INSTITUTE OF ACTUARIESGENERAL INSURANCE STUDY GROUP

COMMERCIAL Fire UNDERWRITING WORKING PARTY REPORT

Members of Working Party - Ν Gillott (leader)Ρ CarrollG ChamberlinΒ HudsonS MaldeG MastersΡ TaylorA Thomson

1986 General Insurance Convention

CONTENTS

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2.

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4.

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5.---—

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Scope and Objectives

the objectives of the paper

Background to Fire Insurance

an underwriter's perspectivescope of coverbases of covergeneral

Rating

introductionrisk profilemethods used before FOC demisemethods currently usedactuarial thoughts on ratingexperience ratingdeductiblesother perilsmarket statisticscomputer systems

Reinsurance

backgroundindividual riskslevel of retentionscatastrophe protectionaccountingsecurity of reinsurerscoinsurancecooperative agreement

Claims

the basis of settlementclaims handling procedureslegal decisionsclaims reserving

Statistics

data collection and analysisavailability of dataanalysis of results and statistics

Section

1.1

2.12.22.32.4

3.13.23.33.43.53.63.73.83.93.10

4.14.24.34.44.54.64.74.8

5.15.25.35.4

6.16.26.3

Page

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281213

17182528394250515154

6060606162636464

65656666

686972

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"The author has no doubt that the time is approaching

when the present loose and almost undefined method of

estimating (Fire Insurance) premiums will give place to oneof a more scientific and definite nature."

Preface to "The Theory and Practice of Assurance" (1847) byW E Hillman FIA.

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SECTION 1

SCOPE AND OBJECTIVES

The working party feel that the level of knowledge ofcommercial fire insurance is relatively low within GISG.This may be a relevant factor contributing to the recentdecline in numbers of specialist general insurance actuarieswithin the larger composite companies. Actuaries may haveentered the arena with some worthwhile ideas on reserving,statistical analysis and motor rating. However, while theirideas in these areas have been refined over the years, theyhave never made the important transition into the centre ofthe general insurance stage within the direct writingcompanies. This would involve contributing ideas within thecommercial insurance field and considerable contact withunderwriters. The members of the working party feel thatactuaries have a lot to offer in this area. Others may agreewhen they see the wide diversity of thinking betweenactuaries and underwriters that is portrayed in the paper.

In many ways this is a "chicken and egg" situation.Actuaries cannot be helpful to commercial underwriters untilthey are involved in and understand the business; yet theyare unlikely to be involved in the business unless they canbe helpful to underwriters. It is hoped that this paper willbe a start in helping to break the vicious circle.

With the above thoughts in mind the working party hasproduced this basic educational paper on commercial fireunderwriting - a class of business which covers any propertyexcept domestic dwellings. Such business produces nearly £1billion worth of premium in the UK alone. Although the paperdoes give background information, particular emphasis isgiven to areas where actuarial ideas could be most profitablyemployed. These could perhaps be developed in later papers.Similar work could also be usefully done in other areas ofcommercial insurance business.

Finally it is hoped that this paper could be simply modifiedto make it appropriate as educational material for the B3general insurance exam. At present the lack of suitablereading for commercial fire insurance is a real problem tothe students. The CII course dwells rather too much onstrict underwriting considerations and gives too littleinformation on rating and other financial matters to be ofmuch use to actuarial students.

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SECTION 2

BACKGROUND TO FIRE INSURANCE

2.1 An Underwriter's Perspective

What is the view which a Fire Underwriter has of hiswork and how does he guide his course in business life?It is worth spending a little time on this question,since the perspective of the underwriter may differsignificantly from that of the actuary. For effectivecommunication, one needs to understand the other man'spoint of view.

(a) Influence of the Tariff

The first point is a clear one. Like actuarialwork, fire underwriting is a discipline with astrong tradition. Because of the long history ofthe FOC (Fire Offices' Committee), and the 120-oddyears of the tariff, there is a coherence to fireunderwriting thought which runs virtually acrossthe industry. The unity is much greater than onewould find, say, in Liability Insurance orPecuniary Loss, and the principle applies even tothose offices which were non-Tariff, since theywere strongly influenced by its existence.Although proclaiming independence, many wouldfollow the same rating structure, and might even bein possession of under-the-counter copies of theTariff itself!

The rating methods of the Tariff are described morefully in Section 3.3. But, in brief, the Tariffcomprised a set of basic rates, on a trade orindustry basis. To these, various adjustments wereprescribed according to the particular features ofa risk, and the warranties which an insured wasprepared to undertake. The schedules were basedmore on underwriting 'feel' than exact science, butnevertheless incorporated many years of businessexperience. As a result, at the overall level, theTariff was successful in prescribing premium ratesthat gave offices a very adequate level ofprofitability. But it was not always sosatisfactory in terms of fine tuning, and someproblems were experienced with the system as the20th Century progressed into its later years.

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These problems related mainly to the lack offlexibility of the Tariff. The industrial scenewas changing, and the effort of incorporating wholenew industries into the structure proved too great,and the commercial market was changing with suchrapidity that there was no hope of keeping theTariff rates up to date, other than by a crudesystem of overall adjustments. Most important ofall, Commercial Fire became a very competitivebusiness. Offices would have to fight at eachrenewal to retain their custom. Even those whichwere FOC-diehards had to permit exceptions toTariff ratings, or lose substantial premiumincome.

Hence there were good commerical reasons, as wellas political ones, for the eventual disbanding ofthe FOC in 1985. But though the formally agreedrating structure may have gone, there is acontinuing legacy from the Tariff era. The way ofthinking that lay behind it will remain a stronginfluence for many years to come.

(b) The Underwriting Cycle

The second main point relates to markets andcompetitive pressure, which are a reality for theFire Underwriter. Their expression in practice isthrough the underwriting cycle, a phenomenon whichcan be described in classic economic terms. Forexample, in the early 1970's, there was ahardening market, reaching its peak in 1972/73.Premium rates were relatively high, and goodunderwriting profits could be made. New companieswere attracted to enter the market and establishedones increased their capacity for business. Soonthe market was overprovided, competitionintensified and premium rates began to fall. Thisled to a protracted soft market in the later 1970'sand early 1980's. By the end of the period manycompanies were suffering substantial losses. Somereduced their capacity, while others left themarket altogether. This led to the opposite aspectof the cycle, and in 1984/85 the hard marketreasserted itself. Premium rates were restored tohigher levels relative to risk, and those companiesleft in the market returned towards a position ofunderwriting profit.

A significant aspect of the recent hardening of themarket has been the drastic reduction in reinsurancecapacity. This feature has particularly hit the smallercompanies, and largely destroyed their ability toundercut the bigger, better established offices. Thus,in the soft market, a small company could write largetranches of business far beyond its own capacity, simplyby reinsuring the greater part away - in some cases 95%and more! But the option is no longer open today.

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There is a corollary to be drawn from theunderwriting cycle. It is that, in the soft years,an office may deliberately take or retain business,knowing that the rate set is not a profitable one.This is because it has a feel for the cycle, andwishes to keep the business on its books for thehard years which are likely to follow. The aim isto make a good profit in the longer term, and notjust for the current year in isolation. (Even so,the sensible underwriter will have some lower limitin mind, below which he will not be prepared to goin the competitive scramble).

(c) Underwriting vs Insurance Profit

This is an issue on which actuaries andunderwriters may well express differing opinions.The actuary, with his knowledge of investmentprinciples and discounting will be inclined tofavour the concept of "Insurance Profit" (ie.including investment returns) over that of"Underwriting Profit" alone. But to theunderwriter there may be good reasons for takingthe latter as the main goal. For example, in alarge organisation with many branches involved inunderwriting, clear instructions have to be givento the staff. To them, the term "UnderwritingProfit" will have a direct and simple meaning, andwill help to guide the course of their work. Butthe staff would not fully understand the concept of"Insurance Profit", nor how it is arrived at by theactuary. Hence direction and momentum will belost, and with them, perhaps the chance of makingany profit at all.

A further point is that, if premium income can beexpected to cover claims, expenses and a margin forprofit, then investment income may be used forbuilding up the reserves. This strengthening isparticularly desirable under modern conditions, sothat solvency margins can be maintained at anadequate level as the business grows. Also, astime goes by, the individual risks tend to becomemuch larger in size, so that a stronger capitalbase is needed in order to give the proper cover.

(d) Trends in Risks

The trend towards larger risks is an easilyobservable one. There are nowadays more 'ostricheggs' in the nest, in comparison with the ducks andchickens of yesteryear. The effect comes simplyfrom the industrial trend towards larger units withgreater concentrations of valuable equipment -computers, aircraft, chemical plant and so on. Amodern shopping complex would be another example.

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The losses which occur in such cases can beextremely large, eg. Donnington ordinance depot,Cricklewood warehouse fire, BAC at Weybridge, etc.It seems that there is a functional relationshipbetween increase in square footage and increase inestimated maximum loss, (EMI, of which a moredetailed definition follows on page 13), and thatthe function is more geometric than arithmetic incharacter.

A second significant trend is towards greater moralhazard - damage resulting from arson and otherwilful types of vandalism, together with laxstandards of discipline, security and managementcontrol. Poor housekeeping is on the increase, andappears to have been a contributory factor, eg. tothe Bradford Football Club disaster of 1985.

(e) Claims & Rating: The Classic Approach

How does the underwriter feed back the claimsexperience into his rate-making decisions? Underthe classic theory, when the Tariff was in itsheyday, he would adopt a 3-tiered approach tolosses.

Small losses should be borne by the individualcase. With large or medium policies, there wouldbe no problem, but a small policy might well notpay for itself. Such a policy should either bedeclined at the next renewal date, or its rateshould be increased to an economic level.

Medium sized losses should be borne, not case bycase, but funded out of the total class premium.That is, each trade or industry, considered on itsown, should be self-supporting. If the experiencefor a given trade were in debt, then the ratesshould be increased, say by 5 or 10%, or someappropriate margin.

Large losses (or, at least the excess of large overmedium) should be borne by the whole of theportfolio. Thus, the Commercial Fire business intoto should be profitable, although given tradesmight not be, on account of exceptional largerlosses during the period in question. A deficiencyin the portfolio from large losses would need to becorrected by an overall increase in the rates.

(f) Claims and Rating: Modern Statistical Approach

In an office with a modern data system, theunderwriter may take a more detailed and objectiveapproach. Thus, every risk will be classified, andthe results collated over the years, until at leasta 10 year run of exposures, premiums and claims isavailable. From these figures, such information asthe claims incidence per 100 policies and the

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average size of claims can be obtained, together withtheir trend over the years. In addition, a statisticallybased set of burning rates can be derived, giving ineffect the pure risk premium for each class of businessin the Fire portfolio.

A number of fixed markers are thus established forthe underwriter, giving him a firm base. His nextstep will be to predict the future mix of businesswhich the company may expect to obtain. The purerisk rates can then be converted to a range, inorder to cover the business mix expected withineach class. It is at this stage that the factorsmaking for heterogeneity, such as physicalconstruction, management and housekeeping, fireprotection systems, etc. can be brought into theaccount. As a third step, the rates are convertedto working rates by adding margins for expenses,profit, catastrophe losses, inflation and otherfactors. Inflation has its place, since there isbound to be delay between the writing of a risk andthe settlement of any subsequent claims. But thefactor is not nearly so significant in fireinsurance as it is, say, in liability.

The final result of the process is a rating scalefor each trade, in many ways akin to the earlierTariff version. The differences are:

That trends in the statistics can quickly berecognised and applied at the next rating review,

- That there is more evidence available foranalysing the effect, say, of a change in the mixof business, or of a given underwriting factor,

- There is no need to wait scrupulously on otheroffices of the FOC, and hence particularopportunities in the market can be more quicklytaken up,

The rating base is more accurately set, in termsof its structure as well as its overall level.

(g) Treatment of Substandard Risks

Here is a further area where actuary and underwriter maynot always see eye to eye. A Life Office may decide, asmarketing policy, to seek substandard lives at aptlyhigher rates of premium. But the tactic is not reallyemployed in Commercial Fire. The underwriter's aim iscertainly to take on risks, but only those he wouldregard as reasonable. When a proposal comes in, he willlook for any bad features present, and place each on ascale of ascending severity. If the features are minorones, he may ignore them, or introduce a small loadingto the premium, and so on up the scale as the severityincreases.

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But eventually he will reach a point where thehazard is so great as to make the risk notcommercially viable to his company. By the law ofaverages, ultimately, there will be a loss which isfar greater than the premiums paid.

To put the point in figures, if there is a 100%chance of a total loss within 10 years, or a 10%chance of such a loss in any one year, then therisk is quite beyond the pale. In fact, no insurerwants to charge more than 2% as a premium in theproperty market.

A risk, then, may not be reasonable as it stands.The question is, can it be changed? If so, thenterms may be offered, and a contract negotiated.The classic answer is to have sprinklers put in,and then reduce the effective rate by 50% or more.But there are aspects of risk more difficult todeal with - Management and Housekeeping being aprime example. There is an underwriters' adagethat if you have a bad insured, it does not matterhow good the property, you always have a bad risk.As an example, consider a clothing factory withunrestricted smoking by the work force and a lackof management concern about the safe extinguishingof smoking materials. That is evidence of amanagement attitude so lax that without a completechange the risk will not be worth taking on. Asthe text books say, you can never rate adequatelyfor moral hazard.

As a means of control on poor risks that areacceptable, the underwriter will frequently imposea lower acceptable limit than normal. That is, hewill restrict the amount of cover given.Consequently, a poor risk is more likely to needco-insurance, with a number of companies eachunderwriting a proportion only of the sum insured.In such cases, the influence of a competent brokerwith good market contacts may be essential to theplacement of the risk. The key, perhaps, lies inthe proposer's attitudes - if these are acceptable,then attempts will be made to take part of the riskby the underwriters concerned.

(h) Independence of Underwriting Factors

Generally speaking, the underwriter will take thevarious factors such as Physical Construction,Trade Processes, Heating Systems, etc as beingindependent in their effect on the level of risk.This is the traditional way of working, with allthe advantages of convenience and continuity. Butit is not the only way of proceeding, and suchdistinctions as the inception and the spread offire could well be useful. As a particularexample, consider two similar warehouses, one

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containing reeled paper and the other pig iron.The fire inception risk might be identical, but thespread hazard is clearly very different. Sosmoking regulations and other management pointshave a quite different significance in the twocases. But conclusions in this area, whileamenable to common sense, are more difficult totackle from a statistical point of view.

In conclusion the most important point of all is that,while there is one truth to be found in statistics,there is another to be found in the market place. It isa fact that market conditions heavily influence GeneralInsurance rates, and the underwriter disregards thisimperative at his peril. The time when the annualrenewal of business would be a matter of course hasgone, and he must fight to retain and expand hisportfolio of business.

