Be prepared: insurers need ways to monitor their operations and results so they don't fall apart amid the clamor for lower prices and better terms that comes with a soft market.
With signs of a softening insurance market in view, insurers should evaluate whether they are prepared for the more difficult times ahead. Increased competition will drive demands for lower prices and improved terms from both insureds and agents.
Investment in performance monitoring systems is essential for companies to measure and manage changes in their risk portfolios. Detailed information issued regularly is essential to monitor changes in pricing, policy terms and conditions, the nature and quality of accounts written and financial results. Monitoring systems enable 'companies to verify their actions, meet their objectives or provide an opportunity to take corrective action before problems linger for extensive periods.
Performance monitoring systems may take various forms, depending on what factors are being measured. Processes or systems to monitor the following factors are essential:
* Price changes;
* Underwriting and marketing changes;
* Claims actions; and
* Actuarial indicators of deteriorating loss ratios.
Price monitoring systems enable management to determine if pricing to exposure is deteriorating. Effective price monitoring system characteristics are as follows:
* Clear rules and objectives for the front-line pricing staff;
* Good pricing benchmarks that are industry or company based;
* Effective price monitoring measurement systems;
* Monitoring of new business pricing as well as renewal pricing; and
* Price monitoring well integrated with the reserving, profitability analysis and forecasting systems.
The front-line pricing staff should have a clear understanding of the pricing goals. For companies writing standard lines business, benchmarks should be established and related to industry rates or loss costs. Typically, Industry-based rates are a composite of industry loss costs and a company's expenses and profit factors. In these cases, the pricing goals are usually set as a percentage of industry-based rates, often referred to as "mod targets." While insurers can establish pricing goals over an aggregated book, the pricing of an individual risk still needs to comply with the insurer's rate filings.
Companies doing business in specialty segments may not have readily available industry benchmarks. It is critical that they develop effective benchmarks for theft front-line pricing staff. Monitoring of new business would be relative to these benchmarks.
An exposure-based price should always be developed and considered in pricing accounts, even when historical loss experience for that account is available.
Following best practices, insurers should have systems that compare renewal pricing to expiring price levels and new business pricing. Insurers should monitor the percentage of new business by segment to determine if certain business units are writing larger than expected percentages of theft total premium as new business. They should watch these segments closely to see if the new business pricing is at least at renewal pricing levels. As insurers know less about a new business risk than a renewed risk, it may take several years for new business loss ratios to reach the more favorable loss ratio levels of the renewal book of business. In addition to monitoring the volumes of new business written, new business pricing benchmarks must be established to ensure pricing goals are met.
Most insurers integrate anticipated rate changes in their planning and forecasting systems. The information developed from price monitoring systems should be incorporated into forecasting and planning systems for the upcoming years, as well as the reserving process for evaluating ultimate loss ratios for the more recent accident years. Price changes, as well as other factors such as loss trend, are critical in tying older years' ultimate loss ratios to current and future accident years' results.
Underwriting and Marketing
While underwriting and marketing actions may not always directly affect price levels, they can serve to exacerbate the effects of soft market pricing or offset intended company pricing actions.
Companies can identify metrics to project the impact of today's underwriting and marketing actions on future accident years' results. These metrics are critical to companies in managing through competitive cycles, but also in measuring the use of best practices within theft organizations.
Companies without a strong track record of underwriting performance may need to embrace different metrics than companies that have a strong underwriting culture. The former should be more concerned with reinforcing the key tenets of underwriting: information capture and management, exposure analysis, risk selection, pricing, application of coverage, deployment of proper authority levels and controls. The company will need to keep track of its progress in execution of these key fundamentals.
The company should formally audit and grade its performance in each of the fundamental underwriting process areas, including the impact of tougher and more consistent underwriting guidelines, re-underwriting programs keyed to eliminating risks that do not meet the target customer profile, implementation of risk-control engineering policy/guidelines, actions taken to address agent loss-ratio performance and means to improve general execution of underwriting policy.
Within each of these areas there are specific actions necessary to ensure underwriting Integrity. For example, in exposure analysis the following need to be addressed:
* Analysis of account operations and exposures;
* Evaluation of hazards and loss potential presented by class;
* Assessment of quality of risk within class;
* Confirmation of exposures and operations through a risk control survey; and
* Evaluation of financial condition/security.
A company that has already mastered the key tenets of underwriting may be more concerned with quantifying the impact of pricing, exposure management and business mix while keeping a watchful eye on underwriting discipline through a peer review process, regularly scheduled audits and rigorous metrics.
