Brehm Ch 5

Question 1

Define underwriting cycle

Answer 1

Recurring pattern of increases and decreases in insurance prices and profits.

Question 2

Are underwriting cycle the same for each LOBs?

Answer 2

Typically, each LOB experiences its own cycle.

For example, auto insurance tends to follow a 6y cycle.

However, economic and societal shocks can cause correlations between cycles across LOBs.

Question 3

Identify the 4 stages of the evolution of a LOB.

Answer 3

1. Emergence
2. Control
3. Breakdown
4. Reorganization

Question 4

Describe the emergence stage of LOB evolution. State its primary driver.

Answer 4

When a new LOB arises, data is thin, demand grows quickly and pricing is erratic.

Price wars set in as competitors enter the market.

Eventually, a sudden price correction occurs and weak competitors leave the market.

A period of profitability follows, which brins in more competitors and restarts the cycle.

Driven by competition.

Question 5

Describe the control stage of LOB evolution. State its primary driver.

Answer 5

Stabilization of the LOB is eventually gained through collective coercive control:
Restricting entry
Standardizing insurance products
Stabilizing market shares

Rating bureaux and state DOIs regulate price changes.

Driven by statistical data lags (growing lines experience large losses in early years and EP catch up to losses in financials).

Question 6

Describe the Breakdown stage of LOB evolution. State its primary driver.

Answer 6

Due to technological and societal changes, new types of competitors enter the market and take business away.

This causes a breakdown in the control regime.

Driven by competition and data lags.

Question 7

Describe the reorganization stage of LOB evolution. State its primary driver,

Answer 7

This is a return to the conditions of the emergence phase, as a new version of the old LOB emerges.

Driven by competition.

Question 8

Briefly describe 2 theories that drives UW Cycle

Answer 8

1. Institutional Factors
   Cycle is driven by time lags involved in pricing.
   Time lags due to reporting and regulatory delays also contribute to UW cycle.
2. Competition
   The cycle is driven by competition between insurers toward lower rates.
   Underwriting strategies fluctuate between growth and price maintenance.
3. Supply/Demand, Capacity Constraints and Shocks
   Shocks to capital (ex: CATs) reduce capacity, causing price increases.
4. Economic Linkages
   Insurance profitability and cost of capital are driven by macroeconomics.

Question 9

Provide 3 examples of economic drivers

Answer 9

1. Insurance profitability is linked to investment income
2. Cost of capital is linked to wider economy
3. Expected losses in some LOBs are affected by inflation, GNP growth or unemployment

Question 10

Provide 2 quantities used as DEPENDANT variables in modelling UW Cycle.

Answer 10

1. Loss Ratio
2. Combined Ratio

Question 11

Provide 4 quantities used as INDEPENDANT variables in modelling UW Cycle

Answer 11

1. Historical values of dependent variable and its components
2. Internal financial variables (reserves, investment income, cat losses, capital)
3. Regulatory/ratings variables (upgrades and downgrades)
4. Reinsurance financials
5. Econometric variables (inflation, unemployment, GNP)
6. Financial market variables (interest rates, stock market returns)

Question 12

Provide 4 sources of competitor intelligence

Answer 12

To help predict the turn in UW cycle, competitor analysis techniques are advised.

Sources of information include:
1. Own agents and field staff
2. Customer surveys
3. Trade publications
4. News scanning
5. Rate filings
6. Internet

Question 13

Identify 3 styles of UW Cycle modelling

Answer 13

1. Soft approaches
2. Behavioural or econometric modelling
3. Technical modelling

Question 14

Describe the soft approaches to UW Cycle modelling

Answer 14

Focus on gathering data and doing competitor intelligence, which analysts look at to gauge the state go UW cycle.

Data analysis techniques include:
1. Scenarios
2. Delphi method
3. Competitor Anlysis

Question 15

Describe the technical modelling of UW Cycle

Answer 15

UW Cycle is modelled as a time series such as an autoregressive model.

Model can then create forecasts for the future, which can be used in an ERM model or for strategic planning.

Question 16

Describe the econometric modelling of UW Cycle (behavioural modelling)

Answer 16

Balances soft approaches, which seek to understand structure of UW Cycle, and technical modelling, which seeks to create a statistical model.

