We're Not Fulfilling Our Obligations
By David Spiegler

Below is an excerpt from the CAS Web Site describing what casualty actuaries do:

Actuaries evaluate the financial impact of current economic, legal, and social trends on future events. The accurate and responsible matching of risk to price is the foundation upon which the financial integrity of the actuary's company or client rests.

With respect to general liability (GL) business, I'd suggest that we need to recognize the danger of continuing with our current methodologies regarding the "accurate and responsible matching of risk to price." Because current pricing methodologies do not properly match risk to price, we imperil the "financial integrity of the actuary's company or client." This problem typically manifests itself in reserving problems, but like all reserving problems, the root cause is found in pricing and business planning weaknesses.

I'll briefly define the problem, and then I'll offer three alternative ways for us, as a profession and as members of the insurance industry, to address it. Simplistically, a GL policy covers the insured for anything they may become liable for, except for certain known items that are specifically excluded from coverage. The problem is twofold:

• By the time we think to exclude a specific exposure, it's too late. Our companies are already liable for these exposures without having been compensated for assuming these risks. The exclusions address future occurrences; they don't mitigate exposures that were underwritten prior to the introduction of the exclusions. Examples include asbestos and pollution.
• We don't know what to exclude in terms of future exposures. And even if we did, we'd still be responsible for any liability incurred prior to the introduction of any exclusion. Think of examples of these as future liability storm #168 or future liability 8.0 earthquake.

Here are three ways to address this problem:

1. Write GL business only on a named perils basis. That is, only include coverage for the types of claims that we know are built into the policy's pricing. The effect of this option would be to provide considerably less coverage than is currently the case for approximately the same premium.
2. Price the product to recognize the fact that GL policies cover potential mass torts that have not yet occurred (or have occurred, but we don't know about them yet). One way to do this is to price casualty coverage in much the same way that property catastrophe coverage is currently priced. That is by assigning frequency and severity guesstimates to future liability storms and future liability earthquakes. The effect of this option would be to provide the same coverage that is currently offered for considerably more premium.
3. Continue with the status quo. Keep our heads in the sand and pretend that we're properly matching price to risk on GL policies. This option can be thought of as implicit socialism-a redistribution of wealth from the owners/policyholders of insurance companies to all other industries, fulfilling a vital public policy need of ensuring the smooth operation of the overall economy.

Let's use these three options to explore our problems in the "accurate and responsible matching of risk to price." Let's say that Pn=premium for named perils coverage; En=expected losses for named perils coverage; Pa=premium for all risks coverage; Ea=expected losses for all risks coverage. Option 1 tells us to charge Pn to cover En. Option 2 tells us to charge Pa to cover Ea. Both options appropriately match risk to price. Option 3, however, implies that we charge Pn to cover Ea. This mismatch in pricing creates the vicious cycle we currently find ourselves in. Our business plans are developed using loss ratios based on En/Pn. Next we use these business plan loss ratios to book the reserves in our financials. Unfortunately, the appropriate plan and reserving loss ratios are Ea/Pn. The desire to show business plans that meet required profitability levels, and the long-term nature of the underlying exposures, conspire to allow us to ignore the problem, both as a profession and as an industry. Alas, ignoring the problem does not make it go away. The question is not whether we'll have future reserving problems, but when will we recognize them and how large will they be.

It seems clear that unless we recognize this issue, our profession will continue to have severe credibility problems. As currently configured, the business planning and pricing practices of the industry virtually guarantee a future of significant reserving problems.

Obviously, policyholders don't want to hear that their options are to pay more for the same coverage or to pay the same for less coverage, but our obligation as actuaries is the "accurate and responsible matching of risk to price." That is, our responsibility is "actuarial equity," not "social equity." Politicians and regulators are charged with addressing the latter.

While I focused on GL business here, it should be noted that the failure to accurately match price to risk exists on any liability coverage where, to paraphrase the mutual fund industry, "past experience is not an indicator of future performance." Some good examples would be directors & officers, errors & omissions, and employment practices liability.

The future of our profession, and its credibility, is at stake here. We need to address this issue publicly at industry events, through the CAS and the American Academy of Actuaries, internally at each of our own companies, and with regulators and rating agencies.

David Spiegler, FCAS, FCA, MAAA, is executive vice president and chief actuary of BMS Vision Re Intermediaries, Inc., in East Brunswick, NJ. He is also an ARIAS-U.S.-certified arbitrator.