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Novices often treat ratemaking and reserving as separate silos. In reality, reserving errors directly cause pricing errors.
Consider this virtuous (or vicious) cycle:
If you over-reserve (you set $2M, but ultimate is $1.5M):
Thus, the actuary’s motto: “Reserving is truth-telling. Ratemaking is forward planning. Never let wishful thinking contaminate either.” Novices often treat ratemaking and reserving as separate
An insurer’s liability for claims is called Loss and Loss Adjustment Expense (LAE) Reserves. It has two components:
The total reserve is:
Total Reserve = Case Reserves + IBNR Reserves If you over-reserve (you set $2M, but ultimate is $1
$$Premium = Losses + Expenses + Profit$$
The actuary’s goal is to ensure that the premium is sufficient to cover the Expected Loss Ratio and the Expense Ratio while allowing for a target profit margin.
The exposure base must be highly correlated with loss potential. Thus, the actuary’s motto: “Reserving is truth-telling
While loss reserving looks backward, ratemaking looks forward. The goal of ratemaking is to set a price (premium) sufficient to pay all future claims, cover expenses, and provide a reasonable profit—while remaining competitive.
| Reserve Type | Definition | Example | | :--- | :--- | :--- | | Case Reserve | Set by a claims adjuster for a specific, reported claim. | Adjuster estimates a $50,000 car injury claim. | | IBNR (Incurred But Not Reported) | For claims that have happened but the insurer hasn't been notified yet. | A slip-and-fall accident yesterday that will be reported next month. | | IBNER (Incurred But Not Enough Reported) | Additional development on known claims. | A minor injury claim that develops into a major surgery claim. |
| Issue | Impact on Reserving | Impact on Ratemaking | | :--- | :--- | :--- | | Social Inflation (increasing litigation severity) | Chain Ladder understates reserves if not trend-adjusted. | Historical loss ratios become misleading; need explicit trend factor. | | Hard/Soft Market cycles | No direct impact. | Underwriting profit margin may be negative in soft markets (cash flow underwriting). | | New technology (ADAS, telematics) | Claims frequency drops, but repair severity rises. | Requires segmentation and telematics rating factors. | | Pandemic (e.g., COVID-19) | Business interruption (BI) claims – untested contract language. | Exclusions added; new models needed for systemic risk. |
The premium must cover both fixed and variable expenses.