That said, actuarial and statistical methods are farfrom being irrelevant. The passing of the Tariff, andthe advent of modern methods, does give offices a firmerbase and better opportunity for fine-tuning their mix ofbusiness. By 1986, the better prepared offices willhave available 10 years' worth of detailed statistics ontheir Commercial Fire portfolios, although they may notbe in an ideal actuarial format. These can be ananlysedin many ways, in particular to show the significanttrends in the experience - whether rising or falling -and to distinguish them from the hiccoughs which fromtime to time disturb the business. Thus the benefits ofthe scientific approach are not entirely lost on theunderwriter, and there may well be better prospects forco-operation with the actuary in future.

2.2 Scope of cover

Basic Cover

Since 1922 most leading insurance companies have adopteda standard form of policy; the smaller companies,however, have tended to follow broker wordings. Thishas led to a uniformity of cover and limitations andalso of conditions and their interpretation. Followingdissolution of the Fire Offices Committee (FOC) thisuniformity may diminish as new wordings appear althoughthe Association of British Insurers (ABI) is preparingrecommended wordings for its members. The standardpolicy covers the property against:-

i) Fire (whether resulting from explosion orotherwise) not occasioned by or happening through:

(a) Its own spontaneous fermentation or heating or itsundergoing any process involving the application ofheat. [That is to say that the material undergoingsuch a process is not covered although the damagecaused by a resulting fire is]

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(b) Earthquake, subterranean fire, riot, civilcommotion, war, invasion, act of foreignenemy, hostilities (whether war be declared ornot), civil war, rebellion, revolution,insurrection or military or usurped power.

ii) Lightning

iii) Explosion, not occasioned by or happening throughany of the perils specified in i(b) above:

(a) Of boilers used for domestic purposes only.

(b) In a building not being part of any gas works,of gas used for domestic purposes or used forlighting or heating the building.

The conditions of the policy exclude other types ofexplosion, nuclear risks, property insurable under amarine policy, and unless specifically mentioned, goodsin trust or on commission, and items like money,documents, plans etc.

The wording of the Lloyd's Policy is similar butslightly wider.

Fire implies actual ignition and must be accidental inorigin from the point of view of the Insured. Damage tothe insured property caused by measures taken to put outthe fire, and through such associated occurrences assmoke, scorching or falling walls is covered. Arson (orwilful fire raising in Scotland) is also covered,provided it is not committed by, or with consent of, theInsured.

A standard specification identifies the property coveredand would list

(a) The building, including landlords' fixtures andfittings

(b) Machinery, plant and all other contents

(c) Stock and materials in trade

Other specific items of property may be added to thislist. Memoranda would generally be attached to thisspecification to define more closely the cover given.Special clauses may be added to the standard policy tocover items like computer systems records, the fees ofprofessionals (eg architects and surveyors), costs ofcomplying with the requirements of public authorities,and property while temporarily removed.

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Special Perils

The following additional covers, known as dry perils,may usually be bought:

EXPLOSION

This would extend the very limited explosion cover givenunder the standard fire policy. Damage from explosionsof non-domestic boilers and steam pressure vessels underthe Insured's control is excluded but can be covered byan engineering insurance policy. Nuclear explosions andwar and riot risks are excluded.

AIRCRAFT

This covers non-fire damage caused by aircraft or byarticles dropped from them. War risks and damage bysonic booms are not covered.

RIOT, OTHER SPECIFIED DISTURBANCES AND MALICIOUS DAMAGE

Damage by fire and other causes like wreckage andlooting is covered. Under the Riot (Damages) Act 1986it may be possible for insurers to recoup losses causedby riots from the Police Authorities.

IMPACT

This covers damage by impact of road vehicles, horses orcattle not belonging to or under the control of theInsured. Impact by the insured's own vehicles can becovered on request.

EARTHQUAKE

This can cover fire and shock damage caused byearthquake.

SUBTERRANEAN FIRE

This includes fires in mines and oil wells as well asthose of volcanic origin and fires in made-up ground.

SUBSIDENCE OR LANDSLIP

Because of the strong possibility of selection againstthe insurer this cover is written with caution. Itwould have a substantial excess.

SPONTANEOUS COMBUSTION

This covers property damaged by its own spontaneouscombustion. It would apply to property stored in bulkwhich may be liable to self-heating but would be subjectto stringent requirements about storage conditions.

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Cover against the following wet perils may also bebought:

STORM, TEMPEST AND FLOOD

This is common where the premises contain propertysusceptible to water damage. The cover is subject to anexcess, usually £100.

BURSTING OR OVERFLOWING OF WATER TANKS, APPARATUS ANDPIPES

Similar Comments as for Storm, Tempest and Flood apply.

HAIL

Damage to farm crops in the open is usually on a shortperiod basis whilst glass in greenhouses is covered byan annual policy.

Sprinkler leakage

This covers the risk of water damage caused by theaccidental discharge of sprinkler heads or by accidentaldamage to supply pipes, valves or any part of thesprinkler installation.

"All Risks" Cover

This offers cover not only against named perils butagainst accidental loss of or damage to the propertyinsured from any cause other than those individuallyexcluded in the policy wording. There would be theusual exclusions of war and nuclear risks. The list ofexclusions can be extensive. Examples of excluded risksare: fraud or dishonesty, mechanical breakdown,explosion of boilers. Those of excluded property are:property in transit, money. There is a facility to'buy-back' some of these exclusions for an additionalpremium.

Variations in Cover

Blanket Policies

These show only total sums insured in each of the 3categories (ie buildings, contents and stock), for firmswith works and warehouses spread over more than one firerisk.

Declaration Policies

These cater for businesses where stock values fluctuate. Thesum insured chosen is the maximum likely to be at risk duringthe year and at regular (say monthly) intervals the Insureddeclares the value at risk. An initial deposit premium ispaid and there is an adjustment at the end of the year. Theneed to amend the sum insured from time to time toaccommodate fluctuations in value is thereby obviated.

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Consequential Loss

This type of insurance is also known as profits, loss ofprofits or business interruption insurance. Whereas thefire policy provides protection against destruction ofor damage to buildings and contents a CL policy protectsthe earning capacity of the business. It makes good theloss in profits while the premises are being rebuilt andthe machinery and stock replaced. Items may be insuredon the basis of gross profits, revenue, income, rentreceivable or earnings in any other form. Additionalexpenditure to reduce the loss of earnings is includedin the cover. A range of perils can be covered and itis common for the corresponding Fire policy to have atleast that range. The cover is normally for a 12 monthsindemnity period but covers for 18, 24 and beyond areavailable. The indemnity period begins with theoccurrence of the damage and ends not later than themaximum period selected during which the results of thebusiness are affected by the damage.

This paper does not consider consequential loss policiesin any great detail.

'All-in Cover' (Trader's Combined Policies)

These cover the basic risks against which shopkeepers,offices, hotel proprietors and other small traders needcover. One inclusive policy, with a number of sections,might typically cover fire, consequential loss,employers' and public liability, glass, money and theft.There is also a simplified package policy in which thecover is generally standard, there are size limits andthe premiums are based on relatively few ratingfactors.

No further mention of such covers will be made in thispaper.

2.3 Bases Of Cover

Indemnity

The measure of the Insurer's liability is the value(after depreciation) of the destroyed property at thetime of the loss or the amount of damage if lower. Thesum insured should therefore represent the value of theproperty.

Reinstatement

This is available for buildings and machinery (but notfor stock) and the Insured receives new for old withoutany deduction for depreciation. Destroyed property isrebuilt or replaced by similar property. For damagedproperty, the damaged portion would be repaired andrestored. In neither case would the insurers be liablefor any betterment. If therefore, the replacement

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machinery or plant is better than that destroyed, theInsured bears the cost of betterment. Thus a destroyedmachine will be replaced with a new one of the samequality; any upgrading of the machine will have to bepaid by the insured.

First Loss

The sum insured is restricted, with the Insurer'sagreement, to a figure less than the full value of theproperty. It represents the maximum value the Insuredconsiders vulnerable to a single loss. It is usedusually where there is no possibility of the buildingbeing reinstated (eg stately homes) or for insurancescovering water damage.

2.4 General

Aspects of Market Practice

Estimated Maximum Loss (EML)

One definition of EML is: "It is an estimation of themost serious loss from a single occurrence that canreasonably be envisaged (or, is within the realms ofprobability) from any peril. In the case offire/explosion, the factors of construction, sub-division of the risk, occupation and hazards pertainingto the risk at the time of examination are consideredbut sprinkler protection and other automatic preventionor extinguishing arrangements are ignored." The EMLhelps the underwriter to determine, in the light ofreinsurance facilities available, the extent of hisacceptance.

EMLs are equal to the sum insured in the case of smallbuildings but in large modern office blocks may be only10% of the sum insured.

Collective Policies and Coinsurance

Large commercial risks are often co-insured, thecoinsurers contributing to all claims in the proportionsof their participation in the insurance. The office withthe largest proportion, the leading office, surveys therisk if necessary (see section 3.2), prices the cover,administers the insurance and prepares thedocumentation. It will issue a collective policylisting the insurers and their shares. If a proportionof the risk is placed at Lloyds then a separate policywould be issued for that.

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Long Term Agreements

The insurer offers a 5% discount to the Insured if heagrees to renew his policy for a term of three (orsomtimes five) years and signs an agreement to thateffect. The Insurer is not bound to accept the offer ofinsurance at the renewal date. He may want an increasedpremium in which case the Insured is not obliged torenew.

Aspects of Cover

Average

To encourage full insurance and to ensure as far aspossible that each insured pays an equitable premium thecondition of average is applied to virtualy everyinsurance other than first loss covers. It requires theinsured to bear losses in proportion to the level ofunder-insurance. The application of average reduces theamount payable for partial losses, if the sum insured isless than the full value of the property at the time ofthe loss. With a total loss the sum insured will be paidin full but leaving the insured short of full indemnity.Agricultural produce is subject to a special rule ofaverage which only comes into operation if the suminsured is less than 75 per cent of the value of theproduce covered at the time of the fire.

On reinstatement policies, the sum insured at the timeof destruction of or damage to the property is comparedwith 85% of the figure necessary to reinstate the wholeof such property at the time of reinstatement. Only ifthe sum insured is less, does average apply.

Allowance for Inflation

Adequate sums insured must be maintained and it is notonly necessary to provide for inflation during thepolicy period but, in the case of reinstatementpolicies, also during the period required to reinstate.The 85% rule mentioned above acknowledges the difficultyof predicting future inflation.

Various schemes for inflation provision have beendevised and these generally apply to buildings andmachinery. A brief description of the main schemesfollows:-

Escalator Clause

The declared sum insured increases on a day by day basisaccording to an agreed annual inflation rate. Cover maybe on an indemnity or replacement basis.

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Valuation Linked Schemes (VLS)

The declared sum insured is established by aprofessional valuer, and the policyholder states hisrequired inflation provision. This method is commonwith property companies. Cover is on a reinstatementbasis.

Notional Re-Instatement Value (NRV)

The declared sum insured represents the insured's viewof reinstatement value, including an allowance forinflation during the policy year and reinstatementperiod. Cover is on a reinstatement basis. This methodis rarely used now as the Day 1 Basis is moreappropriate.

Day 1 Basis

The policyholder gives a notional assessment of hisproperty's value on Day One and is then given anautomatic inflation provision of, most commonly, 50%.The premium paid is based on the Day 1 Value plus a 15%loading for the inflation provision. This method canalso apply on an adjustable basis in which case thepolicyholder pays a loading of 7.5% for the inflationprovison. At the end of the year, he then pays anadjustment equal to 50% of the difference between theprovisional premium and the provisional premium for theensuing period. Inflation provision at a figure higherthan 50% is available if desired. The Day One value isused to decide whether Average will apply and cover ison a reinstatement basis.

Index-Linked

The sum insured on such a policy is declared to increaseby amounts not expressed in the policy but the value ofwhich can be determined by reference to an inflationindex. Such policies are generally taken up by smallbusinesses. Cover may be on an indemnity orreinstatement basis.

Allowance for Self-Insurance

Besides retaining a proportion of the risk, the Insuredmay bear part of a loss through:

(a) Compulsory excess. This rarely applies to the fireperils but is invariably imposed for the wet perilsand on "all risks" cover.

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(b) Voluntary excess or deductible - in this case theInsured is granted a reduction in premium. Thedeductible can range from £250 to £50,000 and evenmore and discounts from 5% upwards. With asubstantial deductible, sometimes applying to bothmaterial damage and consequential loss covers, anaggregate deductible of say 4 times the deductiblemay be agreed. (An aggregate deductible is onethat applies to the total of all claims in a givenperiod).

(c) Franchise - In this case, provided the claimexceeds the franchise amount then the full amountis paid. However, this method is rarely used.

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SECTION 5

RATING

3.1 Introduction

Section 3 provides a detailed introduction to theconcepts involved in rating Commercial Fire business andputs flesh on the bones outlined in Section 2.

Section 3.2 (Risk Profile) looks at the way and theextent to which the limited information on the proposalform can be expanded. This should lead to a rate beingcharged that is closer to the underlying risk and canalso lead to measures being suggested that will improvethe risk or possibly make an unacceptable risk moreacceptable.

Section 3.3 looks at the methods of premium rating thatwere in force prior to the end of the FOC. The workingof the FOC is described and a hypothetical tariff islooked at in order to illustrate the processes involved.Although the FOC has now been wound up, this section isof more than historical interest since most companiesstill follow many of the FOC principles.

Current rating methods are described in Section 3.4.Whilst a lot of the principles of the FOC have beenfollowed, they have been applied in many different ways.To illustrate the considerable variability of the ratingstructures currently in use, the structures of sevendifferent companies were investigated. In order to makecomparison between the companies easier, the ratingstructures for each of the companies have been set outin the same format.

Section 2 included an underwriter's thoughts and view onrating. Section 3.5 suggests how the rating structurecan be quantified and how rational judgements might bemade about the suitability of the rating structure. Itindicates the areas where an Actuary might be able touse his expertise.

Section 3.6 looks at experience rating of risks bothfrom the viewpoint of what is currently happening andhow a more theoretical concept might be used.

Other aspects of rating are discussed in Sections 3.7and 3.8 where the question of deductibles is assessedand a brief comment on other perils is provided.

The availability of Market Statistics is discussed in Section3.9. This section looks at the historical position inrespect of FOC data. It also looks at the current positionand considers the data being collected by the ABI under theMarket Fire Statistics Scheme.

Finally section 3.10 deals with computer systems; particularemphasis is given to expert systems.

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3.2 Risk Profile

The proposal form can give only a general description ofthe risk: the type of buildings, the business carried oninside it and its location. In order to get moredetails, insurers employ specialist fire surveyors.This section examines how the fire surveyors carry outtheir responsibilities, discusses some by-products oftheir work and looks at the sort of people they are.

