Managing Overconfidence
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Transcript of Managing Overconfidence
Managing Overconfidence
Douglas J. Collins, FCAS, MAAA
Tillinghast London (Tel: 44 (0)207 170 2162)
CAE Zurich – 23 April 2004
2© Copyright Towers, Perrin, Forster & Crosby, Inc
Many factors contribute to errors (and bias!) in pricing and underwriting
Common Sources of Pricing and Underwriting Error/Bias (Micro)
Inadequate internal [historical] data upon which to develop estimates (e.g., old, incomplete or inaccurate data; inadequate/inappropriate sample)
Inability to collect and synthesize all relevant sources of data within the organization
Lack of reliable information about external market conditions and trends (e.g., inflation, tort costs)
Excessive concern for “competitive pressures”
Lack of adequate oversight over pricing decisions
Lack of “metaknowledge” — reinforces inherent overconfidence when making estimates, forecasts and predictions
Systemic Sources of Pricing and Underwriting Error/Bias (Macro)
Long feedback loop
No skin in the game
3© Copyright Towers, Perrin, Forster & Crosby, Inc
The results of a recent Tillinghast “Confidence Quiz” illustrate the prevalence of overconfidence
The Quiz
Objective: To test respondents understanding of the limits of their knowledge
Respondents were asked to answer ten questions related to their general knowledge of the global property/casualty industry
For each answer, respondents were asked to provide a range that offered a 90% confidence interval that they would answer correctly
Ideally (i.e., if “well calibrated”), respondents should have gotten nine out of ten questions correct 0
7
12
18
28
44
44
69
56
67
29
10
9
8
7
6
5
4
3
2
1
0
Number of Respondents
Raw Scores of Online Respondents
Note: based on 374 respondents as of 4/5/04.Profile of respondents: 86% work in P/C industry; 73% are actuaries.
Tillinghast Confidence Quiz
4© Copyright Towers, Perrin, Forster & Crosby, Inc
The best way to manage overconfidence is to implement a control cycle for pricing and underwriting
The Control Cycle: Retrospective Test of Pricing/Underwriting
A control cycle for P/C pricing and underwriting entails identifying, testing and validating all of the assumptions that underlie the projection of future loss costs used to price and underwrite the business
1. Define/Refine Process
2. ImplementProcess
3. MeasurePerformance
1. Pricing and Underwriting Process Elements Data required
Actuarial methods employed
Underwriting policies and rules
Decision authorities and reporting
Quality assurance
3. Formal Retrospective Performance Testing Data accurate and adequate?
Pricing methods sufficiently robust?
Policies and rules effective?
Decision authorities appropriate?
Variances between projected and actual experience within tolerances?
5© Copyright Towers, Perrin, Forster & Crosby, Inc
While improving pricing/underwriting requires a sustained commitment over time, three near-term steps will jump start the process
Retrospective Analysis
Process Design/Refinement
Case-study Training
Analyze relevant sample of pricing and underwriting results to identify/pinpoint specific causes and sources of error
Define (or refine) and institutionalize an ongoing process of continuous improvement (i.e., control cycle) for pricing and underwriting Incorporate insights from retrospective
analysis to address key challenges and deficiencies
Develop/institute case-study oriented training modules for underwriters and pricing actuaries to provide practical experience and rapid feedback Base training materials on past
business where results are already known
6© Copyright Towers, Perrin, Forster & Crosby, Inc
Managing overconfidence in pricing and underwriting
Pricing ElementBest
Estimate Standard Deviation
90% Confidence Low High
Historical experience not fully credible 957 5.0% 897 1,020
Historical experience not fully mature 191 20.0% 146 242
Subtotal Ultimate Historical Loss Costs 1,149 6.7% 1,052 1,249
Frequency and severity changes 138 50.0% 67 226
Mix of business or underlying exposure changes 10 200.0% 1 23
Subtotal Projected Future (Attritional) Loss Costs 1,297 12.0% 1,105 1,500
Non-attritional loss elements 610 33.0% 383 874
Total Projected Expected Future Loss Costs 1,906 17.3% 1,508 2,340
-20.9% 22.7%