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The Actuary The magazine of the Institute & Faculty of Actuaries
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Insurance: Rate monitoring systems

During the soft cycle currently being experienced by the general insurance sector, it is vital for insurers to clearly understand the profitability of the business they are writing. In a hard market, it is possible, although not advisable, for companies to get away without this clear understanding because market conditions help profitability. However, in a soft market, this will not be the case and insurers will need a detailed understanding of what they are underwriting to ensure that either:

>> The business is being written at rates that are expected to lead to a profit; or
>> If an insurer has decided for commercial reasons, to write some business at rates that are likely to be unprofitable, he does so with his eyes open; that is, with an appreciation of the likely level of losses.

The worst outcome is for an insurer to write unprofitable business without realising it, and this is a trap that many fell into during the last soft market in the late 1990s. By the time many of these companies appreciated what had happened, it was too late to mitigate significant losses.

So what can insurers do in order to avoid the danger this time? The answer is to develop a management information system to regularly monitor the business they are writing. Such systems are often referred to as "rate monitoring" systems, although a good system will do far more than just track rates.

What might be included?
Such a system could monitor a variety of metrics to allow insurers to measure the success of their underwriting. These could include:

>> Renewal rates
>> Comparison of claim ratios on renewed and lapsed business (as one indicator of whether the insurer is retaining the best business)
>> Rate changes on renewals
>> New business volumes
>> Comparison of rates on renewals and new business (to see whether the new business is improving or worsening the book)
>> Expected claim ratios and combined ratios of business being written
>> Changes in commission rates.

For many of these metrics, the information produced could include comparisons with the business plan. These are likely to be more informative for senior management and senior underwriters than the metrics themselves since it enables them to judge the results in the context of the company’s targets.

One enhancement that can work very well is a simple "traffic light" coding system, where metrics that are significantly behind plan are coloured red, metrics that are in line with plan are coloured orange and metrics that are ahead of plan are coloured green. This can be very effective in focusing users on the areas that require the most urgent attention.

Features of a good rate monitoring system
There are a number of features that are important when designing an effective rate monitoring system.

Regular reporting: The reports should be produced on at least a monthly basis, since it is important for management to be able to react to the results as quickly as possible. Profitability could be reduced if key management decisions are delayed until results become available at, say, the end of the quarter.

Timeliness: For similar reasons, it is important for the results to be produced as soon as possible following the month-end. The faster the information becomes available, the more valuable it is. Some delays may be unavoidable: for example, it may be a few days after the month end before all policies are loaded onto the computer systems. However, these should be kept to a minimum.

Homogeneous groupings: In order to make the results more meaningful, the analysis should be split between blocks of business with similar characteristics that are likely to experience similar rating pressures.

Relevant groupings: It is also important that the groupings used are relevant to the way the company is managed. If the account is split in one way for most purposes, it is unhelpful for the rate monitoring system to use a different split. Using groupings that management and underwriters are familiar with will make the analysis more meaningful to them. Otherwise they are less likely to be able to interpret the results and consequently, to take any notice of them.

Reliability: The analysis should be based on accurate data and robust assumptions so that the results can be relied upon. If they are unreliable then either they will be ignored or, worse, they will lead to inappropriate management decisions being taken.

Consistency: It is also important that frequent changes to the methodology used and the presentation of the results are avoided. Constant changes will undermine the confidence that users have in the figures.

User-friendliness: The results should be made as clear and easy to interpret as possible. This will help to maximise the information that users gain from the output which will, in turn, lead to more informed management decisions.

Types of insurers
The ideal book of insurance business to enable the best possible rate monitoring system to be built would be a book where there is complete data on all policies written and there are large numbers of policies, because the results will be based on averaging over groups of policies.

These conditions mean that some types of insurers lend themselves more readily to rate monitoring systems than others. Such systems work particularly well for personal lines insurers who, by the nature of the risks they write, tend to satisfy both of the above conditions. The next best results will be for commercial lines insurers who are likely to have good data but who, by comparison with personal lines insurers, write smaller numbers of risks which are on average larger.

London Market companies also tend to write larger risks. However, because of the nature of the business written and the way it is transacted, they will have less data than commercial lines insurers, meaning that they fail to satisfy either of the conditions above.

Reinsurers are more problematic since they are very unlikely to have good exposure information on the underlying risks they are insuring.

As you go through the scale from personal lines insurers through to reinsurers you get a "double whammy" effect, because not only does it become increasingly difficult to build a rate monitoring system, but the reliability of the system’s output also worsens. However, this does not mean that there are companies for which there is little point in developing a rate monitoring system. Having such a system will add considerable value to all insurers, although it is important to understand and communicate the limitations that apply in any particular case.

Data
The reliability of the results produced by a rate monitoring system will be heavily dependent on the quality of the available data. If the available data is limited it may not be possible to calculate rate changes from information on the company’s computer systems. In this case, it will be necessary to rely on subjective assessments instead and the best people to make such judgements are the underwriters. If this approach is adopted, then a more objective assessment will be obtained by asking the underwriters to estimate the rate change on each policy as it is written, rather than just asking them for a single figure for an entire book of business.

Some practical points
There are a number of practical points to bear in mind when building a rate monitoring system.

Start simple: It can be a daunting and time-consuming task to construct a system that monitors all of the metrics listed earlier. Consequently, it may be preferable to begin by building a system that just includes the key metrics. Firstly, this will make the task more manageable and, secondly, it is better to produce something relatively quickly that senior management can use to help run the business, than to wait until the perfect “all-singing, all-dancing” system has been developed. A more advanced system that incorporates additional features can be developed as a second stage.
The development of a rate monitoring system does not necessarily need to be a major IT project. For many insurers, a spreadsheet-based system can be perfectly adequate, and an initial version can be completed in a matter of weeks.

Automate the system: The system is going to have to be run every month so the effort required to produce the results should be minimised. To this end, the process should be automated as much as possible.

Update previous results: As the metrics are produced as soon after the month end as possible, there are reasons why the information on the company’s computer systems may change after the data has been extracted. Examples include late processing, premium adjustments and corrections of errors. Given this, it is vital not to set the results for a particular month in stone the first time they are produced.
Instead, each time the rate monitoring system is run, the metrics should be adjusted for a number of earlier months to reflect any additional information that has become available since the previous rate monitoring run. One possibility is to calculate and display metrics on a rolling 12-month basis so that whenever rate monitoring is first run for a particular month, the results for the preceding 11 months are also updated. This will ensure that the final figures produced for each month are as accurate as possible.

Get users up to speed: There is clearly no point in building a wonderful rate monitoring system if no-one uses it. The key users of the information are likely to be senior management and senior underwriters and it is worth investing as much time and effort as necessary to explain the output to them, and ensure that they are able to interpret the results.

Conclusion
For a rate monitoring system to be successful, the system and output need to be both theoretically correct and practically applicable. The two biggest dangers are a system that produces perfect answers but which no-one uses, or a system that is widely used but which gives incorrect results. Arguably, the latter situation is even more dangerous than the former. However, if these dangers can be avoided, a successful rate monitoring system will be one of the key tools that senior management uses to run an insurance company.


Simon Sheaf is an actuarial director within Grant Thornton’s Financial Markets Group. He specialises in the General Insurance sector.