The fire survey report is addressed to the underwriterand typically covers the following aspects of the risk:

1. physical features of the building;

2. the contents;

3. the process being carried out in the building;

4. an assessment of the quality of management of theproposer;

5. recommendations for improving the risk;

6. a check on whether any recommendations of anearlier survey report or any warranties on anexisting policy are being observed;

7. recommendations for the underwriters;

8. an assessment of the Expected Maximum Loss (EMI)

Each of these items will be examined in turn below. Itmay be helpful in considering the following sections tobear in mind (see section 3.5) that the fire risk may belooked on as having 3 distinct elements:

1. The "inception hazard": features of the risk likelyto start fires.

2. The "contributory hazard": features of the riskthat would cause a fire once started to spread.

3. "Special Perils" (essentially weather hazard):often covered under "fire" policies.

In examining the various aspects of a risk the FireSurveyor will look for aspects affecting each of thesehazards.

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THE PHYSICAL FEATURES OF THE BUILDING

Here the surveyor is interested in:

the extent to which the building is itself combustible

features which would prevent or encourage the spread ofa fire

the extent to which the building would, while notnecessarily actually burning, be damaged by a fire

He will therefore be looking at:

1. Locality

What are the buildings round about like? How close arethey? Is the gap filled with combustible material suchas old cars?

2. Construction of walls

At least 9" brick, stone or concrete is needed and thewall must extend right to the roof before it can beclassified as a fire break. This may be difficult toascertain because of plaster coverings etc. Theexternal walls are important especially if they supportthe roof.

3. Supporting framework of building

Is it timber (combustible but likely to stay in place ina moderate fire), metal (may expand and buckle causing atotal loss in only a moderate fire - unless protected),reinforced concrete etc?

4. Floors

Fires will spread upwards very quickly unless there areproper concrete floors. The thickness may be difficultto ascertain because of claddings but in modernbuildings should be satisfactory because of the buildingregulations.

5. Roofs

Is it combustible? What is the framework? Aluminium isparticularly bad as it melts at a low temperature,causing collapse.

6. Roof Lights

If they fail, eg because they are plastic and melt, achimney effect may result.

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-

-

-

7. Communications with other building

What is the risk in these buildings? Are there measuresto prevent fire spreading from or to the otherbuildings?

8. Age of the building

This, together with knowledge of the buildingregulations, may give an indications of the standard ofconstruction.

9. State of repair

This will help the surveyor to assess the possibility oftotal loss through the building collapsing or becomingunsafe. It may also help the surveyor to assess thequality of management (see later).

10. Number of storeys, height

As fire tends to spread upwards this is obviously veryimportant. A fire at the bottom of a tall narrowbuilding might cause a total loss, the same fire in abuilding with the same total floor area but all on theflat could be quite cheap.

11. Methods of space heating

Is it through oil/gas/electric fires, or are there hotwater radiators? If the latter, where is the boiler andsee item 7. Where is the oil storage tank and is thebuilding properly protected against seepage from leaks?Are there adequate guards round heaters (to preventgoods being placed too near to them). What aboutportable heaters - they may not be apparent if thesurvey is done in the summer (they may be moved too nearto goods). The surveyor will pay particular attentionto watchmen and storemen's cubby holes where there maybe unauthorised heaters unknown to the management.

12. Methods of lighting

Not usually a problem with modern electic lighting.

13. General condition of electrical wiring

PVC insulated cables have now been around long enoughfor the rubber on the previous generation of rubberinsulated cabling to have decayed. The surveyor willalso look for any signs of overheating of cables orcircuits eg through the use of multiple adaptors.

14. Methods of storage

High piles or high racks, can prevent the detection offire and also render sprinklers ineffective. This is aserious hazard of modern warehouses.

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15. Sprinkler Systems

These are very important in preventing small cheap firesbecoming disastrous - a total loss may cost as much as1,000 small fires. The surveyor will check that thereare enough sprinkler heads (about one every 10 feet),and that the rate at which water is delivered throughthe head is sufficient (about a gallon a minute). As itis not possible to turn sprinklers on to test them, thedelivery rate has to be calculated from characteristicsof the system.

If Special Perils are covered and the building is notheated in winter, the sprinkler system must be capableof being drained (sprinkler heads must point upwards)and be of the "dry" or "alternative" variety. Drysystems are filled with compressed air, which holds avalve shut against water in a tank elsewhere. When ahead breaks the air escapes releasing water into thesystem. Alternative systems are dry in winter and wetin summer.

16. Vertical Openings

The Surveyor will be particularly interested in measurestaken to prevent fire spreading through verticalopenings such as lifts or stair wells.

17. Horizontal Openings

An opening such as a door in a fire-break must beproperly protected otherwise the fire-break will beineffective.

18. Area with no fire-break

The Surveyor will be wary of large open plan buildingsas the likelihood of fire spreading (and the EML) willbe greater than for a well partitioned building.

THE CONTENTS OF THE BUILDING

The surveyor will want to know what is or might be kept inthe building and the quantity: machinery, process material,waste material, finished goods, packaging. Modern PVC orexpanded polyurethane wrappings are particularly hazardous.Warehouses may contain a large amount of valuable goods, ascompared with factory buildings which may be largely emptyspace. Food and Pharmaceuticals are a problem because asmall fire may cause contamination and total loss.Similarly, electronics may be easily damaged by heat, smokeor water or hydrochloric acid vapour gives off by burning PVCinsulation. A small fire may again be very costly.

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THE PROCESS

It will generally be obvious from the trade whether theprocess uses inflammable materials or is one which is likelyto start fires. However the degree of hazard may not beapparent. The surveyor will therefore examine the wholeprocess, including the transportation at each stage and thepackaging of the final product. He will look out foranything likely to cause heat (chemical reactions, dryingprocesses) inflammable vapours (solvents), dust (many dustsare explosive when mixed with air), sparks (substances beingground will usually contain stray metallic impurities). Thesurveyor will examine the storage of the process material,waste material and finished goods, bearing in mind theircombustibility. He will look for frayed electric cables andany other unsatisfactory features. He will ask whatequipment is switched off when work ceases at night, and whatprocedures are adopted for clearing up and checking that nofires have started before buildings are closed up.

Most fires are caused by human error. The surveyor willtherefore want to know the number of "hands" (for thispurpose each worker is deemed to have only one hand!). Thiswill also give him a measure of how congested the building iswith workers. The surveyor will also want to know thethroughput: a warehouse with a constant turnover of goods ismuch more hazardous than one used for long term storage.

MANAGEMENT

The safety procedures will only be as good as the managementis in enforcing them. The surveyor will therefore want toassess the quality of the management and will pay particularattention to matters such as:

1. No-Smoking Rules

The Surveyor will look out for indications that they arenot enforced. It is not unknown for the manager tosmoke while showing the surveyor round! It is better tohave recognised smoking areas and smoke breaks than atotal ban which is impossible to enforce.

2. Safety Regulations

Again the surveyor will watch for signs that they arenot enforced. This applies not just to anti-fireregulations. Are fire doors wedged open?

3. General Housekeeping

Are floors swept regularly and waste cleared away?Because of arson it is usually safer nowadays forinflammable waste (eg wood shavings) to be stored insidethe building in a specially designated area rather thanoutside as formerly. Is the place tidy? The spread offire is hindered by tidily stacked goods because of the

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exclusion of air. The surveyor will also be on the lookout for moral hazard and will ascertain the well-beingof the business. If the management confide in him that2 sets of books are kept, the surveyor will be dubiousabout the fire risk, never mind the Consequential Loss!The surveyor will take the opportunity to speak to staffto ascertain how much respect they have for themanagement. By that means he may discover that he isthe 5th surveyor that week or that there have beenseveral fires which management had omitted to tell himabout.

With arson (or wilful fire raising as it is known inScotland) forming such a high proportion of fire losses, theassessment of the management and the associated moral riskmay be the most important part of the surveyor's report.

RECOMMENDATIONS FOR IMPROVING THE RISK

The surveyor will often be able to make suggstions to theproposer of ways in which he can reduce fire risk. Often ifthe proposer acts on the recommendations he may save himselfsome premium. Since the premium rate for an entire buildingwill generally be based on the most hazardous process carriedout in it, it may be worth the proposer's while to arrangefor the hazardous processes to be grouped and kept separatefrom the non-hazardous. The surveyor will often also adviseon housekeeping. Other examples will be obvious from pointsdiscussed in earlier sections. Premium (or in extreme casescover) may depend on the proposer taking certain actions.

Fire Surveyors over the years have made a considerable impacton building design. Architects will now automaticallyinclude fire safety features. Such features are often muchmore expensive to incorporate after the building is up. Thepremium saved can be quite substantial.

Fire Surveyors are therefore often used in an advisory rolein the planning of new buildings or of major alterations toexisting buildings. An example of the latter which isbecoming common these days is the splitting up andredevelopment of large redundant industrial buildings.

CHECK-UP

One final aspect of a survey will be to check on whether therecommendations to the proposer in an earlier survey havebeen carried out. The surveyor will also check whether anywarranties under an existing policy with his own company arebeing observed. If they are not, the rate may be increasedat renewal, or in extreme cases cover withdrawn forthwith.Although non-observance of a warranty would give the insurergrounds for rejecting a claim, in practice it would bedifficult to prove after a fire has happened.

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RECOMMENDATIONS TO UNDERWRITERS

The surveyor will submit to the underwriter a written report,including a scale plan of the site. He will makerecommendations as to:-

1. Whether the risk should be accepted or declined.

2. If acceptable, the rate to be charged (thisrecommendation may be in the form of loadings ordiscounts to be applied to tabular or Tariff rates).

3. Any conditions or warranties which should or might beapplied and their effect on the recommended rate.

ASSESSMENT OF EML

As part of his report the surveyor will estimate the EML.This will follow naturally from many of the points alreadydiscussed such as the high likelihood of a building with anunprotected steel framework, or the contents of apharmaceutical warehouse, becoming a total loss.

A FIRE SURVEYOR

A Fire Surveyor will not generally be a qualified surveyor inthe sense that he will not usually be a member of one of theprofessional surveying organisations. He will neverthelesshave a general knowledge of building construction andregulations, and he will have a working knowledge of manychemical processes and their attendant fire hazards.He will be able to recognize fire-hazardous wiring and thelikelihood of sparking or arcing and he will know enoughhydraulics to be able to determine from the characteristicsof sprinkler pipework, and water pressures, whether thedischarge rate will be adequate.He will have a good knowledge of fire technics, firedetection/prevention and above all a thorough knowledge ofthe principles and practices of fire insurance.

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3.3 Method Used Before FOC Demise

The Fire Offices' Committee was in existence for over100 years up to 30 June 1985. It consisted of a groupof offices who agreed by committee to regulate rating,wordings, commission levels and other practices such asthe collection of statistics. Whilst the greaterexperience generated from the sharing of knowledge byall tariff members had benefits to the individualcompanies, the purpose was to give stability anduniformity to the market. As the tariff controlled asizeable proportion of the market this was, in practice,the case. Indeed except for 1984 (when fire wastage wasparticularly high) profits were very substantial overthe years. The reason for the collapse of the FOC inmid 1985 was proposed Government legislation and theeffects of high levels of competition undermining thesignificance of the collected experience.

Companies not in the FOC were not bound by the Committeepractices; the more traditional of these companiesregarded themselves as independent rather than non-tariff because they employed FOC tariff rating practicesas a basis for their underwriting. In some cases theonly rating difference would be that they gave an NTD(non-tariff discount). Other non-tariff officesemployed completely different methods of rating,different policy wordings and different commissionamounts.

Although the FOC tariffs had worked well for many yearstheir rating methods would not be considered actuariallysound. Nonetheless the rating methods used are worthnoting. It is relevant to say that, up until last year,a number of people had suggested other possible ratingstructures. However the very existence of the FOC meantthat few of these could be tried out in practice.During last year many companies were effectively forcedto think about new rating methods. It will be seenbelow that most companies kept many of the FOCprinciples but changed the way in which they wereapplied. This should probably be seen as a vote ofconfidence in the FOC practices; alternatively it mightshow some unoriginality among underwriters!

Recently a number of risk classifications (eg shops andrestaurants) were decontrolled (ie taken out of FOCjurisdication); although there were a number of possiblereasons for this it is probably true to say thatGovernment pressure was an overriding consideration.Before these moves virtually all commercial fire risksfell within the FOC and something more than 50% of themhad a very explicit tariff, while the others had theirrates rather more loosely controlled by the minimumrates tariff.

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Where an explicit tariff existed it could be verycomplicated. The basic principle of all propertyinsurance, however, is to apply a rate per cent to thesum insured to give the total premium payable. For thefire risk you started with a base rate which representedwhat was considered to be the standard rate for a riskof that trade. Then amounts were added or subtractedfor unfavourable or favourable aspects of the risk. Avery simple hypothetical example of a tariff for aparticular trade might be as follows:

Toy Makers' Tariff

Applicable to buildings in which toys are made and anybuilding on the same site used for storage.

Excluding buildings in which more than one third of theemployees are involved in packaging toys rather thantheir manufacture.

Normal rates (per £100 sum

Factories wholly usedmanufacture of toys

Other buildings

insured):

for the

WithWarranty1

0.06

0.075

WithWarranty2

0.15

0.10

Additional rates:

If the total area of the non-standard construction in theexternal walls and roof is(1) more than 20% but less

than 50% 0.025(2) more than 50% 0.05

If ground floor area exceeds3,000 square metres then foreach further 3,000 square metre 0.01

For each power operated machine

in excess of one 0.025

Discounts:

Construction - Standard IStandard IIStandard IIIStandard IV

Buildings

40%35%30%20%

Contents

25%20%15%10%

For approved fire extinguishers a discount inaccordance with standard amounts.

Automatic sprinklers - Standard A 30%

Standard Β 25%

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Warranties:

1 . Liquids with a flash point below 32 C to bestored in closed tins not exceeding four gallonsand kept in a compartment made of brick orconcrete.

2. Liquids with a flash point below 32°C to be storedin closed tins.

3. No working in wood by power.

[Warranties are clauses by which the insured must abideor else the policy cover will cease. Either warranty 1or warranty 2 will be deleted, warranty 3 will apply inall cases.]

This hypothetical tariff is very much simplified. Eventhe simple tariffs might be three of four times longerthan this and some of the complicated tariffs (eg forthe manufacture of plastics) were very complex.

Other factors that might typically have been accountedfor in a tariff were a full description of theoccupancies included within the trade covered, allaspects of the construction of the premises, the heatingused in the buildings, the use of any hazardouschemicals, the carrying out of any hazardous processesnot normally found in the trade, and the exact discountsto be allowed for different sprinkler installations andother fire extinguishing apparatus. The warrantiescontained in the policy affected the premium charged.

