Casualty Quarterly, Summer 2017

Predictive Analytics: Regulatory Review

By Rachel Hemphill
Insurance regulators must review data, methods, and models from diverse companies and diverse product lines, in an industry—and a social, economic, and technological environment—that is constantly changing and presenting new challenges. To be effective, regulators must be familiar with the latest modeling methods used by companies for insurance rating and underwriting. The continuing evolution of methods employed by insurance companies has increased the importance of regulators understanding several potential pitfalls. Three such problem areas are proxy variables, spurious correlations, and price optimization. In each case, a major reason for heightened regulatory concern has been the incorporation of Big Data into insurers’ predictive analytics.

Proxy Variables
Proxy variables occur when a variable is highly correlated with another variable that cannot be used directly. Proxy variables are problematic when they are proxies for a variable that is itself prohibited. That is, the proxy variable is in essence a “stand-in” for a prohibited variable, and so raises the same concerns as the prohibited variable. Big Data increases regulatory concern about proxy variables due to the vast increase in the number of variables available for incorporation in the model. For example, data on grocery store purchases could conceivably be used to construct a proxy variable for ethnicity. This increase in variables considered has also led to an increased use of methods, such as dimensionality reduction techniques, that result in variables that may not have an intuitive interpretation or a clear relationship to loss. It becomes more difficult for the regulator, and even the company actuary, to understand what the predictor variable represents and whether it is a proxy for a prohibited variable.

Spurious Correlations
The widely used rule for measuring the significance of a variable is that the p-value must be 0.05 or smaller. In the Casualty Actuarial Society monograph, Generalized Linear Models for Insurance Rating (page 9), the authors explain, regarding the common 0.05 threshold, that “Since in a typical insurance modeling project we are testing many variables, this threshold may be too high to protect against the possibility of spurious effects making it into the model.” Spurious correlations exist when the historical correlation between two variables is random or coincidental. In these cases, one variable cannot reliably be used to inform a projection of the other variable going forward. For example, over the past year the number of California Department of Insurance rate regulation actuaries has increased, as has California average rainfall. Unfortunately, however, we cannot expect to influence future California rainfall by hiring additional actuaries. While the authors of Generalized Linear Models believe that a requirement stricter than the 0.05 threshold may be necessary to avoid spurious correlations, regulators have actually seen filings moving in the opposite direction, attributing significance to p-values of 0.10, 0.15, or even 0.20.

The question of spurious correlations has become more relevant as technical specialization has increased, creating distance between subject expertise and methodological expertise. For advanced models and predictive analytics, regulators have seen insurers increasingly rely on models that are outside the specific area of expertise of the company actuary, supplied by third-party vendors or actuarial consultants. This separates the individual with the deep understanding of the book of business—the company actuary—from the individual with the deep understanding of the modeling methods. When this is the case, company actuaries should still have at least a basic understanding of the model, evaluate whether it is appropriate for the intended application, and follow the other related guidance described in ASOP No. 38—Using Models Outside the Actuary’s Area of Expertise (Property and Casualty). In addition, it is prudent for the company to ensure that the vendor or consultant will be available to answer later regulatory questions regarding the model, or the model review may reach an impasse.

Price Optimization
While definitions vary, price optimization generally means setting prices based not solely on the cost of the individual risk transfer but also, in part, on the price that a customer or group of customers will tolerate. Why are regulators concerned about price optimization? One simple reason is that free-market forces are not a reliable defense against unfairly discriminatory insurance pricing, due to asymmetric information, for example, or because legal requirements can result in inelastic demand. Twenty jurisdictions have issued bulletins on price optimization; actuaries should be very familiar with the bulletins for their jurisdictions. If a jurisdiction has not yet issued a bulletin regarding price optimization, this does not mean that price optimization is allowed in that jurisdiction. Indeed, many jurisdictions that have issued bulletins considered them not to be introducing a new requirement, but simply reiterating an existing requirement, that rates not be unfairly discriminatory.

