PTP assumes a fixed ULAE cost to settle each thousand dollars of claims.
For example, it may cost $5.00 to settle $1000 of claims. This assumption
is not valid, however, when comparing claims of different sizes. It is
unlikely that the internal cost of settling a million-dollar claim is 100
times the cost of settling a $10,000 claim. The ratio of ULAE to claims
costs probably decreases uniformly with claim size, ranging from infinite
for those claims closed without payment, to something much less than $5 for
claims at policy limits.
What makes PTP's unrealistic assumption a problem is that PTP takes its
paid-to-paid ratio from one mix of claims (all those claims that are
handled in a calendar period), having one average size, and then applies it
to a different mix of claims (those claims that remain open at a single
point in time) having a greater average size.
For most claims portfolios, larger claims take longer to close than smaller
claims. Thus, the average size of claims open at a point in time is
greater than the average size of claims handled over a calendar period.
Continuing the example, suppose that the average claim handled in a
calendar year (including claims that are both reported and closed in the
same calendar year) is $10,000, while the average claim open at year-end is
PTP would take its ratio of $5.00 per thousand from claims averaging
$10,000. (Ignore, for illustration purposes, the 50% ratio applied for
claims already reported). It would then apply the $5.00 per thousand to
claims averaging $25,000. But, the correct cost of settling a set of
claims averaging $25,000 is less than $5.00 per thousand. Thus, the
paid-to-paid method is too conservative.
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