DEFINITION of 'Cape Cod Method'

A method used to calculate loss reserves that uses weights proportional to loss exposure and inversely proportional to loss development. The Cape Cod (CC) method operates under the assumption that premiums or other volume measures are known for historical accident years, and that ultimate loss ratios are identical for all accident years. The Cape Cod method is sometimes called the Stanard-Buhlmann method.

BREAKING DOWN 'Cape Cod Method'

The Cape Cod method is based off of the framework created by the Bornhuetter-Ferguson method of loss development, which also serves as the framework for the chain-ladder method and additive method. The primary difference between the Cape Cod and Bornhuetter-Ferguson methods is that the Cape Cod method creates ultimate loss estimates using both internal and external information.

In the Cape Cod method, loss reserves are calculated as the loss to date divided by the exposure divided by the ultimate loss development factor. Both the loss to date and exposure are adjusted for trend. Cumulative losses are calculated using a run-off triangle, which contains losses for the current year as well as premiums and prior loss estimators. This creates a series of weights that are proportional to exposures and inversely proportional to loss development.

The Cape Cod method has its drawbacks. It does not take into account variability in both historical loss estimates and loss development factors, and the loss exposure is assumed to be constant over time. This method can understand incurred but not reported (IBNR) losses if the insurer is underwriting the same policies at lower rates over time. The method also provides greater weight to historical experience over recent experience, since more mature accident years are closer to the ultimate loss.

A best practice for actuaries is to use a loss reserving method that combines the chain-ladder method with an exposure-based method, such as the Cape Cod method.

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