumptions concerning loss development factors and selection of a pure loss rate.

Analytical Tools to Help

Specific Software Solutions provides a product called Loss Forecaster II which gives you the ability to utilize actuarially sound techniques to forecast the ultimate incurred loss for a given policy period. The software is designed for non-actuarial insurance professionals. Learn more about Loss Forecaster, including sample screens and reports, at http://www.specificsoftware.com/lf/lfproduct.htm.

SIGMA Actuarial Consulting Group, Inc. provides the necessary analysis of past and future liabilities to insure proper financial reporting and program funding.

For more in-depth information on loss forecasting and other analytical topics, refer to the following articles in our library:

You can also contact SIGMA's Al Rhodes at (615) 352-3944 or by e-mail at AL@SIGMAactuary.com

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