Although the tariffs were updated and changed from timeto time they were not changed every time the experienceof a particular trade changed. Instead the FOCpublished a schedule of percentage adjustments (SOPA).This gave the amount for each trade which should beadded (or deducted) from the rate derived from thetariff to give the premium to be charged. Theappropriate SOPA for each risk was set periodically bythe FOC by considering the aggregate experience of allmember offices.

As already mentioned some risks within FOC jurisdictiondid not have specific tariffs. For these each officewould have its own rating structure. Nonetheless, evenfor these risks, the FOC did publish SOPAs. Inprinciple each office was supposed to calculate the ratefrom its own rating structure and then add the SOPA.However, as some SOPAs were very large (sometimes up toa few hundred per cent) and basic premiums withindifferent offices could be very different, the methodwas not very scientific. Indeed it is thought that insome offices the basic rate was chosen having regard tothe amount of SOPA.

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Despite all the problems the FOC offices did comereasonably close to all charging the same rate for anyparticular risk. Even given the complex nature of manyrisks and the fact that two underwriters might look atthe same feature differently there were relatively fewcases where different rates from two offices caused anyreal problems.

3.4 Methods Currently Used

Following the demise of the FOC the participatingoffices needed to produce their own rating manuals. Inpractice so did many non-FOC offices who had previouslylargely followed the FOC rating. In theory officescould have continued to abide by the tariffs; however,in practice, many offices felt they could produce arather better rating structure. Among other reasonsthis was because the tariffs were inflexible inoperation as they basically charged an average rate.There was no allowance for features such as goodhousekeeping and superior management; equally some poorfeatures could not be penalised. Thus many offices feltthey could do better than the tariff and, with a bit ofluck, select against the market.

As already stated the principles underlying many of thenew methods are similar to those used by the tariff.Many offices have taken what they consider to be thebest aspects of the tariff and brought in a few newideas to produce their new rating manuals. Althoughmany of the basic ideas and philosophies have thus notchanged there have been changes in the way these havebeen applied. For example the basic idea of having arange of rates (or a given rate) for a particular tradehas remained although there are some new ideas about howthe rate for any given risk should be chosen within theparticular band. Examples of some such methods will begiven below. The actuary should perhaps decide whetherthe basic philosophy is correct and, if so, whether themethod of applying it is an optimum one.

Over the past two or three years many offices have thusproduced new rating manuals. Although such new ratingmanuals could have been introduced from 1 July 1985, theywere, in practice, phased in slowly; the old tariff rates, orat least some aspects of them, continued to be used by someoffices where this was to their advantage. This helped leadto a reasonably stable market following the demise of theFOC, rather than a rate cutting battle which would havehelped nobody. However many would say that this stabilitywas only possible because of the prevailing conditions at thetime in which companies were losing money. A new mood wasbeginning to emerge in the market following the withdrawal ofthe British National and a significant reduction in capacityof other fringe companies; in some areas this was hastened bytheir inability to renew their reinsurance covers. This,combined with the continuing underwriting losses of all UKfire insurers, did cause hardening of rates and attitudes.

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However with reasonable profits now (July 1986)returning to the fire market competition is increasingand a period of rate cutting is likely to follow. Thiswill probably herald the end of the use of FOC tariffsdirectly and an increasingly important role for theoffices' new rating structures. It is therefore worthconsidering the basis of this new rating. Despite theimportant input actuaries could have had to the manyrating structures described it is almost universallytrue to say that they had no such input. As mostcompanies consider their new rating methods to beconfidential what follows is an outline description ofwhat a number of anonymous companies are doing.

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Company A

Rating Basis and Philosophy

This company applies a rate to sum insured. A separate rateis applied to buildings as opposed to contents and stock;under the FOC only some of the tariffs gave different ratesfor the two different types of cover.

Method of Rating

The appropriate rates are derived from a table of rates whichis in the form shown below. The relevant table for theparticular trade and for buildings or contents has to bechosen.

Trade

It can be seen that each of the three factors ofconstruction, housekeeping and processes will be rated asgood, average or bad. Then, given the trade and whether ornot buildings or contents are being rated, the appropriatepercentage rate is taken from the appropriate table. Thegood, average or bad rating for each factor is determined byan experienced underwriter having regard to the surveyreport. Discounts to the base rate are allowed for superiorconstruction or housekeeping, for sprinklers etc.

underwriting Guidance

The form of the table is such that little discretion isallowed to the underwriter. The rates are centrallycontrolled.

Special Perils

Standard amounts are added for additional covers within thewet and dry peril categories.

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GOOD AVERAGE BAD

Construction

Housekeeping

Processes

Company B

Rating Basis and Philosophy

This company uses the same percentage rate to apply tobuildings, contents and stock. However, as a number ofcompanies do on some other commercial classes, they havegiven a band of rates that is applicable for each particulartrade.

Method of Rating

To determine where a particular risk should lie within theband the underwriter has to consider the risk potential underfour headings; these are construction, hazardous processes,heating and housekeeping. For each of the factors he uses hisjudgement and the guidelines laid down, to determine a pointscount reflecting the appropriate degree of risk. Essentiallythe points are added up and, using an addititive model, theactual rate to be charged within the band is determined.

The way the points system works is, however, rather morecomplicated than a standard motor points system. The numberof points allocated to one factor will affect the range ofpoints from which a figure can be chosen for the next factor.In this way an allowance can be made for dependency betweenrating factors. No formalised method of experience rating isset down. To the basic rate calculated as above for therisk, discounts are allowed for such features as sprinklersand other fire extinguishing apparatus.

Underwriting Guidance

By standardising the way in which a rate is chosen for aparticular risk within the trade band, rather less discretionis allowed to the underwriter. Central control is increasedand statistical monitoring of how a premium has been made upis more easily carried out.

Special Perils

Appropriate standard amounts are added for additional perilsto be covered.

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Company C

Rating Basis and Philosophy

Of all the companies considered this one used the mostdetailed method of rating. Only time will tell whether theincreased sophistication in the rating formula will reallygive a better answer.

Method of Rating

From the broker's presentation and the survey details, theunderwriter grades the most important features of the risk ona scale between one and five. For each particular trade arange of rates is given and the underwriter decides where topitch his basic rate from within this band according to thegraded features of the risk. An appropriate discount (from astandard table) is allowed for fire extinguishing apparatusand a loading is made for ground area. This gives the basicstock and contents rate, from which is subtracted aconstruction discount, depending on the type of building, togive the building rate.

Appropriate loadings or discounts are allowed throughout forinflation schemes, deductibles and stock covered on adeclaration basis. Finally a size and experience discount isallowed; this comes from a relatively standard table givingthe discount to be allowed for a particular size of premiumand a particular five year loss ratio.

Underwriting Guidance

A reasonable amount of discretion is allowed in the way inwhich the underwriter interprets the survey and the broker'spresentation.

Special Perils

A dry peril rate is added which depends on the number andnature of such perils covered. For wet perils a differentrate for buildings and contents is used; the susceptibilityof contents and stock is graded from one to three and thisdetermines the rate to be added for storm cover (which alsodepends on the construction of the building), for flood cover(which additionally depends on the number of floors andwhether there is a basement) and for burst pipe cover.Standard amounts are charged for other wet perils and adiscount is given according to how many, and which wet perilsare covered. The total wet perils premium is then discountedby a factor which increases as the total sum insuredincreases. Finally an amount for any other risks covered isadded.

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Company D

Rating Bases and Philosophy

This office was non-Tariff and what follows describes therating method used up to now. A complete review is currentlyin progress.

Rates are expressed as % of the sum insured. In most cases,the same rate applies to Buildings, Contents and Stock.

The rates are based partly on detailed internal statisticalanalyses; they have also evolved from the underwriters'judgement over years of experience and from marketconsiderations.

Method of rating

Risks are classified according to the trade of the occupier.Most risks are then rated either by reference to Tariff ratesor by reference to internally produced tabular rates. Tradesrated by these tabular rates are grouped into about 50classes. The grouping of trades into classes is according tothe underwriters' perception of the similarity of the risk astranslated into premium rate terms, rather than similarity ofthe risks themselves. As a result, many of the members of aclass are clearly related (for example manufacturers usingthe same or similar raw materials). On the other hand manyothers are completely unrelated (for example manufacturers,retail shops, public buildings).

In addition to the trades rated as above, there are 3 listsof trades which are outside the normal rating system.

1. A list of automatic declinatures.

2. An "accommodation" list of trades which will be acceptedonly in exceptional circumstances, for example, becausethe fire insurance may be part of a package. Rating insuch cases would be done on the basis of individualconsideration by Head Office underwriters.

3. A further list of trades where acceptance is not indoubt but the rate is fixed on the basis of individualconsideration by Head Office underwriters.

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Underwriting Guidance

The tabular rate for a given class is usually a range, withinwhich a rate has to be selected by the underwriter using hisjudgement. The range between the minimum and the maximumrate varies between classes. In some classes the range isnil. In others the maximum is usually between 1.25x and 4xthe minimum. In an exceptional case (with a low minimumrate) the maximum is 6x the minimum.

There is clearly considerable scope for judgement on the partof the underwriter. In exercising his judgement, theunderwriter would take into account the surveyor's report andthe past experience.

The basic rate may then be adjusted upwards or downwards, asappropriate, for the following features of the risk. Thesurvey report would play an important part here too.

1. The construction of the building (is itcombustible/"fireproof", will it collapse easily in afire, etc)?

2. Factors contributing to rapid fire spread (undividedroof, etc).

3. Methods of space heating (gas fires or hot waterradiators, etc).

4· Management and housekeeping (including "moral risk",although a bad moral risk would normally be unacceptableon any terms).

5. Special storage arrangements (compartmentation, heightetc).

6. Presence or absence of sprinklers or other fireextinguishing appliances.

In practice there could be overlap between these adjustmentsand the selection of the basic rate within the tabularrange.

Special Perils

These are rated independently of the Fire risk using tabularrates. A separate rate is provided for each peril to becovered. Tabular rates are also provided for variouscombinations of perils at less than the sum of the rates forthe individual perils in isolation. The rates vary by suminsured: the higher the sum insured, the lower the rate.

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Company E

Rating Basis and Philosophy

This note outlines the approach of one office to FireUnderwriting. The office concerned was a non-tariff officeand the abolition of the tariff has not fundamentally alteredthe approach which was to have regard to the tariff amendedon a subjective basis. The major change is that the companyhas now issued its own rating guide which includes thesesubjective amendments to the tariff. Rates are quoted as aband of rates for particular classes of risk, with discountsfor deductibles.

Method of Rating

In determining the rate to apply to a specific risk, theunderwriter will have regard to:-

Construction of buildingHeatingFire fighting equipmentSecurityMoral hazardGeographical areaLong term agreementEML relative to sum insured (the rate should increase withincreasing proportion).

Housekeeping standards.

A change in recent years is the increasing emphasis placed onsecurity as a rating factor. Malicious claims account foraround 40% of claims by amount.

Experience rating is not used.

Special Perils

Dry Perils (catastrophe in nature) - aircraft, explosion,riot, earthquake andimpact

Wet Perils - storm, flood, burst pipes

For dry perils, the rate does not vary with sum insured. Forwet perils, the rate decreases as sum insured increases. Forrating wet perils, location and claims history over a numberof years is vital.

Underwriting Guidance

The underwriter has some discretion on risks within his levelof authority. On bigger cases, he will refer to the centralcontrolling department which provides a feedback on thelatest thinking as applied to individual risks and augmentsthat given in more general terms by circular.

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Company F

Rating Basis & Philosophy

This company classifies risks into trade classes. Each classhas a start fire rate, used for both buildings and contents,applicable to the sum insured. There is also a minimum rate.

Method of rating

The start rate can be adjusted, at the underwriter'sdiscretion, for the underwriting features of the risk.Factors like management, housekeeping, hazard variation andconstruction would be considered. Discounts are applied tothis adjusted rate for:

a) the standard of construction for the non-sprinkleredrisks - this discount only applies to the buildings

b) sprinkler installations conforming to prescribedregulations

c) automatic sprinkler installations and other fireextinguishing appliances and for fire alarms.

The discounted rate arrived at must not breach the laid downminimum rate.

There may also be discounts for size. The form of experiencerating used is to give discounts for a low 5 year loss ratiowith the level of discount increasing with size of risk.

Underwriting Guidance

Although the start and minimum rates are set at HO, theunderwriter has a considerable amount of discretion in wherehe pitches his rate. There are some trade classes wherereference has to be made to HO and some where the ratingprocedure is more complex than described above.

Special Perils

The rate for each peril is separate but is applied to alltrade classes. This rate is for normal risks and isincreased for risks presenting greater than normal hazard byapplying a loan and/or excess. There is a size discount onone scale for 'dry' perils and on a different scale for 'wet'perils.

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Company G

Rating Basis and Philosophy

The calculated fire rate applies to all elements of the riskeg Buildings, Machinery/Plant, Stock and Rent.

The rating structure adopted is fairly complicated but thecentral aim is to provide, as far as is possible, consistentrating by restricting the discretion allowed to theindividual underwriter.

Method of Rating

For each particular trade there is a basic rate which is thenadjusted in the light of the particular risks. The followingfeatures would attract additional premiums in the form of aflat additional premium per cent.

a) Non-standard construction - FOC definitions are used.b) Height of building; there is an additional premium for

each non-fireproof floor above the lowest level.c) Conbustible linings/ceilings/partitions where these are

not covered with incombustible material.d) Ground floor area in excess of a basic size.e) Multitenanted (in excess of 2) properties.f) Portable heating systems.g) Packing where this is combustible and is in excess of

one day's supply.h) Storage or indiscriminate use of highly flammable

liquids/LPG/Oils.i) Presence of combustible waste.j) High piled storage.k) Spray painting not in accordance with FOC

recommendations.l) Woodworking.m) Plastics.n) Distance of risk from nearest Fire Brigade.

Discounts are given for Fire extinguishing/detectionsystems:

a) Fire extinguishing appliances - the following wouldattract discounts:-

i) Mobile power pumps.ii) Hydrants on the premises.iii) Hydraulic hose reels and internal hydrants with small

bore hose attached.iv) Approved portable extinguishers.v) Buckets.vi) Portable manual pumps.

Scales are also set down for various combinations of theseappliances which gives a fixed maximum discount.

b) Approved sprinklers: the discount varies according totype and an additional discount is given where there isan automatic alarm to the Fire Brigade.

37

c) Automatic fire alarms.

Experience rating is performed for larger risks but there isno set definition of what exactly a larger risk is. Inpractice it is restricted to those cases where there ispressure from the broker.

Underwriting Guidance

Some flexibility is granted to the underwriter in adjustingthe rate as a result of consideration of the unique featuresof the risk where they have not been taken into account inthe previous calculations. A reduction of up to 20% may beallowed. The subjective items which are to be taken intoaccount are:-

1) Management of the property.

a) General housekeeping.b) Security.c) Electrics.d) Waste disposal.e) Heating.f) Workforce (ie make up, industrial relations).

