What Is the Expected Loss Ratio – ELR Method?

What Is the Expected Loss Ratio – ELR Method?

Let me explain the Expected Loss Ratio (ELR) method directly: it's a technique you use to determine the projected amount of claims relative to earned premiums. I rely on this method when an insurer doesn't have appropriate past claims data, maybe because of changes in product offerings or when there's not a large enough sample for long-tail product lines.

The Formula for the ELR Method

Here's the formula you need: ELR Method = EP * ELR - Paid Losses, where EP stands for earned premiums. That's it—straightforward and essential for your calculations.

How to Calculate the Expected Loss Ratio – ELR Method

To calculate it, you multiply the earned premiums by the expected loss ratio and then subtract the paid losses. Follow this step by step, and you'll get your projected figures accurately.

What Does the ELR Method Tell You?

Insurers set aside a portion of premiums from new policies to cover future claims, and the ELR helps determine exactly how much. Remember, the frequency and severity of expected claims factor in here. You can use various forecasting methods for claims reserves, but in cases like new business lines, ELR might be your only option to set the right level of loss reserves.

Apply the ELR by multiplying it with the earned premium to estimate ultimate losses, whether paid or incurred. For some lines, government regulations might require minimum reserve levels, so keep that in mind. This method projects claims relative to earned premiums, sets aside funds for future claims, and is ideal for businesses lacking past data—unlike the chain ladder method for stable ones.

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

You can also use ELR to calculate the incurred but not reported (IBNR) reserve and total reserve. The ELR is the ratio of ultimate losses to earned premiums—calculate ultimate losses as earned premium times ELR. Total reserve is ultimate losses minus paid losses, and IBNR is total reserve minus cash reserve.

Take this example: suppose an insurer has $10,000,000 in earned premiums and an ELR of 0.60. They've paid $750,000 in losses and have $900,000 in cash reserves. The total reserve comes to $5,250,000 ($10,000,000 * 0.60 - $750,000), and the IBNR reserve is $4,350,000 ($5,250,000 - $900,000). That's how you apply it in practice.

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

Both ELR and the chain ladder method (CLM) measure claim reserves, but CLM uses past data to predict the future. Use ELR when there's little historical data, and turn to CLM for stable businesses and lines.

Limitations of Using the ELR Method

Actuarial models and forecasting determine how much reserves an insurer should set aside. You often use ELR based on available data quality and quantity—it's helpful early on because it doesn't factor in actual paid losses. But later, its lack of sensitivity to changes in reported and paid losses makes it less accurate and less useful.

Learn More About the Expected Loss Ratio (ELR) Method

If you want to dive deeper, look into calculating insurance company profitability using loss and combined ratios.