How well do you know your portfolio?

As more countries move away from tariff pricing, the key to profitable underwriting lies in a deep and detailed understanding of the risks you accept, says Naeem Ali of EMB. 

Tariff-based insurance underwriting is on the retreat throughout the world as governments and regulators look to competitive forces to determine the best rates for our policies. In Asia, we see this trend in India, South Korea and Singapore. It is only a matter of time before other jurisdictions follow.

The arguments in favour of dispensing with tariffs assume that market mechanisms are the most efficient and, from the consumer’s point of view, fairest way to determine the cost of insurance. But what about the insurers themselves; how do they protect their interests?

The short answer is that there will be winners and losers. Liberalised insurance markets differentiate in favour of underwriters who understand better than their competitors the risks they are accepting or rejecting. The more detailed the analysis of your portfolio, the greater your competitive advantage.

Classic insurance theory emphasises safety in big numbers. Underwriters, to quote the risk academic Professor John Adams, know that “there are groups that will have higher or lower than average claim rates, but the costs of identifying them accurately … are considered not worth the effort.” You may get some risks wrong but, as long as your average levels are okay, you will make a healthy profit.

Unfortunately Adams was writing more than ten years ago and this approach is increasingly out of date. It will only make you money nowadays when rates are either kept artificially high (e.g. through tariffs) or when there is a hard market – and even then only if you are lucky. In normal competitive circumstances your customers will select against you, accepting risks that are cheap and rejecting anything overpriced. Some of your competitors, those who can write with more precision, will avoid these pitfalls and continue to make profits even when your own P&Ls show nothing but red.

In this article, I am going to look at the Motor market to show how some insurers are staying ahead of the game. The principles, though, could be used with any personal lines class where data is plentiful. The uses to which companies put their data - and their systems to store, retrieve and analyse it – make up a key differentiator in any liberalised market.

Let’s consider comprehensive Motor cover for men aged between 21 and 25. All insurers have got the idea that this group carries greater than average risk, being both male and young. They will also know to look at the type of car they drive, the city in which they live and their occupation.

After taking into account these and a few other factors, many underwriters will feel comfortable quoting terms. How accurately, however, have you assessed the characteristics you know about? For example, your policyholder may live in a district where residents have a low average claims experience, but there may be huge variations within that district depending on precisely where they live. Alternatively, his residential area may have a high claims experience, but only because it has a young population rather than because it is inherently risk-prone. There is a danger that you may load his premium unfairly and lose good business to a rival that understands the risk better.

Of course, many underwriting questions are more complex. They may involve, for example, balancing premium volume against profitability and the competition for capital between different classes of business. In tariff-free markets, getting this kind of dynamic right will guarantee and maximise profitability. By using your data, supplemented by market-wide records, it is possible to answer the following questions, among others:
- How will our policyholders respond if we raise our premiums?
- What effect will increased price competition have on our retention rates?
- How much new business do I require next year to maintain premium levels?
- Which distribution channels should we exploit?
- What loss ratios might we expect next year if we follow our current strategy?
Having the correct answers will clearly have far-reaching commercial advantages, and the exercise is also are likely to produce additional useful underwriting information. I know several insurers that have found correlations between source of business (i.e. whether direct or intermediary, and what type of intermediary) and predicted claims record; doing so has helped them to refine their underwriting.

This kind of analysis will sound complicated to some people, but a gradual approach to building up the necessary knowledge is eminently achievable. A good place to start may be to review the way your company records claims and whether the data could be stored in a more usable, accessible way. You may also have to reconcile historic data. There are then a number of powerful software products that can help make sense of all the information at your disposal.

None of this is to suggest that any major strategic decisions should be driven entirely by numbers. There are many wider issues to be considered, but unless you do the arithmetic first this will inevitably involve a bigger element of guesswork than necessary. In a competitive market, that could make all the difference between commercial success and failure.