Expected Loss Ratio – ELR Method

What Is the Expected Loss Ratio – ELR Method?

Expected loss ratio (ELR) method is a technique used to determine the projected amount of claims, relative to earned premiums. The expected loss ratio (ELR) method is used when an insurer lacks the appropriate past claims occurrence data to provide because of changes to its product offerings and when it lacks a large enough sample of data for long-tail product lines.

The Formula for the ELR Method Is

E L R   M e t h o d = E P   ∗   E L R   − P a i d   L o s s e s where: EP = Earned premiums \begin{aligned} &ELR\ Method = EP\ *\ ELR\ - Paid\ Losses\\ &\textbf{where:}\\ &\text{EP = Earned premiums}\\ \end{aligned} ELR Method=EP ∗ ELR −Paid Losseswhere:EP = Earned premiums

How to Calculate Expected Loss Ratio – ELR Method

To calculate the expected loss ratio method multiply earned premiums by the expected loss ratio and then subtract paid losses.

What Does the ELR Method Tell You?

Insurers set aside a portion of their premiums from underwriting new policies in order to pay for future claims. The expected loss ratio is used to determine how much they set aside. It's also important to note that the frequency and severity of the claims they expect to experience also plays a role. Insurers use a variety of forecasting methods in order to determine claims reserves.

In certain instances, such as new lines of business, the ELR method may be the only possible way to figure out the appropriate level of loss reserves required. The ELR method can also be used to set the loss reserve for particular business lines and policy periods. The expected loss ratio, multiplied by the appropriate earned premium figure, will produce the estimated ultimate losses (paid or incurred). However, for certain lines of business, government regulations may dictate the minimum levels of loss reserves required.

Example of How to Use Expected Loss Ratio (ELR) Method

Insurers can also use expected loss ratio to calculate the incurred but not reported (IBNR) reserve and total reserve. The expected loss ratio is the ratio of ultimate losses to earned premiums. The ultimate losses can be calculated as the earned premium multiplied by the expected loss ratio. The total reserve is calculated as the ultimate losses less paid losses. The IBNR reserve is calculated as the total reserve less the cash reserve.

For example, an insurer has earned premiums of $10,000,000 and an expected loss ratio of 0.60. Over the course of the year, it has paid losses of $750,000 and cash reserves of $900,000. The insurer’s total reserve would be $5,250,000 ($10,000,000 * 0.60 - $750,000), and its IBNR reserve would be $4,350,000 ($5,250,000 - $900,000).

The Difference Between the ELR Method and the Chain Ladder Method (CLM)

Both the ELR and the chain ladder method (CLM) measure claim reserves, where the CLM uses past data to predict what happens in the future. While the expected loss ratio (ELR) is used when there’s little past data to go off of, CLM is used for stable businesses and business lines.

Limitations of Using the ELR Method

The amount of claims reserves that an insurer should set aside is determined by actuarial models and forecasting methods. Insurers often use the expected loss ratio on the amount and quality of data that is available. It is often useful in the early stages of forecasting because it does not take into account actual paid losses, but in later stages, this lack of sensitivity to changes in reported and paid losses makes it less accurate and thus, less useful.

Learn More About the Expected Loss Ratio (ELR) Method

See more about calculating the profitability of insurance companies with loss and combined ratios.