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11-05-2004, 04:20 PM
Can anyone please explain the concept of target loss ratio?
I am just reading McClenahan's Ratemaking paper. According his
paper,

T=(1-V-Q)/(1+G) (page 89)

But above doesn't make sense to me.

Avi
11-05-2004, 04:57 PM
Not 100% mathematically accurate, but maybe it will help you with the concept. The idea of the target loss ratio is what % of premium could be paid out as loss and still remain with enough to cover profit and expenses?

Lets start with 100% of the premium. We have to take away the percentage we need for premium-dependent expenses (expenses that are a function of the premium volume). That is V. We also have to make a profit to return to our shareholders, otherwise no one will by our stock. We also need to build a contingenies fund to protect against events like catastrophes and other unforseen events. These are combined into Q.

So right now, we can afford ro pay (1-V-Q)% of the premium collected out as losses and still have enough for variable expenses and profit.

But there are other expenses loaded into the premium we charge, fixed expenses for things like overhed and property taxes on the corporate HQ etc. So the actual premium we would charge is Losses + Variable + Fixed. We need to keep some of the premium for fixed losses.

G is that ratio of fixed expenses to losses (F/L).

So in a sense, we can afford to pay out fewer \$ of loss if we have to retain some for fixed expenses. That is why the denominator of the TLR is not 1 but 1+G.

A past test question has been to relate the PP method with the LR method algebraically. It is the F in the numerator of the PP method that becomes the G in the denominator.

Hope that helps.