Bornhuetter-Ferguson Technique
Contents
Understanding the Bornhuetter-Ferguson Technique in Insurance
Unraveling the Bornhuetter-Ferguson Technique
The Bornhuetter-Ferguson technique stands as a cornerstone in the realm of insurance, offering a robust method to estimate incurred but not yet reported (IBNR) losses for insurers. Conceived by two pioneering actuaries, Bornhuetter and Ferguson, this method made its debut in 1975 and has since solidified its place as one of the foremost tools in loss reserve valuation.
Delving into the Core of the Bornhuetter-Ferguson Technique
The Bornhuetter-Ferguson method amalgamates elements from the chain ladder and expected loss ratio methods, providing a nuanced approach to estimating loss reserves. It assigns specific weights to the percentage of losses paid and incurred, offering a tailored perspective on an insurer's potential exposure to loss.
Two Paths to Calculating Loss:
The technique offers two algebraically equivalent methods to calculate loss. The first method involves adding undeveloped reported (or paid) losses directly to expected losses, adjusted by an estimated percent unreported.
scssBF L ELR * Exposure * (1 - w)
In contrast, the second approach employs a chain-ladder approach to develop reported (or paid) losses to their ultimate value using a loss development factor (LDF). This ultimate value is then adjusted by estimated percentages for reported and unreported losses.
scssBF L * LDF * w ELR * Exposure * (1 - w)
The estimated percentage of reported losses is deduced from the reciprocal of the loss development factor, paving the way to compute IBNR claims by subtracting reported losses from the Bornhuetter-Ferguson ultimate loss estimate.
Bornhuetter-Ferguson Technique vs. Chain Ladder Method
While both methods aim to estimate IBNR losses, their approaches differ fundamentally. The chain ladder method relies on past loss experience, juxtaposing past estimates with actual claims to project future losses. In contrast, the Bornhuetter-Ferguson technique crafts a model grounded in an insurer's exposure to loss, offering a more holistic estimation process.
When Does Bornhuetter-Ferguson Shine?:
The technique shines brightest in scenarios where actual reported losses fall short as indicators of IBNR. Specifically, it excels when faced with low frequency but high severity losses, a combination that often eludes precise estimation. Such conditions challenge insurers, making accurate predictions more elusive, especially compared to the more predictable high frequency, low severity claims.
Fact 1: The Bornhuetter-Ferguson technique was introduced in 1975 by actuaries Bornhuetter and Ferguson, revolutionizing the estimation of IBNR losses for insurers. Source: Wikipedia
Fact 2: The Bornhuetter-Ferguson method is renowned for its versatility, combining features from both the chain ladder and expected loss ratio methods to provide nuanced loss reserve valuations. Source: National Association of Insurance Commissioners (NAIC)
Fact 3: Bornhuetter-Ferguson's efficacy shines in scenarios of low frequency but high severity losses, challenging traditional estimation methods and providing insurers with more accurate predictions. Source: U.S. Department of Commerce