THE INCREDIBLE SHRINKING

RESIDUAL MARKETSession: PL-39

Presented by:

Tom Daley, ACAS, MAAA, NCCI

John Winkleman, Jr., FCAS, AIPSO

Richard Amundson, FCAS, MN DOC

© 2000 National Council on Compensation Insurance, Inc.

WORKERS COMPENSATION

Presented By: Tom Daley

© 2000 National Council on Compensation Insurance, Inc.

OUTLINE

• Historical Perspective

• How did it get so large?

• Impact of a large residual market

• What caused the shrinkage?

• Ratemaking implications today

• How will we keep it from growing again?

®

© 2000 National Council on Compensation Insurance, Inc.

RESIDUAL MARKET ESTIMATED ULTIMATE PREMIUMSAS OF 9/30/2000

* Excludes Maine Residual Market Pool

2.11

2.602.84

3.49

3.964.39

4.80

4.09

3.08

1.96

1.000.57

0.33 0.27 0.30

0.0

1.0

2.0

3.0

4.0

5.0

6.0

Premium ($Billions)

19

86

19

87

19

88

*

19

89

*

19

90

*

19

91

*

19

92

*

19

93

19

94

19

95

19

96

19

97

19

98

19

99

20

00

Policy Year

© 2000 National Council on Compensation Insurance, Inc.

HOW DID IT GROW SO LARGE?

• Inadequate rates

• Overly generous benefits

• Lack of cost containment

• Poor underwriting results

®

© 2000 National Council on Compensation Insurance, Inc.

RESIDUAL MARKET UNDERWRITING GAIN/LOSSAS OF 9/30/2000

* Excluding Maine** Excluding Maine and New Mexico# Excluding New Mexico

-1354

-1760 -1848-2018

-1596

-1140

-558

-139

103126

23

-21 -40 -45

-2500.0

-2000.0

-1500.0

-1000.0

-500.0

0.0

500.0

Underwriting Gain\Loss ($Millions)

1986

1987

1988

*

1989

*

1990

**

1991

**

1992

**

1993

#

1994

1995

1996

1997

1998

1999

Policy Year

© 2000 National Council on Compensation Insurance, Inc.

IMPACT OF A LARGE RESIDUAL MARKET

• Carriers stop writing WC

• AR plans grow larger and larger

• Rates increase (both markets)

• Employers costs rise

• Movement towards self-insurance

© 2000 National Council on Compensation Insurance, Inc.

WHAT CAUSED THE SHRINKAGE?

• Reform at all levels of stakeholder

• Residual Market pricing programs

• New state funds

• Increased competition/capacity

© 2000 National Council on Compensation Insurance, Inc.

NCCI RATEMAKING IN TODAY’S

ASSIGNED RISK MARKET

The NCCI approach for overall indication:

1. Use total market data (most states)

2. Use AR data to establish differential

over voluntary market

®

© 2000 National Council on Compensation Insurance, Inc.

RESIDUAL MARKET COMBINED RATIOSAS OF 9/30/2000

164 168 165158

141

126

112104

97 9498

104112

117127

90

110

130

150

170

190

Combined Ratio (%)

19

86

19

87

19

88

*

19

89

*

19

90

*

19

91

*

19

92

*

19

93

19

94

19

95

19

96

19

97

19

98

19

99

20

00

Policy Year

* Excludes Maine Residual Market Pool

Residual Market Policy Size

Large (PY93) Vs. Small (PY2000)

All NCCI States

Premium RangePY 93

Policy Count% ofTotal

PY 2000Policy Count

% ofTotal

$0 - $2,499$2,500 -$4,999$5,000 - $9,999$10,000 - $49,999$50,000 - $99,999$100,000 - $499,999

$500,000 and over

271,76856,22936,49136,697

5,5583,536

163

66.2%13.7%

8.9%8.9%1.4%0.9%

0.0%

75,6848,1614,2383,611

398230

6

82.0%8.8%4.6%4.0%0.4%0.3%

>.01%

Total 410,442 100.0% 92,330 100%

© 2000 National Council on Compensation Insurance, Inc.

NCCI ASSIGNED RISK RATEMAKING

Biggest challenges facing NCCI:

• Volatility of assigned risk data due to low volume

• Increasing expense provisions as % of premium

• Maintaining Servicing Carrier capacity

• Affordability vs. subsidies (break-even pricing)

© 2000 National Council on Compensation Insurance, Inc.

HOW DOES ONE KEEP RESIDUAL MARKETS SMALL?

• Strive for rate adequacy

• Retain pricing programs in AR market

• Help prevent erosion to reforms

• Maintain a target goal of underwriting loss to voluntary premium ratio <1.0%

• Examine alternative Residual Market Structures

PRIVATE PASSENGERRATEMAKING

ASSIGNED RISK

John Winkleman, Jr.

