What Is the Cape Cod Method?
The Cape Cod method is used to calculate loss reserves for insurers, which use weights proportional to loss exposure and inversely proportional to loss development. The Cape Cod 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.
- The Cape Cod method, also known as the Stanard-Buhlmann method, helps with calculating loss reserves.
- This method calculates loss reserves as the loss-to-date divided by the exposure and then divided by the ultimate loss development factor.
- The Cape Cod method creates ultimate loss estimates using both internal and external information.
- A key drawback of the Cape Cod method is that 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.
How the Cape Cod Method Works
The Cape Cod method is based on the framework created by the Bornhuetter-Ferguson method of loss development, although the methods have important differences. The Bornhuetter-Ferguson method also serves as the framework for the chain-ladder method and the 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 and then divided by the ultimate loss development factor. Both the loss-to-date and the rate of 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 exposure and inversely proportional to loss development.
The process of arranging known methods of loss reserving, under the umbrella of the extended Bornhuetter-Ferguson method, of which the Cape Cod method is a part, requires the identification of prior estimators of the development pattern and the expected ultimate losses. This process can be reversed by combining components of different methods to obtain new versions of the extended Bornhuetter-Ferguson method. The Bornhuetter-Ferguson principle proposes the simultaneous use of various versions of the extended Bornhuetter-Ferguson method and a comparison of the resulting predictors in order to select the best predictors and to determine prediction ranges.
Criticisms of the Cape Cod Method
The Cape Cod method has some drawbacks. For instance, 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.