Revised NAIC ALAE and ULAE Definitions or DCC

Revised NAIC ALAE and ULAE Definitions (or DCC and A&O > 1/1/98) A Non-Actuarial Perspective by Richard Carris, CPCU, CIPA, CLU, CFE, APA, AIC, ARM Casualty Actuarial Society Meeting: Casualty Loss Reserve Seminar Session: NAIC Redefinitions of Loss Adjustment Expense Venue: Arlington, VA Date: September 24, 2002 Time: 12: 30 PM to 2: 00 PM Contact: rcarris@qbeusa. com or (212) 894 -7747

Trigger = 1/1/98 Keys on ALAE for the LAE Person ® Traditional ALAE = ® Allocated Loss Adjustment Expense = ® Allocated Loss Expense (in Sch P) = ® New or Revised ALAE = ® Defense and Cost Containment (“DCC”) = ® CAS = Claim Adjustment Services (Interim Period) Whereby CAS = Defense, Litigation and Medical Cost containment Services <DCC but> Traditional ALAE. Used for Discussion Purposes by NAIC. (in name only but not components) 2

Trigger = 1/1/98 Keys on ULAE for the LAE Person ® Traditional ULAE = ® ® Unallocated Loss Adjustment Expense = Traditional LAE = ALAE + ULAE ® New or Revised LAE = DCC + A&O ® Unallocated Loss Expense (in Sch P) ® New or Revised ULAE = ® Adjusting and Other (“A&O”) (in name only but not components) 3

Old NAIC Definitions of ALAE and ULAE Chapter 11 - Loss Adjustment Expenses of the Accounting Practices and Procedures Manual ® Old ALAE - Allocate whatever can be allocated. (Expense identified with a specific claim) ® Old ULAE - Everything else. Defense, litigation and medical cost containment not previously specified. 4

New ALAE (DCC)* (Sch P Columns 6 & 7 Per NAIC 6/24/97 Draft 2001 Annual Statement) ® Specifically, Allocated Loss Adjustment Expense (new ALAE) includes the following items: v Surveillance expenses; v Fixed amounts for medical cost containment expenses; v Litigation management expenses; 5

New ALAE (DCC) (Sch P Columns 6 & 7 Per NAIC 6/24/97 Draft 2001 Annual Statement) v Loss adjustment expenses for participation in voluntary and involuntary market pools if reported by accident year; v Fees or salaries for appraisers, private investigators, hearing representatives, reinspectors and fraud investigators, if working in defense of a claim, and fees or salaries for rehabilitation nurses, if such cost is not included in losses; 6

New ALAE (DCC) (Sch P Columns 6 & 7 Per NAIC 6/24/97 Draft 2001 Annual Statement) ® v Attorney fees incurred owing to a duty to defend, even when other coverage does not exist; and v The cost of engaging experts. The foregoing list is not intended to be all inclusive. 7

New ULAE (A&O)* (Sch P Columns 8 & 9 Per NAIC 6/24/97 Draft 2001 Annual Statement) ® Unallocated Loss Adjustment Expenses are those expenses other than allocated expenses. New ULAE includes the following items: v Fees of adjusters and settling agents; v Loss adjustment expenses for participation in voluntary and involuntary market pools if reported by calendar year; *Effective 1/1/98 8

New ULAE (A&O) (Sch P Columns 8 & 9 Per NAIC 6/24/97 Draft 2001 Annual Statement) ® v Attorney fees incurred in the determination of coverage, including litigation between the insurer and the policyholder; and v Fees or salaries for appraisers, private investigators, hearing representatives, reinspectors and fraud investigators, if working in the capacity of an adjuster. The foregoing list is not intended to be all inclusive. 9

Who Is An Adjuster? (For ULAE) ® And although not defined, the term adjuster is broad enough to include claim examiners, claim investigators, claim representative, claim supervisors, appraisers, reinspectors and other titles that any one company may use. It is not really the title, but the claims adjusting function. 10

Theme ® It no longer matters whether an insurer uses its own employees or independent contractors. The concept of internal adjuster or external adjuster is gone. 11

Exhibit I NAIC Change (Cheat Sheet) MAJOR EXPENSE OLD ALAE/ULAE METHOD <1998 Inside Legal Counsel * ULAE or ALAE but mostly ULAE Outside Adjusters and Appraisers ALAE or ULAE but mostly ALAE Insider Adjuster and Appraisers ULAE or ALAE but mostly ULAE * For Duty to Defend 12 NEW ALAE/ULAE METHOD _> 1998 ALAE +Overhead loading ULAE

