What Is the Expected Loss Ratio – ELR Method?
The Expected Loss Ratio (ELR) method is a fundamental technique utilized to estimate the expected volume of insurance claims in relation to the premiums earned by an insurer. It proves invaluable in situations where an insurer lacks historical claims data due to changes in product offerings or a scarcity of data for long-tail product lines.
The Formula for the ELR Method Is
The ELR Method = EP * ELR – Paid Losses where EP = Earned premiums
How to Calculate Expected Loss Ratio – ELR Method
To compute the Expected Loss Ratio, simply multiply the earned premiums by the ELR and then deduct the paid losses.
What Does the ELR Method Tell You?
Insurance companies allocate a portion of their premiums towards funding future claims when underwriting new policies. The ELR method helps determine the appropriate allocation, taking into account the anticipated frequency and severity of expected claims. Insurers employ various forecasting techniques to gauge claims reserves accurately.
In scenarios like new business lines, the ELR method becomes crucial for determining the necessary loss reserves. It aids in setting loss reserves for specific business categories and policy periods, where the expected loss ratio multiplied by earned premiums yields estimated ultimate losses. However, governmental regulations may stipulate minimum reserve levels for certain business segments.
- Utilized to project claims relative to earned premiums.
- Insurers reserve a portion of premiums for future claims based on the ELR.
- ELR is essential for data-limited businesses, while the Chain Ladder Method suits stable ones.
Example of How to Use Expected Loss Ratio (ELR) Method
Insurers can leverage the ELR method to calculate the Incurred But Not Reported (IBNR) reserve and total reserve. The ELR is the ratio of ultimate losses to earned premiums, with total reserves computed as ultimate losses minus paid losses and IBNR reserve as total reserve less cash reserves.
For instance, if an insurer earns $10,000,000 in premiums with an ELR of 0.60, having paid $750,000 in losses and holding $900,000 in cash reserves, the total reserve would be $5,250,000, and the IBNR reserve $4,350,000.
The Difference Between the ELR Method and the Chain Ladder Method (CLM)
Both the ELR and Chain Ladder Method (CLM) play vital roles in claim reserves; however, the CLM relies on historical data for future predictions, contrasting with the ELR’s use in data-scarce settings, while the CLM suits stable business operations.
Limitations of Using the ELR Method
Determining claims reserves is complex, influenced by actuarial models and forecasting techniques. The ELR’s utility depends on available data quality and quantity, being valuable in initial forecasting stages but less precise later due to insensitivity to changes in paid losses.
Learn More About the Expected Loss Ratio (ELR) Method
Discover more about evaluating insurance companies’ profitability through loss and combined ratios.