2) Environment.

a) Buildings,b) Segregation of hazardous process/materials.c) Inflammables.d) Machinery.e) Storage.f) Compartmentation.g) Location.

Special Perils

A dry peril rate is used for all businesses and no discountis used. Where an increased hazard applies these rates wouldbe loaded or a substantial deductible imposed.

For wet peril rates, each trade/occupation has a hazardcategory which determines the rating table to be used and thebasic water damage rate.

Both wet and dry peril rates reduce with size of risk.

38

3.5 Actuarial Thoughts on Rating

As can be seen from Section 3.4, there is a multitude ofmethods used for rating, virtually every company willhave its own particular unique feature in its ratingstructure.

Furthermore there are a large number of rating factorsthat are used. The following list is by no meansexhaustive and indeed companies may only use some of thefactors but the list does give some idea of the rangeconsidered :-

(a) Occupation/trade being carried out(b) Construction of the buildings(c) Moral hazard/general standard of managementd) General standard of housekeeping(e) Closeness to fire station(f) Presence of fire-fighting equipment(g) Presence of sprinklers(h) Fire alarms and whether automatically linked to

fire station(i) Hazardous processes(j) Floor area of building(k) Types of space heating used(l) Number of floors in building(m) Multi-tenanted property(n) Geographical area(o) Storage of waste and hazardous materials

Few, if any, companies use all of the above ratingfactors but most use a significant number of them.

The question is what is the aim of such a complicatedset of rating factors. In assessing any fire risk,there are two essential elements to consider.

Firstly there is what might be termed the inceptionhazard ie. what features of the risk will actually causea fire to start. Of the rating factors consideredabove, items (a), (c), (d), (i), (k), (m), (n) and (o)are aimed at assessing this part of the risk.

Once a fire has started, there is the question of therisk of spread of the fire to be considered. This cantake two forms. How quickly the fire will physicallyspread to engulf the building (rating factors (b), (j),(1) and (o)) and once started how quickly the fire canbe put out (rating factors (e), (f), (g), and (h)).

39

Looking at the rating factors, it is extremely unlikelythat the rating factors used will be independent whichmeans that all sorts of complicated rating systems couldbe used. Such dependency is very likely to existbecause of the distinct elements of the inception riskof a fire and the spread risk of that fire; for example,it would be expected that the fire premium of a dynamitefactory which generated many sparks would be very muchmore than the sum of the premiums of a dynamite factorywith no such sparks and a similar factory that producedsparks but only used and stored non-flammable products.The assumption that factors are not independent leads toall sorts of possible rating systems; the complicationsof these are such that the actuary is ideally qualifiedto help the underwriter in understanding the fullramifications of his rating method.

It is unlikely that many of the rating structures havebeen formally tested to check whether they trulyrepresent the underlying risk.

At best companies might have looked at burning costs bytrade group and for those where experience was bad, madesome subjective adjustments. Thus the complexity ofrating structure was built up as greater attempts weremade to isolate the "good" risks.

The testing of the relevance of the rating structureswould seem to be a fruitful area for Actuarial activity.There would seem to be three main questions to answer:

(a) Are any of the rating factors redundant ie. do notadd anything to the assessment of the risk?

(b) Can any of the rating factors be further split intoa greater number of levels?

(c) Do the rating structures correctly reflect theinterdependency of the rating factors?

However this process is not straightforward. There area number of problems to be overcome:-

(a) Each rating factor must be capable of being set atdiscrete levels with increasing risk. This meansthat purely subjective adjustments cannot bemeasured.

(b) A sensible rating model has to be postulated.

(c) Data must be collected for each risk under therelevant rating factors. For many companies,because of the wide ranging nature of the types ofrisk in fire insurance, there will be insufficientdata to perform an in-depth investigation. Theultimate solution would appear to be the collectionof market statistics and a start in this directionhas been made (see Section 3.9).

40

The above rating structures take into account almostevery conceivable aspect of the risks. It isinappropriate to make further adjustments to allow forEML's. These are more appropriate in determining limitsto size of risks to be underwritten. The followingfactors given examples of the major features that mightbe considered in assessing EML's:-

(a) Relationship of value to volume(b) Volume of individual items(c) Accessibility of premises for vehicles(d) Location of premises(e) Presence of acceptable automatic alarm(f) Presence of security organisationg) Degree of internal and external physical

"protections"(h) Efficiency/coverage of local police(i) Construction of premises (weakest part thereof).

Items other than rating factors must be considered insetting a premium rate:-

1) Expenses

These should be analysed into their constituent parts.An important part of the expenses associated with thefire policies will be the cost of the survey. Not allpolicies will be subject to a survey so considerationmay be given as to whether the costs of surveys shouldbe spread over the whole class of fire policies or justto those where surveys are undertaken. However,generally surveys will normally be undertaken for thelarger policies and thus the cost of the survey may betaken as related to the premiums.

Expenses will need to be analysed into:-

(i) Those dependant on the premium eg. commission(ii) Policy related expenses eg. policy issue will tend

to be higher for more complicated policies(iii) Claim expenses(iv) Fixed Costs.

2) Investment Income

In assessing the office premium to be charged allowancewould be made for the interest income received arisingfrom delays between receipt of premium and actualpayment of claim. The following factors should beconsidered:-

a) Pattern of Claim Payments

This pattern will vary from year to year (dependingon number of "large" claims) and will also varyfrom company to company. The following pattern istypical:-

41

Within 1 year of incident23456

% Claim Amounts Paid

6080909598100

b) Delays in Premium Receipt

Premiums will not be received as soon as the riskis written. Typically there may be a delay of saythree months before the premium is received fromthe broker. Allowance must also be made if thepremium is payable in instalments.

c) Reinsurance

Allowance must be made for the features ofreinsurance. In particular allowance must be madefor the actual timing and amounts of premium thatare physically paid to reinsurers. There will alsobe delays between payment of a claim and receivingrecoveries from the reinsurers.

3.6 Experience Rating

As part of the rating process, insurers consider thepast experience of the risk. However this is often donein a haphazard way without any attempt at using a methodthat would be considered actuarially sound. Adjustmentsmay be made to the "tabular" rate depending on theunderwriter's perception of whether the experience hasbeen "good" (discount given) or "bad" (loading imposed).In this context the phrase "tabular" rate is used tomean a rate ascertained using all information availableother than the experience of the risk itself. As areminder that the word "tabular" has this specialdefinition it will be included in inverted commasthroughout this section.

The "tabular" rate is assumed to apply to the "average"risk given all the rating factors other than the risk'sown experience.

Usually the last 5 years' experience is taken intoaccount. Where a risk is being rebroked the holdinginsurer provides the experience for the competinginsurers. A standard form has been proposed betweenmany of the insurers writing Fire business. A copy ofthe form and some comments on the form from an actuarialviewpoint, are shown at the end of this section, pages48 and 49.

42

Large claims are rare, but nevertheless contribute asignificant amount to the total losses. As a result, mostexperiences will be better than average ('good'), a smallernumber will be worse than average ('bad') and a very smallnumber will have an appalling experience ('unlucky'). Thiscan lead to more discounting than loading: it would benonsensical to load the unlucky cases for the full cost ofthe large claim. The total premium charged on all experiencerated cases after the experience rating exercise willtherefore be less than the total if all had been charged the"tabular" rate. If the future experience overall is areflection of the past the future claims cost will be inaccordance with the "tabular" rates (by definition) and thetotal business will be written at a loss. The position isfurther exacerbated by the fact that the good risks willdemand experience rating while the bad ones will not.

There is another problem with large fire losses whicharises when experience rating is applied to fireinsurance. The very large losses may sometimes beremoved completely from the experience used in theexperience rating exercise. This could happen becausethe owner of the destroyed building ceases to trade orat least undergoes a major reorganisation. The combinedexperience of all experiences being offered for renewalwill therefore fall short of the "true" or underlyingexperience. This will lead to premiums falling evenfurther short of what is required, and hence to evenhigher underwriting losses.

This would be true even if there were no "tabular" ratesand all the business was purely experience rated. Itwould also be true if an insurer priced its experience-rated business entirely on its own merits without anyreference to the "tabular" rates: the total experiencebeing used in the experience-rating exercise will fallshort of the "true" experience because of the absence ofvery large claims.

A parallel can be drawn with life assurance on anindividual life. When a policy becomes a claim, it isnot offered for renewal. No matter how big the suminsured (and hence the premium) no-one would dream ofexperience rating life policies using only the previousfive years'experience of policies offered for renewal.

The following worked example illustrates the points madein this section.

An insurer has tabular rates which are expected to becorrect for its portfolio as a whole. For large casesit makes 2 adjustments to the tabular rates.

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The first adjustment is justified on account of the sizeof the case: for example because expenses areproportionately less than for small cases. Perhaps theinsurer believes that burning costs reduce as sumsinsured increases (others may disagree). Thisadjustment is independent of the experience of the casebeing examined so in accordance with the definition usedin this section of the paper can be deemed to be part ofthe "tabular" rating system.

The second adjustment applied depends on the cases's ownexperience. It is this adjustment which is beingconsidered in this section.

Suppose that the distribution of claims by size isexpected to be as follows:

Illustrative Distribution of Fire Losses by Size of Loss

ClaimsCost

Percentage ofTotal by no.

RunningTotal

Percentage ofTotal cost

RunningTotal

£1m- ( ) 1 1 .8% 11.8%

About 1/10th of the losses are from 1/10,000th of theclaims. Nearly 1/3rd of the losses are from only1/1000th of the claims. Half the losses are fromperhaps 1/150th of the claims.

For the purposes of this illustration, simplify theoverall distribution to:

Total cost

99.9% of claims cost 0.667 units ("normal") 0.6670.1% of claims cost 333 units ("large") 0.333

Average claim cost 1.000

Assume for simplicity that expenses and commission areproportional to gross premium. An assumption thatexpenses are independent of premium would alter thefigures in the illustration but not the principle beingillustrated.

Suppose 40 cases are offered for renewal and each had 25claims during the experience period examined. Of the1,000 claims, typically 1 will have been large. Thismeans that 39 of the cases will have experienced 67% ofthe "expected" claims cost according to the underlyingexperience. The danger is that they would be classifiedas "good", meriting a discount.

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£0.5m-£1m£0.25m-£0.5m£0.1m-£0.25m£10,000-£0.1 m

-£10,000

(

(0.1%

0.2%2.4%

97.3%

0.1%

2.7%100.0%

)

)9.3%

14.8%30.0%24.1%

21 .1%31.1%45.9%75.9%100.0%

0 . 3%10.0%

The other case would have been disastrous, having anexperience cost of 1,400% of expected. A considerablesurcharge on the tabular premium might well becarriable, but a thirteenfold increase? And if it were,it would hardly be insurance! Even if the discount onthe "good" cases were restricted to 20%, the"disastrous" case would need to carry a 780% surchargeto make the books balance. In practice, these cases maynot be renewed, so the opportunity to collect even amoderate surcharge may not arise at all

Thus, although the portfolio is expected as a whole tohave an experience in accordance with the tabular rates,the application of experience rating could result in thepremium collected as a whole falling seriously short ofthe total required.

This illustration has been based on an average of 5claims a year over the 5 years' experience examined. Inpractice experience rating may be applied with fewerclaims than this. The standard experience reportingform (as shown at the end of this section) applies tocases with annual premiums of £1,000 and above: many ofthese may have had 10 claims or less over the 5 years.The fewer the claims the greater the divergence betweenthe apparently good and the disastrous and the greaterthe possibilities for more discounting than loading.

The distribution of claims size which forms the basis ofthis illustration has been obtained from a particularinsurer with a reasonable amount of Fire business. Ithas been provided solely with a view to illustratingthis point on experience rating. The authors wouldcaution against it being used in any other way, forexample in a claims smoothing exercise. The mainreasons for this are:

1. The claim size distribution for any given portfoliowill depend on the distribution of sums insuredexposed. This will vary considerably betweeninsurers, and for a given insurer, betweenaccounts. Furthermore, the sum insureddistribution for the cases which are experiencerated will be different from the distribution for aportfolio as a whole. And again, the sum insuredof the case being examined, or the distribution ofsums insured if the case is a collection of risks,will be different from the sum insured distributionof all cases being experience rated. For example,if the case sum insured were £1m it would beimpossible for it to have a claim exceeding £1m,yet the distribution shows 11.8% of total claimscost to be in the "over £1m" band.

For this reason, the distribution would not besuitable for adjusting experience rated cases forthe presence or absence of large claims even by theinsurer who provided the data.

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2. The distribution includes all claims under theinsurer's Fire account, including Special Perilsand Consequential Loss. The distribution ofexposure between these will also differ betweeninsurers - and between cases being experiencerated.

3. There are other imperfections in the data which donot invalidate its use for the purposes of thispaper (ie solely for illustration).

There is much to be said for trying through anexperience-rating exercise to load those cases whichappear from the past to have a greater propensity toclaims than is implicit in the "tabular" rate. This maybe because of imperfections in the "tabular" ratingsystem. It may also be because slack management at therisk is showing itself in a large amount of claims,although declinature may be preferable to loading insuch a case.

The experience rating exercise should not attempt toload or discount for past variations in experience whichare due to chance alone. It is difficult to see how themethod described can avoid this. Furthermore, themethod appears to have a built in bias towardsdiscounting.

The whole question of experience rating and itsrelationship to the concept here defined as "tabular"rate raises important issues which are outside the scopeof this paper.

There would seem to be scope here for significant inputfrom actuaries. This could also involve some of themore theoretical concepts which actuaries learn. Forexample credibility theory and premium theory seemappropriate.

Credibility theory is concerned with the systematicadjustment of insurance premiums as claims experience isobtained. Data used can be individual data derived fromthe group of contracts of interest for the particularperiod or collateral data derived from other similarcontracts for the same period. A credibility factor Ζis assigned to this data. This will vary between 0 and1. It is close to one when the individual data areextensive and close to zero when sparse. Parameters canbe estimated using both individual data and collateraldata and the credibility factor Ζ can be used to producea weighted average of the two estimates that can be usedfor purposes of recalculating premiums.

46

Such an approach may seem to have affinity with themethods of rating in use for fire insurance in the UK.There is information on classes of properties. It wouldbe possible to adjust rating systems to take account ofchanging experience paying some regard to individualdata and to collateral data.

