Source of Earnings Analysis for Property-Casualty Insurers

Source of earnings analysis has long been a staple of life insurance policy pricing and profitability monitoring. It has grown in importance with the advent of universal life insurance and of similar contracts with non-guaranteed benefits or charges. SFAS 97 now mandates the use of source of earnings analysis for GAAP reporting of universal life-type contracts. Source of earnings analysis is equally applicable to several lines of property-casualty insurance, such as workers' compensation and personal automobile insurance. An accident of history has restricted it to life insurance. Source of earnings analysis was first developed for allocating policyholder dividends on participating life insurance policies, and it has since been expanded to other policy forms as well. Casualty actuaries have developed their own ratemaking traditions. Casualty actuaries and life actuaries grow up in separate societies with little interaction, and source of earnings analysis has never been extended to the casualty lines of business. This paper shows the uses of source of earnings analysis for understanding the factors affecting policy profitability. Source of earnings analysis is not a specific ratemaking "method," like the loss ratio method or the pure premium method. Rather, source of earnings analysis is a reporting structure that reveals the sources of gain and loss on a block of business, highlighting errors in the pricing parameters as well as the sensitivity of profit and loss to various pricing factors, and enabling more accurate selection of new parameters and factors. This paper develops source of earnings exhibits for casualty insurance, using private passenger automobile insurance policies and retrospectively rated workers' compensation policies as examples. The uncertainty in many casualty insurance pricing factors, such as loss development factors and loss trend factors, make source of earnings analysis particularly important for casualty products. The paper shows how to use the source of earnings exhibits to better analyze the factors driving insurance results. In particular, the paper divides the variance caused by each earnings factor into an estimation error component, which is within the purvey of the pricing actuary, and a random error component, which results from random fluctuations in loss occurrences, inflation rates, or interest rates. Some sources of gain or loss, such as persistency patterns and investment earnings, are not always included in casualty ratemaking procedures. A complete source of earnings analysis incorporates (a) an analysis of expected versus actual experience by each pricing factor and (b) an amortization of initial expense and loss costs by policy year. The initial acquisition expense includes the solicitation costs for not taken business, which can be substantial in large account workers' compensation retrospectively rated policies. These costs are not always considered by pricing actuaries, but they have great effect on ultimate profit margins. Similarly, movements in the achieved interest rate spread is a major factor in life annuity profitability because of the long duration of these policies and the substantial cash accumulation in these policies. Changes in expected versus actual investment income can have a large effect on workers' compensation profitability as well. Pricing actuaries sometimes say that their indications are best estimates, and they disclaim responsibility for variances of actual from expected. In truth, analysis of the .variances from previous years' predictions is one of the best means of improving next year's predictions. Sources of earnings analysis provides the needed post mortem to rigorously measure the variances in each source of earnings factor Source of Earnings Analysis for Property-Casualty Insurers Section h Introduct ion This paper illustrates source of earnings analysis for property-casualty insurance. Source of earnings analysis is a staple of life insurance policy pricing and reporting, and it is mandated by NAIC regulations or GAAP statements for participating policies issued by mutual life insurance companies, for universal life policies, and for other policies with non-guaranteed benefits or charges. We discuss source of earnings analysis for private passenger automobile insurance and workers' compensation insurance ratemaking. Because of the complexity of this topic, we focus on issues that are most germane to pricing actuaries for these two lines. Private passenger automobile insurance ratemaking is well suited to source of earnings analysis, since the volume of business is large and the effects of estimation error and random error can be more easily discerned. In addition, private passenger automobile has high retention rates and different acquisition expense costs for new policies versus renewal policies, making profitability highly sensitive to persistency patterns. Workers' compensation retrospectively rated policies are somewhat analogous to universal life insurance contracts. In both cases, expected profits stem from the margins in the pricing assumptions. The casualty actuary prices the components of the retrospectively rated policy, such as the insurance charge, even as the life actuary prices the components of the universal life policy. In addition, large account retrospectively rated policies have high not taken rates, various premium payment plans, and considerable investment income, which require actuarial expertise for pricing and design. Measuring profitability by comparison of total premiums with total costs may yield little information that can improve the pdcing process. Source of earnings analysis is better suited to identifying the causes of superior and inferior performance. Structure of this Paper Section II provides a description of source of earnings analysis as applied to life insurance products, with specific reference to two areas: (i) calculation of policyholder dividends by means of the contribution principle for mutual life insurance companies and (ii) the FAS 97 accounting for universal life-type products. Section III applies source of earnings analysis to private passenger automobile ratemaking. The general framework is outlined, along with a detailed analysis of trend.