Staying in the Race: Policy retention affects insurers' product development, operations, pricing and profitability. (Property/Casualty).

For property/casualty insurance, business retention has always taken a back seat to its sexy cousin, new business production. But companies and agencies are increasingly analyzing retention and focusing on improving it. Even small improvements in retention can make large improvements in profitability levels.

For example, ABC Agency writes auto insurance. This year, it will write 2,000 new business policies and 8,000 renewal policies. Currently, ABC Agency renews 80% of its business. Next year, it plans to grow to 10,500 policies. If its renewal ratio stays the same, it will have to write 2,500 new business policies, an increase of 25%. However, if the agency can raise its renewal ratio from 80% to 85% (an increase of only 6.25%), it can meet its goal without increasing new business. This is a simple example, but it holds true for any agency or company with a mature book.

While the focus on retention in the property/casualty arena is relatively new, the financial-services industry--especially banking--has been examining retention and "lifetime customer value" for a number of years. In many ways, the recent focus on retention and the associated impact on business processes and pricing is a natural evolution of property/casualty insurance to a more mainstream financial product.

Companies look at retention using different measures. "Retention trends can emerge slowly and are somewhat difficult to see, measure and analyze," said Glenn Renwick, chief executive officer of Progressive Corp., Mayfield Village, Ohio. For example, a simple measure of retention is the percentage of policies in force one year ago that are still in force currently.

Renwick said Progressive, the fourth-largest writer of auto insurance, prefers to analyze "expected policy life." Instead of a single retention percentage for an entire book, expected policy life could be dependent on a number of variables, including how long a policy has been in force, driver age, number of violations, etc. This is a more complex way to look at retention that is analogous to conditional probabilities, and it allows more statistical analysis and better modeling of retention.

Policyholder Personalities

For an automobile private-passenger book, one of the main determinants of retention is the type of policyholder that the company or agency writes. Since auto insurance is purchased by a large number of Americans across all socioeconomic lines, there are several retention differences among these groups. There are three types of customers who purchase auto insurance policies: short-term defectors, loyal policyholders and the in-betweeners.

Short-term defectors. These are policyholders who have little intention or ability to stay with one company or agency for an extended period of time. They often have these characteristics:

* They buy insurance simply to renew a registration tag.

* They have a limited income with a low budgetary priority of continuous insurance coverage.

* They have a very high propensity to price insurance.

* They tend to have violations or accidents, which can cause large price swings in the cost of insurance.

* They are transient.

For this class of business, companies and agencies will have a competitive advantage if they minimize transaction costs. They also need to charge an appropriate rate or commission for the higher loss and expense characteristics of this class of business.

Loyal policyholders. These policyholders tend to stay with a company for many years. They tend to exhibit the following traits:

* They have a personal relationship with an agent.

* They are not likely to shop due to a price increase.

* They have a low cost of auto insurance in relation to their budget.

* They hold multiple products with the company or agency.

* They are long-term residents of the community.

By definition, these policyholders tend to remain with the same company or agency for a significant number of years. One way to target this class is to write preferred business for several years and slowly build this book. An easier path would be to acquire a company or agency with a large number of loyal policyholders.

The in-betweeners. This is the class of folks in between the two categories above. Unlike the "short-term defectors," they tend to keep their auto insurance in force. They do not have extreme loyalty to an agent or might not even have an agent. They may or may not have other products with the same company. This is the class of business in which a company or agency can most improve retention through operational changes.

The company or agency must determine, however, which operational changes to make. Cross-selling, for example, is crucial, since it is "fairly well documented that retention is higher when a customer has multiple lines insured with a given agent or a given company," said Chris Olie, retention leader for Progressive.

Making Service Count

Service is critical to retention. Progressive is "challenging and re-engineering all aspects of our service with an eye toward customer service and retention," Olie said. Some of the services that have an impact on retention are forms and correspondence. These should be understandable and consumer friendly. Another method to improve retention is to have multiple ways a customer can do business with an agency or a company, such as by mail, telephone or the Internet.

Payment options also affect retention. A key element is enabling the customer to "pay us when and how they want to," Olie said. For nonstandard auto, billing programs that do not require a higher payment at renewal than the one made monthly are effective. This lowers the likelihood that the policyholder will shop the renewal.

For the standard or preferred product, an effective tool is electronic funds transfer. Typically, electronic funds transfer will debit an account the same amount monthly on the same date. This changes retention from an active action by a policyholder (writing a check) to a passive one (allowing the debit).

The Product Perspective

On an even deeper level, companies need to realize how retention impacts their products. Retention and loss ratio have strong correlations in auto products, with loss ratios typically much higher for new business than for policies that have been in force for many years. A company that introduces a new product that has high retention (such as a preferred auto policy) may face a period of low profitability because new business loss ratios may be extremely high. This is due to the fact that a larger percentage of this preferred class will be long-term renewal customers.

For any company with a profitable book, increasing retention increases profits. For a new product in the marketplace, however, the situation is more complex. As noted above, loss ratios are much higher for new business. But companies must be competitive on these risks to write policies. Therefore, an increase in new business may strain loss costs. This impact will be most dramatic if retention in the risk class is high, because the new policies will have even higher loss ratios relative to the overall class.

Consider the chart, "Loss Ratios for Various Risk Classes" on page 74. Now, assume that Company A files rates in which credit scores are used to reflect the different risks in specific classes. Rates are then determined based on those risk levels. Because the rates are higher for higher-risk classes, the expected loss ratio is the same for all classes--in this case, 65.

If other companies do not offer the same low rate for classes with favorable credit scores, those customers will go to Company A, causing a large percentage of new business in Company A to have favorable credit scores. As the table shows, the loss ratio will be much higher initially on this business than the overall loss ratio.

Therefore, a program that targeted only good-credit, high-retention risks (credit score 750) would have a loss ratio of 85 in the first year, far above the overall expected loss ratio of 65 or the loss ratio of 76 the company would have had if it had written policies for only fair-credit, medium-risk customers (credit score 600), which also represents an average, first-year business across all credit scores. In this scenario, a high-retention product--which would be priced lower than policies for high-risk customers--will be extremely difficult for a new entrant to write profitability in the short or even medium term.

Pricing Concerns

Retention also has an impact on pricing indications, said Robert J. Walling, a principal and consulting actuary with Miller, Herbers, Lehmann & Associates in Bloomington, Ill. "You need to understand the retention of your book before you price it."

His firm uses a multivariate analysis or generalized linear model to identify differences in either renewal, retention or conversion (sales as a percentage of quotes) within the risk class. By looking at all the rating and underwriting characteristics simultaneously, the firm can identify interactions between these variables. By using the model, the firm can determine which classes are likely to give up a policy if the rate is increased.

Rate changes, either by the market or a company, certainly impact retention. "Market conditions for rate competitiveness change continuously and impact the expected policy life," Progressive's Renwick said.

The practical impact is that a traditional actuarial analysis may tell a company or agency that it needs a 10% rate increase. But unless the company understands how the rate change will affect retention and new business production at a detailed class-plan level, it will not achieve its targeted results.

Refocus on Retention

Retention is a simple concept to understand, but it has a deep and complex effect on a company or agency's operations and a company's products. The most successful insurance companies and agencies strive to continuously improve their retention and understand the impact on their marketing and pricing decisions. The myopic focus on new business production and loss ratio is receding in the world of property/casualty insurance, replaced by a dynamic vision of all the components that make an organization successful, including a better understanding of the role of retention.

Lee Bowron is president of Matthews Actuarial in Birmingham, Ala.

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