How will regulators know if an insurer is using price optimization? We expect the filing actuary to follow ASOP No. 41—Actuarial Communications, Section 3.2, which states:

In the actuarial report, the actuary should state the actuarial findings, and identify the methods, procedures, assumptions, and data used by the actuary with sufficient clarity that another actuary qualified in the same practice area could make an objective appraisal of the reasonableness of the actuary’s work as presented in the actuarial report. [Emphasis added.]

In following ASOP No. 41, Section 3.2, a company actuary would presumably need to provide, as part of the filing, sufficient documentation to review the reasonableness of both the indications and where and why selections differ from indications. The logic of this section would seem to require that all methodologies or modeling processes used in determining the final rates should be clearly documented in the actuarial communication for any filing. This is especially important if the selections are based in part on some form of price optimization, given that the use of price optimization has often not been explicitly documented.

Unfortunately, some have proposed that the solution to the inherent inequity is to shift the burden to the consumer, who is then expected to address imbalances in information, for example by doing exhaustive research on the prices and coverages provided by the various companies. Of course, expecting consumers to understand and address all of the drivers of their own insurance costs is a high demand. This doesn’t just require that the consumers know that they may be charged a counterintuitive penalty for their loyalty to their insurer and should therefore shop around. It also requires that they understand, for example, the effect that their credit score may have on their insurance costs. Further, for consumers to understand their insurance costs, they need to understand complex variables, such as the kurtosis of the average rainfall in a neighborhood where they are considering purchasing a home. The reasons for such variables may be known to an actuary, but will not likely be known to the consumer.

To say that an insured should avoid a loyalty surcharge by shopping around presumes that the insured has an abundance of time and information to research and procure alternative insurance, and that the time cost of that research to the insured should be ignored. In fact, it may be a rational choice for an insured not to invest tens of hours of research to find the best price; yet, the higher price charged to a loyal customer still does not become cost-based with respect to the insurer’s expected losses and expenses simply because it is too costly of an investment for the consumer to avoid the penalty.

Regulatory Resources
The regulatory review process for predictive analytics would be significantly improved by giving regulators readier access to targeted, well-organized, and comprehensive continuing education, which can equip the regulators with general knowledge of predictive analytics topics.  Beyond this, though, regulators also need to discuss these issues from a regulatory perspective with other regulators. A valuable resource for regulatory actuaries is multi-state coordinated training and education efforts through the NAIC and NAIC’s Casualty Actuarial and Statistical Task Force (CASTF). The NAIC is currently assisting regulators on these topics through the following:

• GLM survey.
• Price optimization white paper.
• State model checklists available on the NAIC’s CASTF website, under “Related Documents.”
• CASTF regular meetings
• Training organized by CASTF, such as the recent one-and-a-half day training on predictive analytics by the Academy and regulatory actuaries.

Rachel Hemphill, MAAA, FCAS, FSA, Ph.D., is chief systems actuary at the California Department of Insurance.

This article is solely the opinion of its author. It does not express the official policy of the American Academy of Actuaries; nor does it necessarily reflect the opinions of the Academy’s individual officers, members, or staff.

CPC Capitol Hill Briefing on Flood Insurance

As Congress considers legislation to revise and reauthorize the National Flood Insurance Program (NFIP), the Casualty Practice Council (CPC) presented a June 26 Capitol Hill briefing on flood insurance that was well attended by congressional and federal agency staff.

Presenters included Stu Mathewson and Nancy Watkins, members of the CPC’s Flood Insurance Work Group, with Senior Casualty Fellow Jim MacGinnitie moderating. Reviewing the work group’s flood insurance monograph released in April, The National Flood Insurance Program: Challenges and Solutions, the presenters underscored the Academy’s support for expanding private flood insurance coverage. The briefing was attended by more than 40 people, including congressional staff and representatives of the Government Accountability Office and Congressional Budget Office.

Presenters also expressed concern that none of the pending legislative proposals include a serious plan to repay or forgive the NFIP’s past and future debts attributable to infrequent megastorms, and they reminded attendees that rising sea levels are expected to cause an increase in the frequency of coastal flooding and in the severity of megastorms.

