Staying ahead of the Pricing Roller Coaster

By John Buchanan and Joe Izzo

cover imageOne of the most important functions of property/casualty upper management and chief actuaries is the measurement of profitability. That measurement, like a roller coaster ride, goes up and down dramatically, depending upon where an insurer is in the ongoing underwriting cycle.

The most common metrics for measuring profitability are combined ratios, or operating ratios. Much has been written and discussed about the numerator of those ratios — which reflects losses. However, sometimes forgotten in the discussion is the denominator — the earned premiums — and the price movements that drive those premiums.

Over the last decade, subsequent to the devastating soft market cycle of 1997 to 2001, companies have invested many resources to create robust internal price monitoring systems. To supplement price monitoring information, either for comparison or credibility enhancement, companies require accurate external pricing indications that look both back in time and toward the future. To help measure historical external pricing changes, underwriters and actuaries have access to numerous rate-level survey sources. To guesstimate future expected changes, there are as many, if not more, learned opinions from various industry segments and leaders.

However, survey procedures, motivations, and results are as varied as the sources. Given the extreme diversification of results and the difficulty in getting accurate price movements, using the information poses many challenges. By comparing the survey results to an insurer’s actual data, the insurer can gain deeper insight into those differences. This comparison involves testing the “skill” not only of the historical survey results but of future expectations as well. Both involve comparing survey results to actual data, either internal or external. One such area for more extensive analysis, which can also help explain the differences between surveys, is monitoring pricing by size of account. Ultimately, for a better understanding of its position in the underwriting cycle, an insurer needs a direct comparison of its results with the industry aggregate.

Importance of Accurate Price Movements
Not surprisingly, in a highly competitive marketplace such as insurance or reinsurance, the pricing actions and results for an individual company are strongly linked to the pricing actions and results of its competitors. For successful companies, staying on top of the pricing feedback mechanism is critical. An accurate assessment of the market involves understanding not only a company’s own internal price monitors but also relating them to the broader marketplace.

For example, let’s assume a chief actuary is trying to determine the overall profitability of a line of business. He or she determines through public information that 2004’s loss ratio is 60 percent (that is to say, an insurance company pays out $60 in claims for every $100 in collected premiums). The actuary will use that ratio along with results for all other years until 2012, with varying degrees of credibility, to estimate the expected loss ratio for 2013.

One adjustment among all types of adjustments for loss levels and exposure changes is the impact of pricing changes. If the only (therefore, best) source of rate changes is the values in Figure 1, then the results would be very different. Under Survey 4, the price-level adjustment factor over this eight-year period would yield a 2012 indicated loss ratio of about 70 percent. Using Survey 1, a comparable estimation would yield a loss ratio of more than 110 percent. Surveys 2 and 3 yield indications between those extremes. Clearly, this example offers a broad range of conclusions, leading to much different decisions by top management on the viability of a particular market segment.

Figure 1
Survey of Surveys: Commercial Lines Rate Changes

Portfolio Insurance to Value

To enhance the pricing (and loss) situation, companies invest heavily in building and expanding their data information structures. They then tap into those huge data warehouses to extract whatever knowledge they can about specific markets to turn their data into actionable wisdom and insights. Managing the “information emergence” cycle is critical to the long-term profitability and viability of any company writing long-duration business.

Survey of Surveys
Many independent organizations create price monitors based on surveys. Many insurance companies use these survey results to help benchmark against their own results. These external price monitors are constructed in a variety of ways. All have their strengths and weaknesses.

There are at least four common, often-quoted, survey sources that have been producing results at various levels of detail for many years. The first of these has produced results since the late 1970s, while the most recent started in 2005. Most use some version of survey data and send out many requests for survey completion, with varying levels of responses. Some sources try to supplement the survey information with actual data. Some have a large-account bent, such as those taken of risk managers whose clients tend to be large corporations. However, others will focus on agents and brokers or clients that make up a particular segment of the marketplace. Even when administrators take the utmost care, the nature of surveys is such that biases and sampling errors can be significant and prone to human error.

Future expectations, even from learned experts, by their very nature can be still more problematic. When an exhaustive search for exact pricing changes is impractical, and especially when trying to guesstimate future ones, heuristic methods (experience-based techniques) speed up the process of finding a satisfactory solution. The behavioral sciences are rich in research of heuristics and biases approach. But experts can be excessively overconfident in the replicability of test results from small samples. This overconfidence rings true not just for management and actuaries but in almost any professional field, be it meteorology, catastrophe modeling, or golfing.

In evaluating ISO’s own substantial data sources, drawing upon many large segments of the market in both property and casualty lines, we have clearly verified that premium size is one of the most important areas to differentiate pricing among groups. That is, for example, accounts less than $10,000 in average premium behave very differently than those larger than $100,000. Figure 2 shows how significant the impact can be. The effect depends dramatically on where a carrier is in the underwriting cycle, with larger accounts experiencing much lower lows and higher highs. Therefore, surveys that include a substantial portion of small premium accounts may significantly understate the pricing swings for insurers interested primarily in monitoring larger accounts.

Figure 2
Sample Actual Rate Changes: Impact of Premium Sizes

Portfolio Insurance to Value

Source: ISO MarketWatch® Unleashed

The New-Business Conundrum
Another area of difficulty is measuring and including the impact of new-business pricing. Studies have shown new business across many years can produce results 10 percent worse or more than renewal business. Often, actuaries will convert their various pricing sources into indexes to adjust all their historical combined ratios to current pricing levels. Since companies will have a mix of renewal business as well as new business, an accurate index should include components of both. If the relative profitability and amount of renewal versus new business are fairly constant throughout the cycle, the index is algebraically unaffected even with differences in pricing levels. However, in practice, just as with renewal business, the cycle has dramatic effects on new-business relative profitability. During soft cycles, such as during 1997 to 2001, new-business results can be much worse than results for renewal business.

To help a company keep on top of the underwriting cycle and the effects of price competition — especially during prolonged soft markets — accurate internal price monitors are imperative. It is also critical to attain accurate, credible market information to watch the effects of competitive forces on the rest of the market.

An accurate “skill” assessment against real data for both historical survey indications and forward-looking expectations is necessary in all fields. Only then can insurers begin to discern how much weight to give both the various backward- and forward-looking indications at the disposal of company management. Each of the assessments is critical in determining where a carrier is in the roller coaster of the underwriting cycle, not to mention the long-term viability of its business plan.

John Buchanan, FCAS, MAAA, is principal–reinsurance, Actuarial Consulting, Reinsurance & Contractual Services at ISO, a leading source of information about property/casualty insurance risk.

Joe Izzo, FCAS, MAAA, CPCU, is assistant vice president, Commercial Lines Analytics and Information Management at ISO.