What is the Expected Loss Ratio (ELR) Method?
The Expected Loss Ratio (ELR) method is a valuable technique utilized in the insurance industry to predict the projected amount of claims relative to earned premiums. It’s particularly useful when insurers face challenges such as a lack of historical claims data due to new product offerings or insufficient data for long-tail product lines.
The Formula for the ELR Method
ELR Method = (Earned Premiums * Expected Loss Ratio) - Paid Losses
Where:
- Earned Premiums (EP)
- Expected Loss Ratio (ELR)
- Paid Losses
How to Calculate the Expected Loss Ratio
To calculate the Expected Loss Ratio, multiply earned premiums by the expected loss ratio, and then subtract any paid losses. This provides a meaningful estimate of the amount insurers need to set aside for future claims.
What Does the ELR Method Tell You?
Insurers allocate a portion of their premiums from underwriting to form claims reserves, managing future claims effectively. The ELR offers insights into how much should be set aside, taking into account the frequency and severity of potential claims. It plays a crucial role, especially in new business lines, to figure out the necessary level of loss reserves.
Additionally, the ELR method helps calculate:
- The loss reserve for specific business lines and policy periods.
- The estimated ultimate losses by multiplying the expected loss ratio with earned premiums.
Government regulations may specify minimum levels of loss reserves, which insurers need to adhere to, making methods like ELR even more significant.
- It’s instrumental for businesses lacking historical data
- It determines the portion of premiums to be reserved for future claims
- Helps establish loss reserves for various business lines
Example of Using the Expected Loss Ratio (ELR) Method
Imagine an insurer with earned premiums of $10,000,000 and an expected loss ratio of 0.60. Throughout the year, the insurer has paid losses totaling $750,000 and holds cash reserves of $900,000.
Here’s how you compute various reserves:
- Total Reserve:
Total Reserve = (Earned Premiums * Expected Loss Ratio) - Paid Losses = $10,000,000 * 0.60 - $750,000 = $5,250,000 - IBNR Reserve (Incurred But Not Reported):
IBNR Reserve = Total Reserve - Cash Reserve = $5,250,000 - $900,000 = $4,350,000
ELR Method vs. Chain Ladder Method (CLM)
Both ELR and the Chain Ladder Method (CLM) evaluate claims reserves but differ in their application:
- ELR Method: Used when historical data is scant.
- CLM: Relies on past data, making it suitable for established, stable businesses.
Limitations of the ELR Method
While the ELR method is helpful in early forecasting stages, it potentially lacks accuracy in later phases as it doesn’t adjust for actual paid and reported losses. Therefore, using it alongside other methods can enhance the overall strategic planning and claims management process.
Expanding Your Knowledge on ELR
By understanding ELR, insurers can better forecast and manage future liabilities. For a more complete analysis, it is beneficial to incorporate insights from other forecasting models and methods.
For a deeper dive into enhancing insurance company profitability through loss and combined ratios, exploring additional resources may further improve strategic financial planning.
Related Terms: Underwriting, Earned Premiums, Chain Ladder Method, Loss Ratio, Actuarial models, Forecasting.