Continental academic actuaries have developed anextensive theory of premiums. This is concerned withnet premiums including contingency loadings but notallowing for investment income. If the amount of claimper policy per year is a random variable X then thepremium Ρ is fixed at Ρ = E(X) +g(X) where E(X) is themean of X and g(X) is a function depending on thedistribution of X. On the continent (Belgians and Swiss

have been especially active) many Premium Principleshave been formulated which guide the construction of thefunction g(X). These includes the Swiss premiumprinciple, the Esscher Principle, the Variance principleand several others. Though it is felt that thedimensionality of the Variance principle is wrong andsome results in this connection achieved by themathematicians are regarded as negative manymathematical considerations favour the Varianceprinciple. According to the Variance principle Ρ = E(X)+ k var(X) where var(X) is the variance of X and k is aconstant or parameter that can be fixed in relation tothe class of business. Thus the idea of the Varianceprinciple is to make the contingency loadingproportional to the variance of the total claim size perpolicy. For Fire Insurance such a principle may beregarded as having some intuitive appeal and it would bepossible to pay some regard to the Variance principlebecause Fire Insurance shows greater variation both inclaim size and claim frequency than other kinds ofinsurance and therefore it is desirable to have highercontingency loadings for Fire Insurance.

47

Experience Form

The form referred to on page 42 is shown on the next page.The following comments are pertinent:

i) There is no indication of the exposure over theperiod. Over five years a company's buildings,plant, stock and even the trade carried on may havechanged quite considerably. Cover may even havechanged. Where more than one trade is carried on thetrade mix may have changed. The form asks for the"main" trade, but the main trade from the business pointof view may not be the main contributor to the Firerisk. Cover may even have changed: for example the mixbetween pure Fire cover and Special Perils.

ii) It is not clear whether the claims are thoseintimated or those occurring in the period. Thismakes it impossible to know whether to allow forIBNR. Presumably occured is intended as it is reallypolicy years which are being examined.

iii) There is no split of the total claims cost by peril.Even in the absence of information on exposure byinsured peril this would have been useful because thevariance in the experience varies by peril, being muchhigher for Fire than for Special Perils.

iv) "Large claim" is not defined. Different officesmay therefore interpret it differently.

v) Large claims are identified by "cause" enabling therelated perils to be idenified. However, any attempt tomake allowance for the presence or absence of largeclaims would be hampered by the lack of a similar splitin the total claims cost. This is because thedistribution of losses by size depends on the peril.

vi) It would have been helpful if large claim costshad been split between "paid" and "outstanding" inthe same way as for all claims.

48

MATERIAL DAMAGE CLAIMS EXPERIENCE (For risks with annual premium of £1,000 and above)

Name of Insured:

Main addresses:

Main ABI Classification:

Perils Insured*:

Renewal Date: LTA Expiry Date:

Date to which experience completed:

Where less than five years' experience, including the current year, is available, name of previous insurer:

Last five years' Losses net of Deductible (if any):-

YEAR CLAIMS TOTAL DEDUCTIBLE CLAIMS APPLICABLE

Amounts Amounts NO. Amount £ Paid Outstanding (Other than £ £ £ Standard

Excesses)

19 /19

19 /19

19 /19

19 /19

19 /19

TOTALS

Each large loss during last five years (included in the above details)

YEAR CAUSE* AMOUNT PAID/OUTSTANDING £

F = Fire A = Aircraft Exp = Explosion R&CC = Riot & Civil Commotion MD = Malicious Damage Eq = Earthquake

S = storm FL = Flood BP = Burst Pipes I = Impact IOV = Impact Own Vehicles BOR = Balance of Risks Others (specify)

Signed: . . . . . . . . . . . . . . . . . . . . . . . . . . . . Date: . . . . . . . . . . . . . . . . . . . . .

49

£

3.7 Deductibles

Historically deductibles were little used and indeed theFOC initially discouraged deductibles partly becausetheir statistics would become more unreliable ifdeductibles became common.

The arguments in favour of deductibles are that theyinvolve a degree of self-insurance giving the insured avested interest in the safety of the property insured.

Deductibles can be used as a rating factor. For examplewhere there is poor housekeeping, a deductible, willimpose an element of self-interest and thus may be moreeffective in improving the risk than the submission of alist of recommendations.

Deductibles may take different forms.

a) Compulsory or voluntary

Small compulsory deductibles are generally imposedfor instance in respect of wet perils. This mighttake the form of say a £100 deductible beingapplied separately in respect of (a) storm, (b)storm and flood, (c) burst pipes to each and everyloss at each separate premises. This has theeffect of reducing the number of small claims.

Alternatively voluntary deductibles may be offeredin return for a reduction in premium. However thediversity of risks makes it very difficult to costthe effect of deductibles. In theory it should bepossible to obtain a claim cost distribution andcalculate the reduction in premium directly.However it is doubtful if most companies havesufficient data. Some companies use a version ofLloyd's first loss tables.

An alternative approach might be to try and usedata on fires produced by outside bodies however,this may prove too complicated to apply inpractice.

Care must be taken in assessing the discount to begiven in return for a deductible. The claim costdistribution may itself alter as a result of theapplication of a deductible ie the insured may justinflate his claim so as to obtain the same coverfor a lower premium. Obviously this is less of aproblem where a substantial deductible is offered.

b) Aggregate Deductibles

This is where no payments are made by the insureruntil the claims in a given period, treatedcumulatively, exceed the level of the aggregatedeductible.

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3.8 Other Perils

The cover and scope offered by other perils is set outin Section 2.2 of this paper.

In determining the premium to be charged for theseadditional aspects of cover, it is necessary to collectdata where the claims are subdivided according to theperil covered.

In practice there is generally an additional premiumpercent of Sum Insured to cover dry perils and littleattempt is made to distinguish between different risks.The rate for dry perils will vary depending on thenumber of dry perils covered. Normally compulsorydeductibles are not imposed. However if cover forimpact by the insured's own vehicles is granted, acompulsory deductible may be imposed.

For wet perils, the risk is normally graded according tothe susceptibility of the risk. Again the actual ratewill depend on the number of perils covered. Normally acompulsory deductible will be imposed.

The wide variety of approaches adopted by differentcompanies can be seen in Section 3.4.

3.9 Market Statistics

As briefly mentioned in Section 3.3, the FOC - until itsdemise in 1985 - collected statistics from certain ofits member companies which, after aggregation, were usedto review tariff rates and hence set the amount of eachSOPA. In the recent past, this exercise had beencomputer based with offices supplying input details ofindividual policy transactions and individual claims onmagnetic tapes. In practice, many FOC offices wereextremely small and this detailed data input wasprovided by only about 8 offices although, being thelarger ones, they would have held the lion's share ofthe business.

51

The claims input was used to maintain a claims masterfile of individual records and this could be analysed inwhatever way was required. The policy input recordswere on a totally different basis and consisted only ofpolicy transactions by the office since the previoussubmission was made. This would comprise details of newbusiness, renewals, lapses, cancellations or changes toexisting business (eg in sum insured or classification).Transaction records (each of which showed its effectivestart and end date) were treated in completeindependence of each other - that is, no serious attemptwas made to link together different transactions fromthe same policy. The input records were grouped only bythe period to which they applied and, by summing overthe required period, the appropriate totals could befound.

For example, an input record - perhaps a policy renewal- might have a start date in July 1983 and an end datein July 1984. The relevant proportion of the suminsured and premiums would then be added into theclassification totals for 1983 and 1984 respectively.If the policy was subsequently cancelled, a furthertransaction input record would be received and - whilstthe cancellation record would not be physically linkedto the original renewal record - it should generatenegative contributions to the 1983 and/or 1984 totalswhich would cancel out the positive contribution of theoriginal record.

The FOC output, in principle, gave both loss ratios andburning costs; the validity of the loss ratios obviouslydepended upon the observance of the tariff and, giventhat this was generally so, the figures produced by theFOC were acceptable. The burning cost results, however,were acknowledged to be inadequate and this stemmed fromthe policy transaction method of supplying input. Itwill be clear that for records other than renewals ofnew business, records on the transaction file must showthe incremental or decremental portion of the premiumand sum insured. In general, this requirement presentedno difficulty for premiums - companies obviously knewthe premiums which they were returning or the additionalpremiums which they require, although splitting thisbetween classifications on a multi-class policy didoccasionally present difficulties; the problems were fargreater for sum insured, though, and many offices wereunable to show the proportionate refund or additionalsum insured which was equivalent to the return oradditional premium. For this reason, the FOC burningcosts statistics were not regarded as being particularlyreliable.

52

By about 1980, many offices correctly believed that thedays of the industrial fire tariff were numbered andthey foresaw the need to have a central statisticsscheme for this class of business which did notprimarily depend upon a common system of rating. As aresult, and after some exploratory research andsoundings, the Market Fire Statistics Scheme wasestablished in 1982 initially under the auspices of theBritish Insurance Association but subsequently under theAssociation of British Insurers after the formation ofthat body in July 1985. The exercise runs on a"voluntary group" basis and at present has 24 membercompanies, between them having approximately 80% of thecompany share of this market.

The primary aim of the Market Fire Statistics Scheme isto produce burning cost statistics by tradeclassifications on a market wide basis and which willassist in the underwriting of commercial and industrialfire risks. Having said this, the scheme intends tobuild on the experience of the FOC scheme both byallowing alternative forms of input and by collectingdata which could allow more extensive analyses infuture.

Whilst the transaction style approach outlined earlieris theoretically the most accurate and, as such, isacceptable input from those offices who can provideaccurate data in this way, the scheme also allows forpolicy data to be provided by taking quarterly censusesof the entire in-force file. Although by its verynature this can never be totally accurate, it isbelieved that it will be substantially better thanreceiving incorrect transaction records. Whilst thepurpose of the scheme is the production of burning costfigures, premium data are also collected and will allowfor the calculation of loss ratios if required.

The input files also allow for the provision of otherdata. In particular, it is hoped that it will bepossible to make a more detailed and accurate analysisthan in the past of special perils (eg storm, flood,aircraft damage). Information is also being collectedon features such as size of deductible and type ofpolicy and cover. The scheme operates in two distinctparts - one for material damage and one forconsequential loss insurances. In addition to thefactors previously mentioned, the latter analysis alsoprovides for examination of policies by period ofindemnity and claims by actual period of interruption.

53

3.10 Computer systems

As in other classes of insurance computer systems areextensively used to aid the administraton of policies.Typically these were batch systems although increasingly theyare being converted to on-line systems or even to on-linereal time systems.

A number of companies are now producing computerisedquotation systems. This is an interesting developmentbecause few such systems exist for commerical insuranceswhere judgement plays an important part in premium rating;such systems are more common in motor and domestic insurancewhere the premium can be automatically calculated from a setof rating factors. Recently work has also been done on theapplication of expert systems for fire quotations.

Expert Systems represent a new departure for Commercial Fireunderwriting and, indeed, for the insurance and financialsector as a whole. Although in the last 10 years there havebeen a number of well-documented systems for scientific,medical and engineering applications, little penetration hasas yet occurred in the financial world.

Eut the picture is changing - especially through the Japanese5th Generation Initiative, and the UK response via the AlveyProgramme. In the Insurance Industry itself, pioneering workis being done by a large group of Companies under the bannerof the 'Aries Club'. Aries, aided by expert underwritersfrom 3 major companies, has by now (July 1986) developed aprototype underwriting system for Commerical Fire use.

This prototype system is as yet limited to one particulararea - the Clothing Industry - but the indications are thatit could soon be developed to cover risks in other industriesas well. The benefits to be obtained from such a system areseen as fourfold:

a) Relieving the underwriter of some of the more standardjobs, giving him time to concentrate on the mostdifficult cases,

b) Making head office expertise more widely available inthe branches, and reducing the number of cases referredback to head office,

c) Helping to standardise underwriting practice andcriteria throughout the company,

d) As a training tool to assist new entrants, to learn theunderwriting trade.

54

What exactly is an Expert System? Broadly speaking, it is acomputer system which can, within limitations, tackleproblems which would normally require the services of a humanexpert. Such a system is not necessarily designed to replacethe human expert, but rather to enable him to be moreproductive at his job. In addition, an expert system canhelp to make the best expetise more widely availablethroughout a company, and can be used for training purposes.

Some general characteristics of expert systems are asfollows:-

a) Will deal with a particular domain, or sub-domain only,of human expertise - eg. the well-known system Mycindiagnoses infections of the blood, while Xcon configurescomputing equipment according to specific needs.

b) Contain a special database, known as the 'KnowledgeBase', consisting of facts, rules and other knowledgerelevant to the given domain. In addition, containimplicit structure which models expert understandingof the domain itself.

c) Possess a means of drawing deductions and reasoning withthe knowledge in the knowledge base. This is commonlyeither 'Forward Chaining', reasoning from known facts topossible conclusions, or 'Backward Chaining', testingdesired conclusions against available facts.

d) Have a means of communication with the human user,enabling him to ask questions such as 'How was aparticular conclusion reached?" or 'What if the value ofa particular input parameter was changed?"

e) Typically use software based on the ArtificialIntelligence languages Lisp and Prolog. ('Lisp' isderived from List Processing, and 'Prolog' fromProgramming in Logic). However, other computerlanguages can be used for expert systems work, althoughnot so well adapted for the job.

f) Are best at 'narrow but deep' applications. Expertsystems are generally not appropriate to broad, shallowareas of knowledge, where common sense is likely to bethe best guide.

The Alvey Programme is a large-scale Government sponsoredprogramme of R & D in advanced Information Technology, runningover the 5-year period from 1983. It is characterised bycollaborative research projects between industry, academia andGovernment Departments (in particular DTI, MOD and SERC). It hasan overall budget of £35Om, of which £200m is from Government and£150m from private industry. The work is divided into a number ofareas, relating to the enablingtechnologies concerned, ie. VLSI,Software Engineering, Systems Architecture, Communications, Man-Machine Interface and so on. In addition, there are a number of'Large-Scale Demonstration', designed to increase awareness of thenew technology on as wide a front as possible.

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One main area within Alvey is called IKBS, standing for'Intelligent Knowledge-Based Systems', and it is here thatthe link between Alvey and the Insurance Industry has beenmade. Under IKBS, a number of 'Community Clubs' have beenset up in various industries, including Chemical Engineering,Banking, Water Resources, Engineering Planning, Travel,Quantity Surveying and Data Processing. The InsuranceIndustry is represented by the Aries Club, standing for'Alvey Research for Insurance Expert Systems'.

Aries was founded in mid-1985, after lengthy preliminarydiscussions conducted at the ABI, the DTI and the InsuranceTechnical Bureau. The Club now has 30 members, which are:

18 Insurance Companies1 Insurance Broker2 Consulting Actuaries3 Management Consultants4 Universities1 Professional Institute (I of A).

Since its inception, Aries has collaborated with the computersystems company 'Logica, with the aim of producing 2prototype expert systems for insurance purposes:

a) for General Insurance: Commerical Fire underwritingsystem

b) for Life Insurance: Equity Selection system for theinvestment portfolio.

The development work began in earnest in September 1985, as a15-month programme with 5 main phases. The 3rd of thesephases (now complete) was to construct the prototypeCommercial Fire system. The system was demonstrated in June1986 at a major Club Meeting at City University with 100people present. The 3 expert underwriters who had taken partin the project spoke of their experience in it with anevident enthusiasm. They were positive about the usefulnessand validity of the system as constructed.