Essential Elements Paper on Technology and Auto Insurance

The Academy released a new Essential Elements, “Auto Insurance in the 21st Century,” which explores insurance issues surrounding autonomous vehicles, ride-sharing services, and distracted driving. The Essential Elements series is designed to make actuarial analyses of public policy issues clearer to general audiences.

CPC Presents on Predictive Modeling at NAIC Insurance Summit

In response to a request by state regulators and in an effort to share an actuarial perspective, the CPC presented a full-day program on predictive modeling at the NAIC’s Insurance Summit on May 25 in Kansas City, Mo.

The five presentations, coordinated by Roosevelt Mosley, chairperson of the Automobile Insurance Committee, covered seven basic questions:

• What is predictive modeling?
• Where does predictive modeling occur?
• Who does predictive modeling?
• Why is predictive modeling done?
• When does predictive modeling happen?
• How is predictive modeling done?
• How much predictive modeling is enough?

The presentations also covered the process of developing predictive models, data sources, considerations for insurance companies in developing rate filings, and regulatory concerns about Big Data and predictive modeling. The program concluded with a public policy discussion led by Senior Casualty Fellow Jim MacGinnitie.

Participating in the panel discussion was Rachel Hemphill, chief systems actuary in the California Department of Insurance Office of Principle-Based Reserving (see lead story, above).

“The balanced and informative manner with which the presentations were provided will undoubtedly help our various jurisdictions develop best practices for regulatory review of rate filings that make use of complex predictive models,” said Michael McKenney, actuarial supervisor in the Pennsylvania Insurance Department’s property and casualty bureau, who chairs NAIC’s Casualty Actuarial and Statistical Task Force (CASTF).

Actuaries Climate Index Updated

Actuarial organizations, including the Academy, that represent the profession in the United States and Canada reported in late June that the Actuaries Climate Index (ACI) composite value for fall 2016 was 2.07—the highest seasonal level recorded for the two countries combined.

“We have now seen four of the last five seasons having an Actuaries Climate Index value over 1.50, compared to the 30-year reference period, which had no index values above 1.00,” said Doug Collins, chairperson of the ACI Climate Change Committee.

P/C Issues on Agenda for 2017 Annual Meeting and Public Policy Forum

“Unlike other seminars, the Academy’s Annual Meeting focuses on issues important to actuaries from a public policy angle rather than the technical approach. It grounds our work in the real world,” notes Lisa Slotznick, chairperson of the Academy’s Committee on Property and Liability Financial Reporting (COPLFR), about the Academy’s Annual Meeting and Public Policy Forum, which will be held Nov. 14–15 at the Fairmont Hotel in Washington, D.C. A number of breakout-session topics of interest to P/C actuaries will be included:

• Flood Insurance: The Changing Picture—The National Flood Insurance Program (NFIP) will expire on Sept. 30 unless Congress reauthorizes it. What changes can we expect? What does the future look like for insurers, regulators, actuaries, and consumers? What is the new role for private insurers in the flood insurance market? How might rising sea levels affect the NFIP? (Estimated continuing education (CE) credit: 1.8)
• Auto Insurance in the 21st Century—Speakers will provide an intriguing look at new and emerging technologies and how they will impact—and already are affecting—automobile insurance. Included will be a discussion of autonomous vehicles, shared vehicles, and distracted driving and how these new developments will impact consumers, regulators, and insurers. (Estimated CE: 1.8)
• 2018 Preview: A Survey of the State & Federal Landscapes—Speakers will address expected hot topics for next year in Congress, the state legislatures, and state regulatory agencies. Topics to be discussed may include: climate change, cyber risk, risk-based capital, travel insurance, Big Data, international reserving standards, and more. (Estimated CE: 1.8)

This year’s agenda also features a keynote address by acclaimed journalist Bob Woodward of the Washington Post and Watergate fame, and an interactive plenary discussion featuring nationally syndicated columnist and PBS NewsHour political analyst Mark Shields and ABC News contributor and veteran Republican campaign consultant Alex Castellanos. Early registration rates are available through Sept. 20—register today.