AIPSO

RATEMAKING METHODOLOGY

BASED ON SIZE OF PREMIUM

TOTAL PREMIUM < $1.0M

BASED ON COMPARISON TO NON- STD MARKET

TOTAL PREMIUM > $1.0M

BASED ON PROSPECTIVE RATING

New YorkPPNF Liability

0

200

400

600

800

1000

1200

12 Months Ending

12 M

onth

s As

sign

eds

Thou

sand

s

CountrywidePPNF Liability

0

1

2

3

4

12 Months Ending

12 M

onth

s As

sign

eds

Mill

ions

Countrywide OTPP Liability

0

100

200

300

400

12 Months Ending

12

Mo

nth

s A

ss

ign

ed

s

Th

ou

sa

nd

s

Residual Market Pricing

Richard Amundson, FCAS

Actuarial Director

MN Department of Commerce

A Model of Residual Market Pricing Some assumptions

• Assigned Risk Plan (ARP) sets prices to break even based on its own experience.

• ARP’s profit or loss is allocated to the voluntary market.

• Insurance is mandatory; 2 choices: voluntary or ARP.

• An insured buys from market with lowest price.

• Expenses are proportional to loss and will be ignored.

An Instructive Example

• Insurer needs $100 surplus for $200 yr-end loss.

• Insurer earns 5% risk-free on invested assets.

• Insurer needs a 15% return on equity.

Extreme case 1: ARP has 0 percent market share.

• Insurer collects $200 in premium, invests it & the $100 of surplus.

• Insurer earns $15 during the year.

• Year-end: insurer pays $200, has $100 plus $15 from investments.

Extreme case 2: ARP has 100% market share.

• Insurer has no voluntary premium, but retains responsibility for ARP’s losses.

• Insurer still needs $100 of surplus: all the risk is still around and the insurer still bears it all.

• Insurer has same risk as in case 1, same investment as in case 1, so needs same return. ARP must charge full $200 in order to generate same return.

Regardless of ARP market share, insurer needs the full $100 surplus and the full $200 prem.

FIGURE 1

MARKET RATES IN EQUILIBRIUM

PREMIUM y

y = x

R

y = ax

x EXPECTED

R’ R LOSS

R = ARP price

ax = voluntary market price

The Elusive Search For Equilibrium

What happens when ARP reviews rates?

• ARP overcharged insureds with expected losses between R’ and R and undercharged insureds with expected losses > R. Net effect is undercharge, but analysis will not necessarily indicate rate increase.

• ARP doesn’t include profit in its analysis. ARP may charge enough to pay claims: analysis on non-profit basis may show need for rate reduction. Whether analysis will show need for increase or decrease is function of distribution of expected losses.

• Only sure way to remain in equilibrium is to ignore indications.

Figure 2Market Rates With ARP Pricing To

Break Even PREMIUM

y

29.19 y = x

28.18

27.62

y = 27.62

y = ax

x EXPECTED 28 29 LOSS

27.62 = ARP price

ax = voluntary market price

If consensus is in favor of keeping and controlling residual market, break-even pricing is poor tool.

Assuming that ARP will exist, that it should not be too burdensome on voluntary market and that it should not have wild swings in market share, then there is a reasonable solution to rate problem:

Base ARP rates on industrywide experience, consistently higher than what a typical insurer would need to charge in voluntary market.

How To Set ARP Rates

Guidelines:

Bigger the voluntary market the better.

Residual market should not be unaffordable.

Expected assessment of residual mkt losses on voluntary mkt insureds not excessive.

Rate changes should not be abrupt.

Setting Specific Goals

Possible goals for residual market:

Market share under 1%. Rates under 150% of voluntary. Expected assessment under 0.5%. Annual rate changes < 10% (relative to

voluntary market) during catch-up period.

Using Goals To Set Prices

Residual market can set prices as multiple of voluntary market and measure success directly from goals.

Example of Specific Goals

Yes, to prevent future problems from arising. The best time to repair the roof is when it isn’t raining.

Market-based pricing gives ARP a built-in stabilizer, a governor to keep the system from breaking down.

Should ARP move away from break-even pricing even if already running

smoothly?

Remember the Maine

If you don’t think the system can break down:

State ofRemember theMaine

If you don’t think the system can break down:

If you take one idea home with you, let it be this:

The burden that ARP puts on the voluntary market is not simply ARP’s bottom-line losses.

The burden is reduced return on surplus, even if ARP’s return is positive.

Recap: one last look at ARP’s burden

Put yourself in the shoes of the voluntary market where you have $1 million each of premium and surplus,

and ARP has $500 million of premium & no surplus.

If ARP expects a bottom-line gain of 1% of premium, would you like the right to the gain if it also obligates you to pay in case of a loss?

If you say yes, I have some advice for you on behalf of Governor Ventura and the Minnesota guaranty fund:

Recap: one last look at ARP’s burden

An Illustration

Stay out of Minnesota!