The Aries prototype fulfils the first rule of Expert Systems- it recognises strict limitations in its domain ofoperation. As constucted, it deals only with risks in aparticular industry - the Clothing Trade. However the workinvolved in extending the system to other indutries would befar less than that of building it in the first place.

To create the system, there were 2 distinct phases of work:

a) Knowledge elicitation from the experts, leading to the'Paper Model',

b) Translating the Paper Model into a full system on themachine.

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The phases of work were carried out by different members ofthe project team. In the first phase, two KnowledgeEngineers conducted lengthy interviews with the underwritersconcerned, sketching out the domain of their knowledge, andeliciting further detail by the use of sample cases. Theresults were expressed on paper, in a diagrammatic form knownas the 'Paper Model'. This model was tested with theunderwriters themselves to prove its validity before thesecond phase of the work began.

In the second phase itself, two System Builders implementedthe paper model in the Aries computer. This machine chosenafter a lengthy study of the available equipment, was aSperry Explorer, an AI (Artificial Intelligence) workstationof high quality. The software used was a system called KEE(Knowledge Engineering Environment), specifically designedfor the creation of expert systems and related applications.

Once built the system was subjected to further vigoroustesting, both to establish its inner logical consistency, andto check its validity for the underwriting purposes in hand.

The way the Aries System operates is comparativelystraightforward, and mirrors many of the reasoning processesof the underwriters concerned. At the top-level, the domainis broken down into a number of major factors influencing theunderwriting decision:

Physical Construction of BuildingHeating SystemsTrade ProcessesManagement and HousekeepingFire Protection SystemsLocation

Each major factor is then further analysed according to itscharacteristics. For example, under Physical Construction,information will be needed on the Roof, Floors, ExternalWalls, Interior Partititioning, Staircases, etc and suchfeatures as Exposed Metal. Under Management andHousekeeping, the aspects will be Trade Waste, SmokingRegulations, Discipline of Workforce, Level of Security andso on.

When a particular risk comes up for analysis, the underwriterwill be prompted by the system for information on thesepoints. His answers will be given from his perusal of thesurveyor's report, which he will in effect interpret for themachine. The answers will generally be requested on aqualitative scale with a small number of steps.

57

Eg. Question: How often is trade waste removed- from thepremises?

Scale of Answers:

Less thanWeekly Weekly

2 or 3 xWeekly Daily

The underwriter will select the box which most closelycorresponds to the picture revealed by the surveyor's report.

Once the answers have been given, the system will combinethem according to a settled reasoning pattern to give anoverall 'result' for the factor-area in question. Thisresult will be in terms of another qualitative scale, ie:

RejectRisk

ConsiderRejection

Acceptwith Loading

Acceptat NormalRates

AcceptwithDiscount

After each major factor-area has been examined, the finalpattern will be assembled. At this stage, any negative areaswill tend to dominate over the positive ones. Eg: if 'RejectRisk' is obtained in any one of the 6 main areas listed, ie:Construction, Heating Systems, Trade Processes, etc, then thesystem will indicate that the risk as a whole must berejected.

In the case of an acceptance, however, the system will dofurther calculations in order to recommend a rate of loadingor of discount, as appropriate. (The system will not makeany contribution to the setting of a Normal Rate for a givenclass of risk. It assumes that a standard rate book isavailable for this purpose).

An important feature of the Aries Commercial Fire system isthe 'How' and 'What If' facility. For example, if the systemrecommends 'Reject Risk', the underwriter can ask how thishas come about. The reply will be in the form:

'Reject Risk' because 'Reject' obtained for the Management &Housekeeping factor.

'Reject' on M & H grounds because of risk from unregulatedsmoking by employees.

The underwriter now knows that in this case the firstconsideration will be to persuade the employer to introduce aban on smoking in the factory, or at least a strict control.Supporting this can be achieved, the underwriter may ask thesystem: 'What if a ban on smoking is brought in?' The replywill then be, say:

'Accept with Loading of 135%'

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If the loading is unacceptably high, then further trials of'How' and 'What If will show how the loading can be reduced.Eg: if there is a problem with portable heaters, then removalof such heaters may produce a rating at an acceptable level.

Although the Aries prototype is not a fully viable commercialsystem for Fire Underwriting, it does illustrate in the mostgraphic way possible the potentiality for expert systems inthis area.

For the cases which have been tested in Clothing Risks, thesystem has achieved up to 70% agreement with results byexpert underwriters. Some of the discrepancies have been dueto misunderstandings of wording, and in other cases theexperts have actually preferred the Areas System's result totheir own.

The next stages in the work which are needed are furthertesting within the Clothing Risks domain, followed byextension of applicability to other industries. The AriesClub itself does not have the resources to pursue thesestages, but it is now open to any participating company totake the system further. Indeed, several of the majorcompanies in Aries are known to have a keen interest in thefurther development of expert systems for underwriting andother insurance purposes. Unfortunately, such developmentswill take place behind tightly-closed doors, because of theircommercial implications.

But the Aries experience has at least provided a platform, afairly public jumping-off point for Insurers who wish to takeadvantage of the new technology of expert systems.

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SECTION 4

REINSURANCE

4.1 Background

Commercial fire insurance is concerned with the insurance ofbuildings and stock which can have very high values but withlow likelihood of claim of a significant size. However,where a major loss does occur the claim can run into manymillions of pounds for the largest buildings. Such risks arebeyond the scope of one office to retain entirely for itself.There is also the need to be protected from catastrophes, oneevent giving rise to a number of claims.

4.2 Individual Risks

Whilst facultative reinsurance can be arranged for veryspecial risks, it is impractical to do this on day to daytype business. Companies writing commercial fire businesswill have protection under a reinsurance treaty. In thepast, this has commonly been of the proportional type,surplus and quota share. However, several years of poorresults have recently resulted in significant contraction ofthe proportional market and greater use is now being made ofnon-proportional reinsurance which had previously been usedonly by the largest insurers for individual risk protection.

When a company's reinsurance programme is insufficient tofully write a risk then the risk will be co-insured withother direct insurers until sufficient capacity is availableto absorb the risk.

4.3 Level of Retentions

The setting of retentions is often based on old and trustedrules of thumb, relating maximum retentions to the size ofthe retained premium income. Reinsurers have to be consultedin setting the level. Some allowance needs to be made forincorrectly calculated EML's.

Although companies generally relate retentions to premiumincome they appear to differ in which premium income theychoose. Some will use the income of the fire account whileothers may use the UK general branch premium income. Itwould be possible for a large composite to even go as far asusing the total premium income of the whole group. The sizeof retention will vary considerably according to which viewis taken.

A company may employ several different retentions, the leasthazardous risks having the highest and the most hazardous theleast, although this is contrary to risk theory.

The retentions are based on EML's.

The level of retention is clearly an area where actuarialexpertise could well be employed, using risk theory.

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An example may be helpful:-

Insurance Company ABC has a scale of five limits from£250,000 to £500,000. Its own capacity is supplemented by a10 line surplus treaty.

For a certain risk its limit is £500,000. This risk has asum insured of £5m, but the EML has been calculated at £3M,(60% of sum insured). Then five lines of the treaty capacityare used and the retained and reinsured risk are, therefore,split:-

£m %Company ABC EML 0.5 16.67Treaty R/I EML 2.5 83.33

EML 3.0 100.00

The premiums and any claims arising are then split in thesame proportions.

Suppose a fire occurs and total loss results ie the EML of60% of the sum insured is proved to have been incorrect andEML failure is said to have occured.

The claim is shared out:-£m %

Company ABC 0.833 16.67Treaty R/I 4.167 83.33

5.000 100.00

Then Company ABC finds that instead of a maximum claim of£500,000 it has received a claim for £833,000.

4.4 Catastrophe Protection

Catastrophe protection is required to protect against anumber of claims arising from one event such as storm damageand it is arranged on a non proportional basis to protect thenet retained account.

There are various ways in which such protection may bearranged, such as:-

a) Cost of claims arising from a single event, and may beallowed to occur over a period of 72 hours say, inexcess of a trigger point which itself needs to be abovethe maximum net retention.

b) Stop loss type covers are very helpful in protecting anaccount against an accumulation of many claims arisingfrom say a lengthy period of severe weather. They are,however, difficult to obtain unless good historical datais available to reinsurers and even so only limitedcover may be available.

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Determining the amount of catastrophe cover required isguesswork but would be based on a catastrophic event such asthe damage occurring if the Thames Barrier failed to work andLondon was flooded. It is necessary to have availablegeographical data on exposure.

The catastrophe protection cover would probably also protectthe household account.

4.5 Accounting

Proportional treaty reinsurance is usually accounted for inthe same way as the direct commercial fire account, exceptthat the treaty terras may not fully reflect the company's ownaccounts. In particular, unearned premiums may be at 35% ofwritten premiums for the 12 months period and outstandingclaims at 90% of the company's own reserves. The formeradjustment assume business evenly written over the year andincorporates a realistic deduction for commission, at 30%.

The latter adjustment is because insurers own reserves onfire business are usually in aggregate in excess of theultimate settlement, even though there is no specific IBNRprovision.

Rather than running the year's business off to finalsettlement, portfolio transfers are usually made into thefollowing year's reinsurance, the transfers taking in bothunearned premiums and outstanding claims. This makes dealingwith reinsurers differing shares of the treaty from one yearto the next rather simpler.

An example may clarify the differences:-

A company's fire account has the following results in respectof its proportional reinsured business on its own accountingbasis:-

Written Premiums

Unearned premium B/forwardUnearned premium C/forward

Claims paymentsOutstanding claims B/forwardOutstanding claims C/forwardIncurred claims

Commission @ 30%U/W Profit

1984

£'000

10,000

3,5253,7109,815

5,3004,8005,4005,900

3,000915

1985

£'000

11,000

3,7104,09210,618

5,9005,4006,2806,780

3,300538

Earned premiums are baaed on the twenty-fourths method,with 20% initial deduction.

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In presenting results to reinsurers with unearnedpremiums at 35%, and outstanding claims at 90% ofinsurers own reserves, the results become:-

Written Premiums

Unearned premium B/forwardUnearned premium C/forward

Claim paymentsOutstanding claims B/forwardOutstanding claims C/forwardIncurred claimsCommission @ 30%U/W Profit (before expenses)

1984

£'000

10,000

3,3253,5009,825

5,3004,3204,8605,8403,000985

1985

£'000

11 ,000

3,5003,85010,650

5,9004,8605,6526,6923,300658

Portfolio transfer from 1984 into 1985 = 3,500 + 4,860 =8,360

Portfolio transfer from 1985 into 1986 = 3,850 + 5,652 =9,502

Individual reinsurers would be sent an accountreflecting their share of the treaty for the particularyear. By this means allowance is simply made if areinsurer's share changes from one year to the next.

4.6 Security of Reinsurance

There is no point in reinsuring if the reinsurer is notable to meet the claims when they occur. It isfundamentally important to have a system of scrutinisingreinsurers for financial soundness. In the past, it wascommon, under proportional treaties for the insurer toretain part of the reinsured reserves and pay to thereinsurers rates of interest which by modern daystandards were derisory. Reinsurers are most reluctantto accept such arrangements any more.

The security of captive reinsurers has been put in doubtby the collapse of one such company where the captive'sparent refused to bail out the company despite theparent's obvious financial ability to do so. Thissituation could also apply to any subsidiary of aparent. Thus you cannot necessarily look at a parentsaccount when determing the security of a subsidiary.

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4.7 Co-insurance

Mention has been made in paragraph 4.2 above of the needfor co-insurance on very large risks. Premiums andclaims are shared out proportionately with each co-insurer being a direct insurer. Then if one of the co-insurers become insolvent, the other coinsurers arestill only responsible for their original share on anyclaims that may arise during that period of insurance.

The Lead Office receives an overriding commission fromthe other co-insurers for the expenses it incurs incarrying out surveys setting up the policy etc.

4.8 Co-operative Agreement

Under the FOC rules a risk placed on a coinsurance basishad to be placed at least 60% with FOC offices ( - the60/40 rule). Within this rule the broker had discretionas to whom he invited to have a share of the risk.Following the demise of the FOC some of the largeroffices agreed among themselves that they wouldindividually write all risks 100% and then to reinsurebetween themselves. From those large offices point ofview this appears, at first sight, to be a good way ofmaximising their market share; however it has theobvious disadvantage of leaving them very heavilyexposed in the (unlikely) event of one of theirreinsurers not being able to meet their liabilities.

Understandably the brokers were not happy about sucharrangements as they would then be unable to placebusiness with their "friends". Although many do notbelieve that the system will ever work in practice onecould not say at the time of the writing (July 1986)that the system had proved unworkable.

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SECTION 5

CLAIMS

5.1 The Basis of Settlement

For a fire claim, the amount payable will depend uponthe basis of cover (see section 2.3), and will belimited by the sum insured. Nowadays, the 'average'rule is nearly always applied.

If there is more than one insurer, costs are shared,essentially in proportion to sums insured at risk.Detailed rules deal with cases where the cover providedby the various insurers is not identical, for example asto excess and whether average applies.

In practice, because reinstatement will take some timeduring which the policyholder may not be able to carryon his business, the insurer will usually negotiate acash settlement so that the policyholder can buy anotherbuilding without delay (and minimise the ConsequentialLoss). This is especially likely to happen if thereinstatement cost exceeds the market value to any greatextent.

5.2 Claims Handling Procedures

The insurer will usually employ specialist lossadjusters to advise on the claim. Loss adjusters aremembers of the Chartered Institute of Loss Adjusters,entry to which is by examination together with anexperience qualification.

The loss adjuster is nominally independent of theinsurer and tries for a settlement that is fair to bothsides, but as his fee is paid by the insurer he cannotreally be independent. Because of this some claimantsemploy specialist loss assessors to negotiate on theirbehalf. The loss assessor's fee is paid by the claimantand is not recoverable under the insurance.

The loss adjuster is briefed by the insurer on detailsof cover and any warranties. From his examination ofthe aftermath of the fire he will give an opinion as towhether the claim is valid. As investigations andnegotiations proceed he will also advise the insurer onthe appropriate reserve.

To help him advise on liability and quantum, the lossadjuster may well call on other professionals. If thereis any suspicion of arson (perhaps evidence ofaccelerants) he will bring in forensic experts.Consulting engineers will advise on the extent to whichproperty is damaged and whether it can be repaired.

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The loss adjuster will also take such steps as arenecessary to minimise losses. For example he willarrange for buildings to be shored up, machines to begreased to minimise water damage, and for the disposalof salvage. There are specialist firms who deal indehydration, rehabilitation of furnishings affected bysmoke, etc, and the loss adjuster will use them asnecessary.

5.3 Legal Decisions

There are three main areas where the law has animportant bearing on fire claims.