Exhibit I NAIC Change (cont’d) (Cheat Sheet) MAJOR EXPENSE OLD ALAE/ULAE METHOD <1998 Outside Experts ALAE or ULAE but mostly ALAE Inside Experts ULAE or ALAE but mostly ULAE ALAE or ULAE Attorney Engaging in Adjusting Work 13 NEW ALAE/ULAE METHOD > 1998 ULAE

Question and Answer Session with Richard Roth, JD, FCAS 1. Dick, what was the reason for the redefinition of LAE effective January 1, 1998? 2. Was this an industry motivated redefinition or one thought about by the CATF of the NAIC? 3. How many years prior to the implementation of the new LAE definitions was the CATF considering this redefinition? 4. How were the terms DCC and A&O (post 1/1/98) ultimately determined? 14

Question and Answer Session with Richard Roth, JD, FCAS 5. Besides space issues (22 characters formerly for Allocated Loss Expense and 24 characters formerly for Unallocated Loss Expense) in the annual statement blank heading of Sch P, what was the rational or constraints in selecting new terms? 6. What changes, if any, have there been in the actual implementation of the redefinition from the June 24, 1997 CATF draft on the topic? 15

Question and Answer Session with Richard Roth, JD, FCAS 7. Are you aware of methods insurers have employed to adjust to the change? If so, can you explain? 8. Are you aware of changes, if any, made by ISO and NCCI regarding their definition of ALAE (ALE prior to 1/1/98 and DCC thereafter)? 9. Can you say yet if this change is expense neutral? If not, how has the ALAE/LAE (DCC/DCC + A&O) ratio changed? Would this vary by company? 16

Question and Answer Session with Richard Roth, JD, FCAS 10. Do you think the NAIC change has achieved its objective? 11. Would you ever see the NAIC going back to the pre. January 1 st 1998 definitions of LAE? 12. Did anyone study the cost to the insurance industry of implementation of DCC and A&O as compared with traditional ALAE and ULAE? 17

Question and Answer Session with Richard Roth, JD, FCAS 13. Do you know what the NAIC is doing differently with the new data vs. the old data? 14. How is the NAIC monitoring implementation of compliance with DCC and A&O? 15. By the way, has the NAIC ever determined what is a settling agent? (Source: NAIC Draft June 24, 1997). 18

Question and Answer Session with Richard Roth, JD, FCAS 16. Have you learned of insurers or reserving actuaries that are pleased with the change? 17. Do you have any feedback that you would like to provide to the members in attendance at the CAS? Thanks as always for your help on our favorite topic. 19

Exhibit II Revised Definition of ALAE and ULAE EXAMPLE Coded as ULAE ? (A&O) Coded as ALAE ? (DCC) Salaries of fraud investigators, private investigators, appraisers, hearing representatives and reinspectors. Yes, if working in the capacity of an adjuster. No, if working in defense of a claim. Yes, if working in defense of a claim. No, if working in the capacity of an adjuster. Surveillance Expenses No Yes Fees of Professionals No Yes Salaries and expenses of inside adjusters and fees and expenses of outside adjusters. Yes No Source: NAIC June 24, 1997 Draft and various conversations with Richard J. Roth, Jr. of the California Insurance Department. 20

Exhibit II (cont’d) Revised Definition of ALAE and ULAE EXAMPLE Coded as ULAE ? (A&O) Coded as ALAE ? (DCC) All independent adjuster expenses Yes No All staff adjuster expenses Yes No Attorney fees Yes, for coverage evaluation and litigation between the insurer and insured. (i. e. , D. J. costs). Also, Yes, for any adjustment type of activity. Yes, for expenses incurred under the broad duty to defend concept, even if no duty to indemnify. Does not include any adjuster type of expense. (Include an overhead loading). Selected medical cost containment expenses No Yes Source: NAIC June 24, 1997 Draft and various conversations with Richard J. Roth, Jr. of the California Insurance Department. 21

Exhibit II (cont’d) Revised Definition of ALAE and ULAE EXAMPLE Coded as ULAE ? (A&O) Coded as ALAE ? (DCC) Litigation management expenses including legal bill review No Yes Loss adjustment expenses for participation in voluntary and involuntary market pools Yes, if reported by calendar year Yes, if reported by accident year Outside Expert fees (accountants, physicians, engineers, architects, etc. ) No Yes Inside Expert fees No Yes Claim adjuster expenses Yes No Source: NAIC June 24, 1997 Draft and various conversations with Richard J. Roth, Jr. of the California Insurance Department. 22

Exhibit II (cont’d) Revised Definition of ALAE and ULAE Coded as ULAE ? (A&O) EXAMPLE Coded as ALAE ? (DCC) Internal or external defense and litigation No Yes Medical cost containment expenses No Yes Usual Adjuster Expense Yes No Unusual Adjuster Expense No Yes Expenses not cited above Yes Source: NAIC June 24, 1997 Draft and various conversations with Richard J. Roth, Jr. of the California Insurance Department. 23

