The Combined Ratio the CFO Wants
Lakeshore Mutual writes $120 million of net written premium in a single commercial auto line (earned premium $118 million). For the year: incurred losses $74 million, including $9 million of adverse development on prior accident years; loss adjustment expense $12 million; underwriting expenses $32 million. Catastrophe losses were $14 million against a $6 million budgeted load. Year-end policyholders' surplus is $90 million, after a $6 million dividend. The actuary's central estimate for IBNR is unchanged from last quarter, but the low end of the indicated range would support $5 million less. The CFO proposes releasing that $5 million so the board sees a combined ratio under 100, and separately asks whether to file a 6% rate increase.
1. Compute the calendar-year combined ratio, then restate it excluding prior-year development and excess catastrophe losses. What does the comparison tell the board?
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Calendar year.
- Loss and LAE ratio = ($74M + $12M) ÷ $118M = 72.9%
- Expense ratio (written basis) = $32M ÷ $120M = 26.7%
- Combined ratio = 99.6% - a 0.4-point underwriting loss before investment income
Restatements.
- Remove $9M of prior-year development: ($86M − $9M) ÷ $118M = 65.3%; + 26.7% = 92.0% accident-year combined
- Remove excess catastrophe ($14M − $6M = $8M): 8 ÷ 118 = 6.8 points → ~85.2% normalized
What it tells the board. The reported 99.6% overstates the underlying problem and the underlying result. Two distortions run in opposite directions: adverse development of $9M and an $8M catastrophe overrun are prior-period and non-recurring, but they are also evidence. Eight points of adverse development on prior years is what happens when initial case and IBNR picks are set too low - which means the current accident year's 65.3% is probably optimistic too. Loading a development margin comparable to the observed emergence pushes the accident-year loss ratio back toward the low 70s and the combined ratio back toward the high 90s. Premium leverage is $120M ÷ $90M = 1.33, which is manageable but leaves little room if a second bad year arrives.
2. Evaluate the proposed $5 million IBNR release. What should happen instead?
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Why the release is indefensible as framed.
- The reserve estimate must reflect the actuary's best estimate of ultimate losses, not a target combined ratio. Selecting from the low end of a range because it produces a desired accounting result is reverse engineering.
- $5 million is 5.6% of surplus and would swing the combined ratio by about 4.2 points - material by any reasonable threshold.
- The company has just posted adverse development. Reducing reserves in the same cycle requires stronger, not weaker, documentation.
- The proposal originates with an executive whose compensation is tied to the metric being reported. That is a conflict of interest that must be disclosed to the audit committee, and the actuary's opinion must be free of it.
What should happen.
- The appointed actuary makes and documents the selection independently; the range, the selected point, and the rationale go to the audit committee in writing.
- If the actuary genuinely concludes the central estimate is overstated, the change is made, disclosed, and explained alongside the prior-year development - not announced as a profitability improvement.
- Any release around a bonus target should be reviewed by the audit committee and disclosed as a related-party-sensitive judgment.
- Reserve adequacy and the development history go to the board with the rate discussion, because the two are the same question.
3. Should Lakeshore file the 6% increase? Build the argument using the figures given.
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The case for caution. The normalized accident-year combined ratio of roughly 85% suggests rates are, if anything, redundant - filing a 6% increase on that number alone would invite regulatory pushback and competitive loss.
The case for filing.
- Adverse development proves the historical picks were light, so the 85% is built on a loss ratio that has been systematically understated. Use a developed, trended loss ratio, not the raw accident-year figure.
- $14 million of catastrophe against a $6 million load suggests the cat load in the rate is too small.
- Commercial auto severity has been trending upward; a filing built on current cost levels is stale before it is approved.
- Surplus grew only $4 million net while writing $120 million of premium - the company cannot absorb another shock without leverage rising further.
Recommendation. Do not file 6% reflexively and do not skip the filing because the calendar year looks close to 100%. Direct the actuary to produce a rate indication using developed and trended losses with an explicit cat load, and compare that indication to the 6%. If the developed indication falls in the 0–3% range, file a smaller increase plus underwriting actions (minimum premiums, fleet safety credits, deductible offers) rather than taking the whole adjustment through rate. Document the reasoning for the board and the regulator.