DEFINITION of ‘Priori Loss Estimates’
A technique used by insurance companies to calculate loss reserves. Priori loss estimates are used to determine expected ultimate losses from exposures. A priori is Latin for “from the former”, and refers to the development of an estimate using past experiences.
INVESTOPEDIA EXPLAINS ‘Priori Loss Estimates’
When an insurance company underwrites a new policy and accepts a premium it 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, it also is required to set aside a portion to cover potential claims. This portion set aside is the loss reserve. State insurance regulators help define how much the insurer has to set aside in the loss reserve.
Insurers can use a variety of different estimation techniques, including the chain ladder, 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. Each method is used to calculate the ultimate loss.M
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.
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.
An actuarial best practice is to develop loss reserves using approaches that mix loss development methods with priori loss methods, such as the Cape Cod and Bonhuetter-Ferguson methods. Determining priori loss estimates is best when all accident years are used to develop the estimate for any one year, and when added weight is given to years close to the year being estimated.