24

25

Considerations of LAE ® NAIC ® ISO ® NCCI ® State Bureaus ® GAAP ® Operational - Allocating expenses to their source makes good economics and is proper cost accounting, regardless of the regulatory requirement. 26

Exhibit III-Pre/Post Observations NEW ALAE/ULAE (Practice) ALAE Inside Legal OLD ALAE/ULAE (Practice) ALAE ULAE Outside Adjusters ALAE Outside Adjusters ULAE Inside Legal = Overlap Other Expenses = Overlap 27

Exhibit IV Other Benefits of the Change: An Increase in Demand for Casualty Actuaries Price S 1* P 2 P 1 D 2 D 1 Quantity Demanded Q 2 28

Exhibit V - Net ONE EXAMPLE OLD NEW ALAE Inside Legal Mostly Out In + Loading NET Change to ALAE as % of LAE +X% Factor Independent Adjuster Mostly In Out -y% + if x% > y% - if x%< y% no ^ if x%=y% Net 29

Analytic Geometry of Two Dimensions EXAMPLE Month of Development ACC YR Year x 1 x 2 x 3 x 4 x 5 x 6 x 7 x 8 x 9 12 X X X X X 24 X X X X 36 X X X X 48 X X X 60 X X X 72 X X 84 X X X 96 X X 108 X Month of Development ACC YR Year 12 24 48 60 72 84 96 108 x 1 x 2 x 3 x 4 x 5 x 6 x 7 x 8 x 9 X X X X X X X X X X 2 Triangles = 30

= 1 Claims File EXAMPLE 108 X ® 96 X X 84 X X X 72 X X X X 60 X X X X X If one can do triangles, with double the effort, one can do rectangles (the claims file). 31 48 X X X 36 X X X X 24 X X X X 1 X X X X X Year x 1 x 2 x 3 x 4 x 5 x 6 x 7 x 8 x 9

Economic Benefits of Transforming Traditional ULAE into ALAE ® Proper Analysis of Profitability ® Reinsurance Recoverables (Per terms of Contract) ® Correctly Calculate MGA’s and Agents’ Contingent Commissions ® Additional Premiums for insurers and reinsurers via Loss-Sensitive Insurance Programs ® Subrogation and Salvage Actions 32

LAE Trend Confusion X X =? Sept. 24, 2002 ~ ~ 1: 30 PM Actuarial Student ACAS FCAS 33 1996 1998 2000 2002 Time

E-mail address: For a copy of this presentation – contact Richard Carris at: rcarris@qbeusa. com 34

Richard Carris, CPCU, CLU, CFE, CIPA, ARM, AIC QBE the Americans Wall Street Plaza New York, New York 10005 ® Richard is vice president and internal audit manager for QBE the Americas consisting of QBE Reinsurance Corporation and QBE Insurance Corporation. ® Richard began his insurance career in 1980. In his more than 20 years of property/casualty experience he spent 12 years with a Big 4 accounting firm in the auditing of various insurance company operations (claims, underwriting, premium auditing, finance, accounting, etc. ). His experience prior to 12 years with a Big 4 firm included risk management, brokerage and positions with two primary insurance companies. ® Richard is a member of the professional societies of CPCU, CLU, Ch. FC, CFE, NSIPA (National Society of Insurance Premium Auditors) and NASP (National Association of Subrogation Professionals). He has served for ten years as an Editorial Advisory Board Member for Risk Management magazine (the professional magazine of RIMS) reviewing risk management and other articles for publication consideration. He serves on the ISO Premium Fraud Panel. ® Richard was an Adjunct Professor of Insurance Economics for several years teaching the Part 9 CPCU course at Baruch College – City University of New York and The College of Insurance located in NYC. ® Richard has published over 50 articles on a variety of insurance operational topics including underwriting, premium auditing, claims, risk management and international insurance economics for Best’s Review, CPCU Journal, National Underwriter, Insurance Executive Reports, Subrogator, Risk Management, Global Reinsurance and a variety of construction trade publications. He is the co-author of a Mc. Graw-Hill textbook entitled Construction Insurance, Bonding and Risk Management. 35

Next Speaker. . . “This new definition of ALAE/ULAE is not retroactive. However, prospectively the change could be implemented on a calendar year or an accident year basis. On a calendar year basis, the expenses in the new and older accident years have the new definition as they develop in the loss and expense triangles. On an accident year basis, the expenses in the new accident years have the new definition and the expenses in the older accident years have the old definition. It is optional to the company which way to do it. There is a split among companies as to which is easier. The actuary should be able to handle either way as long as it is known which choice was made. ” Source: NAIC 36