Legislative/Regulatory Update

Following is an update of key federal and state property/casualty legislation, including flood insurance proposals.

Federal Flood Legislation
Congress has begun work on reauthorizing and revising the National Flood Insurance Program (NFIP) before statutory authority for the program expires on Sept. 30. However, it is becoming increasingly apparent that a reauthorization of the NFIP will not occur by the end of September, which means that a short-term extension is likely.

In June, the House Financial Services Committee approved a package of seven bills that would make a wide variety of changes to the program.

• H.R. 2868, the National Flood Insurance Program Policyholder Protection Act of 2017, sets a maximum residential premium at $10,000 and provides for mitigation credit for certain mitigation activities unique to urban areas.
• H.R. 2874, the 21st Century Flood Reform Act as amended, enhances the development of accurate estimates of flood risk through new technology and improved maps. The bill also aims to increase the role of private markets in the management of flood insurance risks, and provides for alternative methods to insure against flood peril.
• H.R. 2875, the National Flood Insurance Program Administrative Reform Act of 2017, makes administrative reforms to increase fairness and accuracy and protect taxpayers from program fraud and abuse.
• H.R. 1558, the Repeatedly Flooded Communities Preparation Act as amended, increases community accountability for areas repetitively damaged by floods.
• H.R. 1422, the Flood Insurance Market Parity and Modernization Act as amended, revises the Flood Disaster Protection Act of 1973 to require that certain buildings and personal property be covered by flood insurance.

• H.R. 2565, requires the use of replacement cost value in determining the premium rates for flood insurance coverage under the National Flood Insurance Act.
• H.R. 2246, the Taxpayer Exposure Mitigation Act of 2017 repeals the mandatory flood insurance coverage requirement for commercial properties located in flood hazard areas and allows greater transfer of risk under the NFIP to private capital and reinsurance markets.

In the Senate, the Banking Committee’s leadership outlined proposed legislation, the National Flood Insurance Program Reauthorization Act of 2017, which would extend the NFIP for six years and make changes in the areas of risk mitigation and mapping.

Medical Professional Liability

• The U.S. House of Representatives approved H.R. 1215, the Protecting Access to Care Act, which creates federal rules for all medical professional liability litigation. It would override state professional liability laws. The bill sets a cap on $250,000 on non-economic damages, places limits on plaintiff attorneys’ fees, imposes a three-year statute of limitations on claims, and requires assessments of proportional liability. No action has been scheduled in the Senate.

State P/C Legislation
Many state legislatures considered P/C insurance legislation, including:

• Texas Gov. Greg Abbott (R) signed HB 1774, which limits insurance companies’ liability for damages from storms and other severe natural events, including floods. The bill goes into effect on Sept. 1.
• Vermont Gov. Phil Scott (R) signed into law S. 56, which provides first responders with workers’ compensation coverage for post-traumatic stress disorder. It also calls for a study of workers’ compensation rates in high-risk industries with few participating employers.
• California Gov. Jerry Brown (D) signed a bill into law that prohibits drivers from “holding and operating” mobile devices, including cell phones.
• The Massachusetts Legislature is considering H. 3682, which requires auto insurance companies to verify personal driving records before basing premium quotes on them.
• The Michigan Legislature is considering HB 4626, which would clarify the handling of assigned claims for auto insurance.

Regulatory Update
States are continuing to issue regulations implementing RBC standards for insurance company assets. The most recent is Colorado, with a proposed rulemaking in June to “establish standards for the minimum capital and surplus to be maintained by insurers, captive insurers and fraternal benefit societies.”