Models changes in supply and demande of insurance and how those changes influence equilibrium price (market price) of insurance.

Question 17

Class the 3 approaches to model UW cycle in terms of data quantity, variety and complexity.

Answer 17

Highest: soft
Middle: Behavioural
Lowest: Technical

Question 18

Class the 3 approaches to model UW cycle in terms of recognition of human factors.

Answer 18

Highest: soft
Middle: behavioural
Lowest: Technical

Question 19

Class the 3 approaches to model UW cycle in terms of mathematical formalism and rigor.

Answer 19

Highest: Technical
Middle: Behavioural
Lowest: Soft

Question 20

Describe the Delphi Method

Answer 20

Method of obtaining consensus on an issue.

Experts are given background information and asked for their opinions in a questionnaire.

Answers are aggregated and summaries are given back to participants.

Participants can changer their answers based on those summaries or articulate their reasons for disagreeing.

Process is repeated until consensus is reached.

Question 21

Describe the competitor analysis.

Answer 21

Attempts to discern the states, motives and likely behaviours of individual, competing firms.

Starts with a database of competitor information, key financials, new items and behavioural metrics.

For predicting turns in UW cycle, goal is observing unusually profitable or distressed financial conditions over a large number of firms.

Question 22

Describe how scenarios and Delphi method feed each other.

Answer 22

Delphi process can create a set of scenarios and scenarios can form the input to Delphi assessment about the likelihood of each scenario.

Question 23

Describe VARMAX method

Answer 23

Generalization of the technical procedure where multiple variables are modelled simultaneously (ex: consumption and income) and interaction and co-movement between variables is quantified.

VARMAX can handle predictive variables external to the time series system (other than Xt-i).

Question 24

Describe a general factor model (technical approach)

Answer 24

Zt = a + biZt + sigmae_t
Xt = c + d(Zt-1-Xt-a) + taudelta_t

In general factor model, e and delta are not necessarily rvs and Z is not observable.

Model results in X randomly varying around a moving average determined by Z.

Difficult to fit as an AR model and may require more sophisticated fitting techniques.

Question 25

Describe the impact of shocks to capital (ex: catastrophes) to supply and demand

Answer 25

Shocks to capital decrease supply and potentially decrease demand if quality decreases.

Question 26

Describe the impact of increased competition on supply and demand.

Answer 26

Increased competition increases supply and potentially increases demand if insurance quality rises.

Question 27

Describe the impact of high expected profits on capital.

Answer 27

Results in capital inflows (new competitors, capital infusions)

Question 28

Describe the impact of low profits on capital.

Answer 28

Results in capital outflows (firms exiting the market).

Capital is used to pay claims.

Question 29

Describe the impact of normal dividends on capital.

Answer 29

Result in a steady outflow of capital.

Question 30

List 4 questions to answer before building econometric model

Answer 30

1. How do economic factors influence the supply and demand curves?
2. How does capital influence the supply and demand curves?
3. Hoes do supply and demand curves jointly determine price and quantity?
4. How do premiums and losses affect capital stock?
5. How does profitability affect external capital flows?

Question 31

Describe how the econometric model can be used to create empirical distribution of possible future prices.

Answer 31

Goal is to determine the equilibrium price that sets the benchmark against which firms must compete.

Various components changes can be simulated to create an empirical distribution of possible future prices.

Question 32

Briefly describe one feature that econometric modelling of underwriting cycle has in common with:
a. Soft approaches
b. Technical models

Answer 32

a. Econometric modelling includes the recognition of human factors impacts UW cycle.

b. Econometric modelling requires mathematical rigour.

Question 33

identify 2 components of an econometric model of the UW cycle.

Answer 33

The supply curve slopes UP and to the RIGHT because price must increase to attract more supply to market.
When competition is strong and/or technological advances reduce firm expenses, initial line shifts DOWN and to the RIGHT.
When available capital is restricted, line shifts UP and to the LEFT.

The demand curve slopes DOWN and to the RIGHT.
When industry capital increases, there is a general increase in capital quality, thus initial line shifts UP and to the RIGHT.
When available capital is restricted, demand reduces and line shifts DOWN and to the LEFT.

The interaction between supply and demand determines the equilibrium market price.
When capital is restricted, price increases.
When capital increases, price decreases.