Underwriting and Risk Management
By Raj Bhat, Ph.D.
Many insurance companies are focusing on retention as a major tool to combat reductions in revenue. When policyholder retention is in the limelight, there is danger that risk management takes a back seat, resulting in deterioration in long-term financial performance.
Some carriers identify and price risk more effectively than others and achieve better financial and risk management results. One fundamental risk management tenet for insurers is that accurate rating information is the key element in the underwriting process. As we have painfully learned from the mortgage industry, when consumers misrepresent facts and underwriters do not validate information, financial performance suffers and risk increases. The same holds true in the property/casualty auto insurance industry.
Misreported information can have severe adverse consequences when the incorrect data is used by actuaries to develop their rating plans, resulting in weak risk differentiation and risk management failures.
Table 1 (below) shows a scenario in which there are three policies — A, B, and C — on a company's books. These three policies have different risk profiles costing $1,000, $1,200, and $1,400. However, since the company cannot differentiate risk, each policy is priced at $1,260. In time period 1, the company collects premium of $3,780, incurs $3,600 in costs, delivers underwriting profits of $180, and has a combined ratio of 95.2%. If the company's competitor is able to differentiate and price these risks better, then, over a period of time, policies A and B will be lost to the competition. At the end of time period 3, only policy C will remain on the books, with a premium of $1,300, a cost of $1,400, and an underwriting loss of $100. The competitor will have policies A and B with premiums of $2,310, costs of $2,200, and an underwriting profit of $110.
Table 1: Impact of Poor Risk Differentiation on Book of Business
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Clearly, inaccurate data results in bad pricing decisions. Poor underwriting results in inadequate risk differentiation and risk management.
Through a systematic re-underwriting program, one misrated policy of the 85 policies is identified. If the combined ratio for the misrated policy was 160%1. This is based on QPC experience. On average, policies that do not renew as a result of a price increase resulting from fixing incorrect rating data have a combined ratio of 160%. , the company would have paid $1,600 in costs. Correcting the error increases premium, and the policy does not renew. The company has 84 policies that renew for $84,000 in premium, expected costs of $83,400 ($85,000 minus $1,600), and a combined ratio of 99.3% ($83,400/$84,000).
The company's retention decreased 1% from 85% to 84%; its profitability improved; combined ratio decreased from 100% to 99.3%. If corporate goals are geared toward retention without regard to profitability, management has less incentive to take action on underpriced policies that may result in lower retention (and probably a lower bonus!).
Risk Management Strategy
Since the company has the policy on its books, it should have enough information to determine its profitability. It is possible to develop scoring models that predict "risk of flight" (inverse of retention). Figure 1 (below) shows actual and predicted retention rates for a retention model based on data from a mix of diverse QPC clients. The "directional fit" of the retention score is extremely good and can be used as an excellent segmentation tool prior to renewal.
Figure 1: Renewal Score
Operational processes can be geared to address the core issues in each segment of the business. Table 2 (below) shows the operational and strategic challenges by segment. This strategic differentiation will produce better long-term performance — and a core advantage for the business.
Table 2: Risk Management Strategies by Segment
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Dr. Raj Bhat is president of ISO's Quality Planning subsidiary. Quality Planning provides tools and services that help auto insurers identify rating errors, recover lost premium, and minimize future losses.