NAIC Update

In mid-July, the Academy received a communication from NAIC leadership about its consultant’s assessment of whether P/C actuaries who obtained credentials from the Society of Actuaries (SOA) should be considered “Qualified Actuaries” and therefore able to sign NAIC P/C Statements of Actuarial Opinion as Appointed Actuaries. An ad hoc group of commissioners oversaw the study and adopted a public letter to the Academy, the Casualty Actuary Society (CAS), and the SOA. The NAIC’s consultant conclusions were stated to be that the SOA credentials do not meet the minimum educational standards for P/C “Qualified Actuaries.” The public letter also stated that the NAIC had sent separate confidential letters to the SOA and CAS with more specific recommendations.

The public letter stated that the NAIC would explore with the Academy a path to document that Qualified Actuaries maintain their competency. The Academy met with the ad hoc group of commissioners at the NAIC summer meetings and offered it cooperation and support to try to address the NAIC’s needs and concerns, as it has throughout our long history of support for the NAIC.

NAIC Presentations

• Lisa Slotznick, chairperson of the Academy’s Committee on Property and Liability Financial Reporting (COPLFR), provided CASTF with an update on recent committee activity. Included in her presentation were reports on COPLFR projects, such as the P/C Loss Reserve Law Manual and annual practice note, and an impending retained risk practice note exposure draft. She also provided an update on the Academy’s Schedule P Survey, which has gone out to 95 potential respondents.
• Academy Senior Casualty Fellow Jim MacGinnitie updated CASTF with a CPC report, including the Academy’s predictive modeling session at the NAIC’s Insurance Summit in May, and a report on the Academy’s planned projects, including a travel insurance monograph and a catastrophe modeling white paper.
• Lauren Cavanaugh, chairperson of the Academy’s P/C Risk-Based Capital Committee, spoke to the NAIC’s Investment Risk-Based Capital (E) Working Group on the joint letter from the Academy’s P/C RBC Committee and Health Solvency Subcommittee regarding the exposure of the C1 Work Group’s “Updated Recommendation of Corporate Bond RBC Factors” June 8 letter.

Post-NAIC Alert and Webinar
The Academy released an alert following the NAIC Summer 2017 National Meeting in Philadelphia in early August, and will host a post-NAIC P/C webinar covering key issues from the meeting on Wednesday, Sept. 6, from noon to 1 p.m. EDT.

COPLFR Comments on Title Insurance

The Committee on Property and Liability Financial Reporting (COPLFR) submitted comments to the NAIC’s Title Insurance Financial Reporting Working Group that raised questions about proposed changes to the way reserves are reported in the title statement of actuarial opinion.

The COPLFR letter stated that the proposal is unlikely to benefit regulators in assessing title insurer solvency; it does not reflect currently existing ambiguity in Statement of Statutory Accounting Principle (SSAP) No. 57—Title Insurance; and it is likely to cause disruption to the title industry and users of the title insurer statutory financial statements in its implementation.

Early Registration Ends This Month for P/C Loss Reserve Opinions Seminar

Do you prepare or sign statements of actuarial opinion on P/C loss reserves for NAIC Annual Statements? Assist with preparing them? If so, make plans to join us in Chicago for the 2017 Seminar on Effective P/C Loss Reserve Opinions, to be held Dec. 7–8. Register now and save—early registration rates are available through Aug. 31.

Health, Casualty Letter to NAIC Addresses RBC Factors

The P/C Risk-Based Capital Committee and the Health Solvency Subcommittee wrote a joint letter to the NAIC Investment Risk-Based Capital (E) Working Group (IRBCWG) on its exposure of the C1 Work Group’s “Updated Recommendation of Corporate Bond RBC Factors” June 8 letter.

The IRBCWG is considering implementing new P/C and health fixed-income asset risk factors based on output from the corporate bond model that C1 Work Group developed at the request of the IRBCWG, with certain adjustments. The letter says that more research is needed to ensure appropriate adjustments are applied to account for differences in the life statutory reporting and business practices and those of P/C and health practioners.

CLRS Early Registration Ends This Friday

Discounted early registration rates are available through this Friday, Aug. 18, for the 2017 Casualty Loss Reserve Seminar and Workshops. This seminar, sponsored jointly by the Academy and the Casualty Actuarial Society, will be held Sept. 10–12 in Philadelphia. Register today.