1. The meaning of 'fire'

In order for a claim to be valid there has to beconflagration. If something is destroyed by heatwithout catching fire and not as a result of a firethere is no claim. An example of this might beplastic material melting because it was placed toonear a heater.

2. Arson

Arson, or wilful fire raising as it is called inScotland, is often quite easy to prove. Howeverthis is no help to the insurer unless he canprove that the deed was done by (or on the ordersof) the claimant. In practice this may mean thatunless a successful prosecution is brought theinsurer will normally have to settle.

3. Riot

Riot damage will be covered if it is specificallycovered in the policy. Otherwise, fire damageresulting from a riot will be covered unlessspecifically excluded. Riot damage applies tobuildings and contents including garaged vehicles.Vehicles parked in the street are not included.

Insurers paying for riot losses may in somecircumstances be able to recover from the police.

5.4 Claims Reserving

Most insurers will normally be guided by the lossadjuster in setting up claims reserves. The lossadjuster will normally advise the possible loss -perhaps not the maximum possible, but a pessimistic viewand more than the 'expected' cost in a probabilisticsense. As a result, the insurer's total reserves, butnot necessarily each case reserve, will usually be morethan sufficient. Typical reasons for the reserve to bean over-estimate include:

66

1. Settlement may be for market value (plus asweetener, perhaps), when the initial estimate wasbased on the reinstatement cost.

2. Recoveries may be possible.

3. The claim may be repudiated.

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SECTION 6

STATISTICS

6.1 Data collection and analysis

Until very recently, a rating tariff existed in the UKfor commercial fire insurance. Major tariff companiessupplied computer based information to the FOC, the bodyresponsible for the administration of the tariff, andfrom this input, statistics were produced which enabledthe tariff rates to be reviewed.

For many years, the underwriting experience wasfavourable and under these conditions, there was littleincentive for offices, whether tariff or not, to createan improved statistical system or to carry out any otherstatistical analyses. When during the 1960 's, theunderwiting experience became increasingly adverse,companies did not have the systems or expertise torespond. Consultants were brought in to advise the FOC,but again the paucity of company systems did not allowtheir recommendations to be fully implemented. Despitesome improvements since then, the data bases availablewithin offices at the present time in respect ofcommercial fire insurance are still probably some 10 to15 years behind those for major personal lines such asmotor business.

The tariff statistics in principle showed loss ratios(ie the ratios of claims to premiums) burning costs andaverage rates by trade although in practice there wereserious reservations regarding the burning coststatistics (see section 3.9). Few companies have beenable to provide more than this, and many have not evenbeen able to go this far. When the ABI Market FireStatistics Scheme was established, it was agreed thatthe statistics produced should relate claims to sumsinsured rather than premiums; this was because, in theabsence of a tariff, there will be no common premium fora given risk and the ratio of claims to premiums on amarket basis would be of little use to individualoffices in re-examining their own particular ratingstructure. It has become clear, though, that in manycompanies reliable information on sums insured was notavailable and so the provisions of such input has becomea major administrative and data processing task.However, if accurate burning cost statistics are to beproduced, whether on a company or market basis, it isessential that these be calculated from accurate sumsinsured and the current inability of much of the marketto provide this information is the most seriousdeficiency at present to statistical underwriting.

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It is not intended to discuss here all the problemsassociated with the provision of accurate sums insuredinformation, but it must be acknowledged that these are nottrivial. Amongst the matters which would need considerationare:-

-

-

All of these difficulties would be compounded if theyaffected only certain of the trade classification linescovered on a multi-line policy.

Beyond this fundamental point, there are other, though lessvital, points which need to be considered. Amongst these arethe need to record and analyse other factors which couldinfluence either the risk or the nature of the claims whichhave to be met - amongst these would be levels of excess ordeductibles, the age and standard of construction of theproperty, fire protection equipment available (particularlysprinkler systems), locality, security of premises and so on,as well as more basic points such as type of policy andnature of cover (eg indemnity or reinstatement cover,traditional full value policy or first loss or layeredcover). For consequential loss insurances, the maximumindemnity period is also important. The treatment ofconglomerate or experience rated risks will also need to beconsidered.

Another major consideration from a statistical point of viewshould be the treatment of 'perils'. It has been estimatedthat up to 30% of material damage claim payments are not inrespect of fire losses, but are due to additional sections onthe policy covering perils such as storm, flood, explosionetc. Despite this, many offices do not record details of theperils covered in a way which would allow premium rates orburning costs to be examined. The most vital need istherefore to record details of the perils covered by thepolicy and the sums insured associated with each. It couldbe argued that peril claims should be analysed by both tradeand locality: for example, some trade processes may be moreexplosion prone whilst some localities may be more liable toflooding. This is undoubtedly true, but given the currentstate of the art, it would be a major development to obtainany information at all on individual perils, let alone byother factors, however desirable this may be in theory.

6.2 Availability of Data

It must regrettably be said that very few statistics areavailable for general use on commercial fire business. Nodoubt many companies carry out analyses of their own figuresbut are generally not prepared to make these publiclyavailable.

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Retrospective adjustments to the sums insured,espcially in respect of stock;

mid-term changes in sums insured or trade,especially if these do not affect the premium;

varying methods of inflation provision.-

In the UK statutory accounts, commercial and industrialfire insurance is included as part of the propertyclass, but since this includes domestic propertybusiness as well as such other varied commercial linesas theft, engineering and so on, the figures availableare far too broad for many purposes. In certain partsof these statutory returns, and in particular thatsection providing a claims run-off by year of origin,the main accounting classes have to be subdivided byrisk group. The regulations do not define these riskgroups and there is little conformity between offices inthe groups which they choose to use. The majority ofcompanies have a risk group called "fire" or somethingsimilar, but this may or may not include domesticbusiness; the only way this can be determined is byseeing whether there is another risk group more likelyto include domestic business and from a knowledge of thekind of business which that particular company writes.

For example, one company uses the five risk groups offire, burglary, domestic, engineering and other. Underthese conditions, it is highly likely that fire will bepredominantly commercial fire. However, another companyhas four risk groups - fire, burglary, engineering andother ; the fact that the "other" category is extremelysmall in size suggests that "fire" includes bothdomestic and commercial business. A third companysimply uses two categories - domestic and other.Clearly the range of possibilities and options isenormous. Of some 26 major property insurersconsidered, "fire" is likely to be predominantlycommercial fire in only about half the cases.

Market statistics have already been referred to insection 3.9 but again these figures will only beavailable to those insurers who are members of theappropriate scheme. The FOC figures, with one exceptionreferred to below, were confidential to the Committeeitself and were used for the purpose of reviewing tariffrates. The ABI scheme is equally confidential and hasthe intention of making results available only tooffices according to the level of detail provided; thatis, an office which did not provide information on aparticular factor would not receive the output from anymarket analysis examining this factor.

The exception referred to above is that FOC statisticshave been provided on a regular basis to the ComiteEuropeen des Assurances (CEA). CEA is a Europeaninsurance association and for many years, the Parisbased secretariat of its Fire Committee has collectedstatistics of material damage and consequential lossbusiness from member states. Participating countriesinclude Austria, Belgium, Denmark, France, Germany,Italy, Spain, Sweden, Switzerland and the UK.

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The statistics are based on the CEA fire classificationwhich is a decimal based system with ten main categorieseach subdivided into ten sub-categories and so on.Special perils (such as storm, flood, explosion) areexcluded from the figures but non-sprinklered andsprinklered risks are collected separately, althoughmost participating countries other than the UK cannotaccurately separate these two types of risk.

As remarked, the present UK return is based on thetariff statistics supplied by the main ex-FOC companies,with the FOC classifications being converted in the UKto CEA classes as accurately as possible before beingforwarded.

The collected returns are published by the CEA at least18 months after the year to which they relate and arecirculated to participating countries. At time ofwriting (February 1986) the latest available figuresrelate to 1983 with summary figures provided from 1968to 1983. Although their subsequent distribution is theresponsibility of each member state, it is inevitablethat their circulation will be restricted.

The main declared use for the figures is to act as abasis for the rating of risks on a European basis. Sofar, Belgium is the only country to attempt a new ratingsystem based on these European figures and it is tooearly to pronounce on the success of the exercise. TheUK attitude to the figures is one of considerablescepticism.

Also on the international front, it may be worthreferring to the World Fire Statistics Centre. Thepurpose of the Centre is the promotion, collection anduse of international figures on fire damage; this, inturn, it is hoped would encourage fire preventionpolicies by Governments, insurers, commerce and industryand other interested bodies.

There is one other source of statistics which might bementioned. In the UK, estimates of total fire damageare prepared and issued regularly by the ABI. These arebased on the collection of information from insurers andthe press on large fires; the information obtained isthen grossed-up to give an estimate of all fire damage,regardless of size. The figures are intended to coverall material damage, whether insured or not, and coverboth domestic and commercial properties. Although theprecise figures will be subject to wide margins oferror, it is hoped that a reasonable indication can begiven of general trends. Summaries of these figureshave been given in previous GIRO Bulletins and a furtheranalysis of them is made in section 6.3 of this paper.

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6.3 Analysis of Results and Statistics

As described in GIRO Bulletin No. 40 the ABI calculatesand publishes an estimate of the total fire wastage forGreat Britain. Monthly figures for the number of largefires and the corresponding total damage are compiledand also grossed up figures which estimate the grandtotal for fire damage for large and small fires areprovided. For purposes of this investigation the ABIhave made avilable the monthly figures for large firesfrom January 1970 to December 1985. The definition of alarge fire is updated regularly using the RPI index andstood at £58,000 at the end of 1985. So as to eliminateto a large extent the effect of inflation for purposesof analysis it was thought best to concentrate onnumbers of large fires rather than amounts of damage.

The data is as follows:-

Year

1970197119721973197419751976197719781979198019811982198319841985

No. of l a r g ef i r e s (GB)

Y1,0401 ,0931,2141 ,2251 ,1121 ,1291 ,054

980910941

1,042905834841875834

No. of c i g a r e t t e s(and c i g a r s ) s o l d . (UK)thousand m i l l i o n

C128.9123.8131 .9138.9138.6134.2132.2127.5126.8126.0123.111 1 .8103.5103.0100.4

99.2

large fires it is natural to look for seasonalinfluences. The variation from month to month isconsiderable. The monthly average for June from 1970 to1984 is 92 large fires whereas the monthly average forDecember from 1970 is 76 large fires. However theredoes not seem to be a real seasonal trend. The figuresfor May and July are lower than those for June and thefigures for November and January are higher than thosefor December. An examination of the periodogram and thespectral estimates confirmed that there is no strongevidence of seasonality.

- Seasonality. Given the series of monthly figures for

Time Series Analysis

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The number has dropped over 12 years from 1,112 in 1974to the peak in 1973 of 1,225 large fires to 834 in 1985.Pitting a straight line to allow for linear trendproduces a much more stationary series but a rathernoisy one.

- Trend. There is a trend towards fewer large fires.

- Stationarity and Differencing. First orderdifferencing achieves stationarity but the result isvery noisy.

- Box-Jenkins models. First order autoregressive andfirst order moving average models were fitted afterdifferencing once. These both could account for some ofthe autocorrelation. The first order autocorrelationcoefficient was reduced from .42 to .26 at lag one withboth models. However the variance and the residualsremained large after fitting. Of the models fitted afirst order moving average seems the most appropriate.

Causes of Large Fires

Each year the FPA - Fire Prevention Association obtainsinformation for statistical analysis from insurancecompany returns and fire brigade reports. The analysisincludes a table showing numbers of large fires and thecorresponding loss under various headings.

The more important headings are:

Deliberate ignition.Electrical appliances and installations.Smoking materials and matches.Unknown and under investigation.

Each of the above major headings can account for asubstantial porportion of fires and fire losses.Deliberate ignition and unknown cases can each accountfor about one third of the large fires investigated inGreat Britain.

Other minor headings often account for a smallproportion, less than five per cent, of large fires:

Acetylene cutting and welding.Oil appliances and installations.Mains gas appliances and installations.LPG equipment.Chimneys, stoves, pipes and flues.Spontaneous combustion.Rubbish burning.Solid fuel installations.Naked light, taper, candle.Other known causes.

Under both the major and the minor headings the figuresand percentage of the total vary considerably from yearto year.

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Regression Analysis

When most fires are either of unknown causes or theresult of deliberate ignition the development of aparametrized model to explain the incidence of largefires is to be approached with caution. However thereis not so much serial correlation in the series ofobservations of numbers of large fires year by year thatthe use of regression is precluded.

The following illustrates the use of the simplest kindof regression model that of bivariate regression with asingle explanatory variable it is possible to use thenumber of cigarettes (and cigars) sold in the UnitedKingdom in the years since 1970. Smoking materials andmatches are known to account for a significantproportion of large fires and may account for a largerproportion of those where the cause is unknown. Herethe response variable is the number of large fires eachyear and the explanatory variable is the number ofcigarettes (and cigars) sold according to the figuressupplied by the Tobacco Advisory Council. The figuresare shown in the earlier table.

The correlation coefficient between number of largefires and number of cigarettes sold is .859.

The simple regression line as fitted is

Y = 8.195 C + 3.149

The fit is good as the coefficient of determination iethe ratio of explained to total variation is the squareof the correlation coefficient, which is here .737 ishigh. A full scale research programme into causes forthe decline in the numbers of large fires would need toconsider other factors besides smoking. These wouldinclude the decline in industrial activity since theearly 1970's, the effect of using the RPI index torevise the definition of a large fire, Fire Preventionactivity, regional variation and other possibleinfluences. Also one would like more investigation ofthe trend over time as a Time Series.

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The Distribution by Size of Loss from Commercial Fires.

The Lognormal is a two-parameter distribution that has been thought suitable torepresent the distribution of fire claims by size.

The two parameters of the distribution are μ and σ .

The probability density function for the Lognormal is:-

and the Moments of the distribution are given by

for the nth moment.

μ _ σThe Mode of the distribution is e

For three pairs of values for μ and σ corresponding to a common mean of 4,195three different Lognormal distributions give rise to the three curves shown.

Parameters

μ

6.5

7.0

7.5

σ

2.0

1.7321

1.4142

Means

4,915

4,915

4,915

StandardDeviation

35,981

21,471

12,423

Mode

90

194

440

Graph

. . .

____

- - - -

Figure and Table from Loss Distributions by Hogg & Klugman.

.

For the specimen distribution of Fire Losses by size of Loss given in Section3.6 the mean was found to be £2,156 and the Standard Deviation £28,000.Thus the Lognormal with parameters 5.1 and 2.27 is the distribution fittedby using the method of moments. However, a closer inspection of thisparticular empirical distribution based on four years experience of aparticular office shows that the fit is not good. The mode of the Lognormalwith these parameters is only £9.3 and the empirical distribution has twopeaks. A better fit could be obtained in this case by regarding the observeddistribution as a mixture of two distributions.

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