Our experience is that the expected impact of many of the actions can be quantified--albeit with more difficulty than price-related adjustments. Some measures can be used as leading indicators of future accident-year results. For example, insuring to value for property lines can boost premium--the denominator of the loss ratio--in the short term. Because most losses are partial ones, these actions may result in sustained loss-ratio improvement. For workers' compensation, improved estimates of payroll and of trending of payrolls for future periods will serve to improve loss ratios. The contributions from these and other quantifiable underwriting and marketing actions can represent significant loss-ratio improvements.
Claims discipline also can improve results. Companies should ensure their claims operations are consistent with industry best practices. The following illustrate these opportunities:
Litigation Management: While every possible effort can be made to avoid litigation, it cannot always be prevented. Potential savings can be realized from effective use of house counsel, where size justifies this approach. Savings can be measured by comparing legal and loss costs before and after deployment of house counsel. For smaller companies, a more practical solution may be application to outside counsel of fee schedules under the company's direction and control.
Recoverables: Recoverables are more likely to be well managed through the use of specialists and networks. A change in process may improve future loss experience. Here it may be possible to objectively measure the dollar amounts that are recovered in comparison to those for prior years.
Specialty Claims: Where critical mass exists, specialization can be effective in bringing expertise to bear on complex claims--environmental liability, medical malpractice, construction defect and workers' compensation. Forming dedicated units can make a material difference in settlement costs. Direct comparisons of claim costs before and after formation of specialized units can be made.
Initial Claims Handling: Improvements in initial claims handling procedures (making three-point contact--insured, claimant and employer--in workers' comp claims within 24 hours of notification) can reduce loss costs. Claim costs should be tracked to measure the impact.
Actuarial Indicators of Future Loss
While it takes a number of years for ultimate loss ratios to be accurately set for commercial casualty lines such as general liability, professional liability and workers' comp, directional indicators can test whether loss ratios are moving differently than expected. Some of these directional indicators are:
* Reported claim frequencies;
* Accident-quarter reported loss ratios; and
* Historical loss ratios on business renewed vs. business non-renewed.
Claim frequencies are typically a better early indicator of deteriorating results than claim dollars, claim severities or loss ratios. Claim frequencies should be measured as claim counts related to some exposure base. If a common exposure base does not readily exist, premium adjusted to a common rate and limits level may serve as an adequate substitute. With the exception of workers' comp--which has experienced frequency reductions for some period of time--many lines of business are expected to incur flat frequency from year to year. If frequencies increase, this may be an early sign of a negative trend, well before it starts to be fully reflected in the reported loss-ratio results.
If an insurer is large enough, in addition to reviewing reported claims frequencies, it can monitor the reported loss ratios (paid losses plus case reserves related to earned premium) on an accident-quarter basis with quarterly evaluations. The relationship of the accident-quarter loss ratio at six months to loss ratios for prior quarters at the same age is often predictive of directional change in loss ratios.
Small insurers may experience too much randomness in results to pick up accident-quarter signals. They may have to rely on longer periods of times to detect changes with any level of confidence. Accident-quarter results for certain segments such as construction also are subject to seasonal influences, so comparisons are best made to a prior year's quarter.
Another test that insurers should consider is comparing the historical reported loss ratios of renewed business with non-renewed business at the same age of development. The historical loss ratios on renewed business would normally be expected to be better than the loss ratios on non-renewed business because of post-claim underwriting and the reflection of exposure knowledge and management for the risks the insurer chooses to renew. The critical measurement is the movement of any gap between the two sets of historical loss ratios. If the gap is narrowing, the insurer should be concerned about deterioration in underwriting results. If the gap is increasing, this is generally a positive sign.
None of these leading indicators tests should be used alone. Several of the tests should be used and questions should emerge as a result. If the tests suggest adverse movements, corrective action may be taken to prevent further deterioration in future accident-year loss ratios.
Top performing companies are continuously developing and enhancing processes and metrics to monitor movements in pricing, underwriting/marketing and claims. A solid projection of current accident-year results requires comprehensive measurement of the expected impact of actions taken. This is especially important in a soft market when some of these actions may cause a company to miss its return-on-equity or combined-ratio targets.
* For some companies, the increased prices and tight policy terms the industry has been enjoying may mask operational weaknesses that will be revealed in the coming soft market.
* Investment in performance monitoring systems is essential for insurers to measure and manage changes in their risk portfolios.
* Monitoring systems enable companies to verify their actions, meet their objectives or provide an opportunity to take corrective action before problems linger.
Joy A. Schwartzman is principal and consulting actuary in the New York office of Milliman. Tom Duffy is actuary and risk management consultant in Milliman's Chicago office, and Urban E. Leimkuhler Jr. is manager and senior consultant in Milliman's Princeton, NJ, office.
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|Date:||Nov 1, 2004|
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