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The Actuary The magazine of the Institute & Faculty of Actuaries

Going soft

“Those who cannot remember the past are condemned to repeat it.” George Santayana, The Life of Reason, 1905-1906.

The concept of the general insurance underwriting cycle has been around for some time and the more experienced readers will have been through both the hard, profitable parts of the cycle and the softer, less profitable or loss-making parts of the cycle. Given that the average cycle is thought to be around seven to eight years from peak to peak, some readers may have been through it several times.

The softening market is top of the agenda for Lloyd’s and the London Market. Lloyd’s has identified the mitigation of the underwriting cycle as the single biggest challenge facing managing agents over the next few years. Unprofitable underwriting was reported to be a primary concern for every chief operating officer in a recent survey.

The key to success will be an ability to make quick decisions based on capturing the right data and producing robust, reliable management information that provides early indicators of when rates are inadequate.

So what issues should management be focusing on to mitigate the impact of the cycle? In answering this, it is useful to think of three distinct parts to the problem — the pricing process, the rate monitoring process and controls around these processes.

The general aim of the pricing process is to come up with a price or premium to be charged for a risk. This is usually based on some historic claims data projected forward to pay for the claims expected to arise from the exposure period for that risk.

This premium will be made up of several elements aside from the expected claims costs, namely loadings for various other items including the volatility of claims, commissions, expenses, profit margin and contribution to capital costs.

Terminology varies but let us call the price that will deliver the expected level of profit from the premium charged, to include the elements described above, as the ‘technical price’ (also known as the benchmark price). We introduce the concept of price adequacy, so we think of this technical price as 100% adequate.

Recognising this minimum technical price is important so that profitability can be monitored without having to wait for the emergence of claims that may take several years.

There is a difference, of course, between the actuarially calculated price and the price charged in the market, due to many competing issues. These are generally referred to as underwriting factors, including supply and demand pressures in the market. Relationship underwriting is also important whereby underwriters may write risks at less-thanadequate prices to maintain relationships for when the market hardens. There is a trade-off between maintaining customer relationships over the whole underwriting cycle and optimising short-term profitability.

Further, it is difficult to ignore the pressure to write for market share and keep income levels up to at least meet fixed expenses, as rating levels drop off in the soft market. The collation of high quality rate monitoring information will allow management to monitor this fall in income with greater confidence.

The technical price is only one of the factors the underwriter takes into account when deciding what price to charge. It is important, however, to understand the relationship between the price that should be charged and the price that is actually charged.

In a hard market price adequacy will be greater than 100%, possibly significantly higher, leading to large profits. As the market softens, however, pricing adequacy will start to fall, perhaps below 100%, where the business may still be profitable but not commensurate with the risk taken. Further falls may lead to business being written at break-even levels, and can eventually lead to losses.

The monitoring of the level of price adequacy leads us to the second part of the problem.

Rate monitoring
In the previous section we introduced the idea of price adequacy. Let us consider a risk written last year, which we considered to be 103% adequate, so making an additional profit beyond that which we expected to make, given the technical price.

Insurance and reinsurance risks rarely give exactly the same risk profile year on year. Several changes may take place to alter the level of premium needed to maintain the same requisite level of price adequacy. These include changes in:

» Premium
» Commission rates
» Historic claim levels
» Underlying exposure
» Terms and conditions
» Infl ation
» Level of deductible/attachment point
» Excesses/limits.

Most, if not all, (re)insurance companies and syndicates now maintain some form of rate index. The idea is to track rates from year to year for each main line or class of business written.

The aim of the index would be to capture the impact of the changes listed above so, for example, using 2000 as a starting point and rebasing to, say, 100, we can track how rate levels have changed each year relative to 2000 levels (see Figure 1).

Such an index is commonly used to roll forward ultimate loss ratios from prior years to give an initial expected loss ratio (IELR) for the Bornhuetter-Ferguson reserving method, to estimate ultimate claims for the most recent year or years. The importance of this rate index can be seen in terms of the level of reserves. For example, applying a 60% or 70% IELR to a $100m book of premium could lead to a difference in reserves of $10m on the most recent year of account.

How is this index calculated? There is a range of sophistication evident, from a subjective view provided by underwriters, based on what they are seeing in the market, to more quantitative approaches trying to capture the impact of each of the factors outlined above. Each factor is recorded with varying levels of complexity and accuracy.

Another issue to consider is whether new business is captured within the rate index or not. In practice it is easier to ignore new business because details of the previous year’s risk may be incomplete. However, new business is typically written on worse terms than renewal business since the business needs to be attracted from the previous insurer, usually by offering a lower price or better terms. Given this, the rate index would understate rate reductions in the softening market. If rates are actually 15% off based on all business, rather than, say, 10% based purely on renewal business, then this could add $3m to $4m to the reserve levels based on rolling forward a 70% IELR.

Overall, it is not clear what constitutes best market practice as to the methods used to calculate these rate indices, and who conducts rate monitoring — the underwriting or actuarial function, or a combination of both?

The controls around the pricing process are fairly standard throughout the market. It is common to have actuaries involved in calculating at least the expected loss cost element of the technical premium. Most insurers have a ‘four eyes’ principle where risks are peer-reviewed, although this is often only after risks have been bound. Further to this, internal audit functions will review a sample of risks written to ensure underwriting guidelines and processes are adhered to.

The controls around the rate monitoring process are generally less well embedded. The calculation of the rate index involves a fair degree of subjectivity and it can be diffi cult to allow for some of the factors discussed above.

An added complication is how to monitor rates in binding authorities where the nature of such underwriting can make it more diffi cult to do so. Again, peer review may be used where underwriters oversee each other’s judgments on rate movements but this could potentially lead to collusion where the underwriters scratch each other’s backs. An internal audit is rarely a reliable option as those involved often lack the relevant skillset to provide effective challenge in this area.

Those insurers that recognise the value to be gained from effective monitoring of profitability are those that will succeed over the length of the underwriting cycle.

The April 2008 edition of The Actuary will feature a roundtable debate on the issues surrounding the general insurance soft market.

The challenges facing insurers in a softening market
» Pricing process Ensuring that the data captured is accurate and complete in order to allow a technically driven price to be calculated to support the underwriting process.
» Rate monitoring process Ensuring that changes in market conditions are captured accurately in order to provide management information to mitigate the effects of the cycle.
» Pricing and rate monitoring controls To ensure that the pricing and rate monitoring processes are effectively controlled through appropriate mechanisms such as peer review and/or internal audit.