WHAT ARE 'Priori Loss Estimates'

Priori loss estimates refer to a technique used by insurance companies to calculate loss reserves. A priori is Latin for “from the former,” and refers to the development of an estimate using past experiences.

BREAKING DOWN 'Priori Loss Estimates'

Priori loss estimates are used to determine expected ultimate losses from exposures.

When an insurance company underwrites a new policy and accepts a premium, the company is taking on an obligation. The insurer is required to indemnify the policyholder for claims covered in the policy language. While the insurer can use a portion of the premium revenue to invest in profit-making activities, the company is also required to set aside a portion to cover potential claims in what is known as loss revenue. State insurance regulators help define how much an insurer has to set aside in the loss reserve.

Insurers can use a variety of different estimation techniques to determine what to set aside in loss revenue. Some of these methods include the Cape Cod, and Bonhuetter-Ferguson reserve development methods. The Cape Cod method, for example, uses priori losses to develop ratios for paid losses and incurred losses. Both methods are used to calculate the ultimate loss.

How the Techniques Work

Loss reserve techniques often require a basic set of data, including information on incurred losses, earned premiums, and priori losses. Each data point requires accompanying origin information, such as the accident year, policy year, or similar time frame.

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 also referred to as the Stanard-Buhlmann method, and it differs from the Bornhuetter-Ferguson method in that the Cape Cod method creates ultimate loss estimates using both internal and external information.

Insurers will also compare priori losses to earned premiums, creating the a priori loss ratio. This is calculated as the priori loss divided by the earned premium. This ratio can be multiplied by the origin, such as a calendar year, to come up with a loss reserve estimate.

Insurance companies develop loss reserves using approaches that mix loss development methods with priori loss methods Determining priori loss estimates works best when companies can use all accident years to develop a given estimate for any one year, and when they give added weight to estimates from years close to the year being estimated.

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