Cape Cod Method

No, the Cape Cod method does not refer to a special fishing or sunbathing technique. Rather, it's a method insurance companies use to calculate how much money they need to keep in a reserve account in order to pay out those pesky customer claims.

The method starts with the assumption that past losses can be used to predict future losses using both internal and external information. The insurance company calculates how much they should have in reserve by adding up the losses to date, dividing by their future exposure to losses (claims filed but not paid), and then dividing by their loss development factor (the difference between final losses and what the insurer originally recorded).

While deriving useful estimates, the Cape Cod method does have its downside. It assumes the exposure to loss will be consistent over time. But what happens if there is a "100 year storm" (such as Hurricane Sandy), which leads to many customers are filing big claims? At that point, estimates go out the window...