Tracking the changes: rating errors in personal auto lines cost the property/casualty industry nearly $14 billion each year.

Americans lead dynamic lives. Statistics show that every hour there are 203 marriages and 109 divorces. Every hour 4,900 Americans move and 7,100 change jobs. Every hour there are 12,400 vehicles registered of which 2,200 are new. Every hour there are 160 drunk-driving arrests, five traffic fatalities and more than 2,000 auto insurance claims paid. Every hour 550 new driver licenses are issued.

All of this makes personal auto insurance risk management a rapidly moving target. The risk profile of auto policies is constantly changing. Consider job changes. The time is long passed when a worker got a job right out of school and stayed with the same company throughout his or her career. In fact, the average worker has held 10 jobs by the age of 56. Overall, 25% of workers change jobs each year. Individual job change is likely to be associated with changes in vehicle usage, commute distance and annual mileage.

Unlike homeowners insurance, with personal auto, the most basic facts of the policy change frequently. Forty-eight percent of household auto policies experience a change of vehicles or drivers each year. Nearly one-third of households replace vehicles each year. These changes, in turn, are associated with changes regarding which driver drives which vehicle, annual mileage, commute and other rating factors.

Insurers provide their policyholders with multiple methods to report changes. Not surprisingly, many changes are not reported. Policyholders are significantly more likely to report life changes that reduce auto premium than report changes that increase premium. For example, we've found that policyholders are more than five times more likely to report midterm mileage changes that lower annual premium than to report mileage changes that raise premium. Every day, in the course of conducting premium audits, we find examples of younger drivers who retain a policy address of their parents in the suburbs long after they have moved to higher rated territories in a city center.

Based on premium audits of more than 14 million personal auto policies, we found pervasive rating errors. For 2002, we have estimated that total premium lost to personal auto rating error was $13.7 billion. A high percentage of this error arose not out of initial misreporting, but from failure to update information.

Risk Management Costs

Rating error leads directly to failures in risk management. For example, policies with unrated 16-year-old male drivers in the household experience an average loss ratio of more than 200.

Failures of risk management occur at the aggregate, as well as the individual policy level. Many carriers, aware of the high error in annual mileage data, only rate in two or three categories such as 0 to 8,000 miles, 8,001 to 16,000 miles and 16,000 plus miles. However, our analysis of the loss histories of vehicles which were driven more than 30,000 miles (verified through odometer readings) found loss frequencies that were 31% higher than vehicles driven 16,000 to 20,000 miles. Failure to identify these higher risk vehicles and rate accordingly represents a major source of unmanaged loss costs. Further, carriers that are capable of building and maintaining finely graduated rating plans enjoy multiple competitive advantages over carriers with flat rating plans.

One often-overlooked cost of rating error is moral hazard. Rating error causes honest insured drivers to subsidize the dishonest, low-risk drivers to subsidize high-risk drivers, and individuals who seldom use their vehicles to subsidize high-mileage drivers.

Our analyses have repeatedly demonstrated that individuals who misreport policy-rating information are associated with high loss experience. For example, individuals driving 20,000 miles a year but reporting an annual mileage of 10,000 will, on the average, have higher claim costs than individuals driving 20,000 miles--and correctly reporting that fact. It's clear to us that rating misreporting is indicative of high general risk.

Premium Rating Error Summary

Private Passenger Auto                % of Premium

Vehicle Rating Factors
Commute/Annual Mileage                        1.5%
Vehicle Characteristics, Discounts            0.6%
Vehicle Usage                                 0.9%
Rated Territory                               0.6%
Vehicle Subtotal                              3.6%

Driver Rating Factors
Unrated Operators                             1.7%
Vehicle-Driver Assignment                     1.2%
Driver Characteristics                        1.5%
Violations/Accidents                          1.4%
Driver Subtotal                               5.8%

Other Rating Factors                          0.2%
Total Rating Error                            9.6%
Estimated 2002 Premium                $141 Billion
Total Rating Error Costs             $13.7 Billion

Source: Quality Planning Corp.

Daniel Finnegan, is president of Quality Planning Corp., a San Francisco-based provider of analytic methods to the auto insurance industry. He can be reached at [e-mail].