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					Risk Classification & Selection:
The Essentials

                 Legs Insured
                 by Lloyd’s
                 $1 million


RMI 4700
Management of Insurance Institutions
Robert Klein
 8-31-09
Underwriting Essential to Success
• Underwriting in many lines of insurance is the most
  important function of successful insurers.
• It involves determining what exposures will be
  insured under what terms.
• What activities are encompassed within
  underwriting?
• Consequences of poor underwriting?
• Tradeoffs in acquiring information
  & refining risk classifications?
• Advantages gained by “incumbent”
  insurers?
Interaction of Insurer Decisions
• Objective  get on the “right side” of adverse
  selection, i.e., get and keep the “cherries” and stick
  your competitors with the “pits.”
• In dynamic, competitive market buyers should
  gravitate toward insurer who gives them the best
  terms.
• With good information, effective market price for each
  buyer-policy should approximate “expected cost”
  including cost of capital and risk premium.
• Insurers who charge above this price will loose buyers
  and insurers who charge below will get stuck with
  exposures at inadequate rates.
Imperfect Markets
• Information Asymmetries
    – between insurer and insured   Need to optimize
                                    expenditures on
    – between insurers
                                    risk assessment
•   Uncertainty                     with value of
•   Transaction Costs               information.
•   Buyer Inertia
•   Impediments and Constraints
    – capital
    – regulatory
• “Sticky” market may influence insurer behavior.
Information & Adverse Selection
• Adverse Selection
  – Individual will be more inclined to buy insurance at
    rates below expected costs and vice versa.
  – Greater buyer choice contributes to adverse
    selection.
  – Buyer’s risk premium may affect decision if no
    other source of risk transfer is available.
• Significance of Competition
  – How does market competition affect adverse
    selection?
Factors in Success
• Overcoming information problems & pricing risk as
  well, preferably better, than competitors.
• Know your niche!
• Effective use of data and methods, as well as “street”
  knowledge and intuition.
• Keep pace with innovations and changes in individual,
  economic, legal & environmental risk factors.
• Induce insureds to lower risk over contract period.
• Use agent/customer relationships.
• Acquire information on your insureds that is not
  available to competitors.
Specialization vs. Diversification
• Advantages to Specialization
  – economies in information acquisition
  – marketing efficiencies
• Disadvantages to Specialization
  – narrows market
  – vulnerability to mistakes & systemic
    risk; correlated risks?
• Advantages to Diversification
                                           • Other Factors
   – greater independence of risk
     exposures                               • scope economies
   – broader markets                            • risk assessment
• Disadvantages to Diversification              • marketing
   – higher information and marketing        • reputation
     costs
Risk Factors: Cost vs. Value
• Consideration in choosing risk factors
  –   information conveyed by factor
  –   accuracy, e.g., incidence of false indications
  –   credibility of information
  –   access and cost
  –   market, social, regulatory acceptance
• Cost vs. value assessment
  – Some factors would be informative but too costly.
  – Some factors that are less informative may become viable
    because of their relatively low cost, e.g., credit scores.
  – Some low-cost factors may encounter resistance, e.g. credit
    scores.
Innovation: Auto Electronic Monitoring
• Progressive has experimented with pilot program that
  utilizes GPS monitoring in pricing auto insurance.
• Program is voluntary – insureds can elect to enroll in
  this program and potentially receive lower rate.
• Monitoring limited to mileage, where driving occurs,
  and time of driving.
• System could be expanded to include things like
  driving speeds.
• How could such a program encourage self-selection
  by insureds that would be helpful to insurer?
Issues in Growth
• Writing less desirable and/or more uncertain
  risks  are you assuming another insurer’s
  problems?
• Moving into new areas, un-chartered territory.
• Capacity Constraints
  – experienced personnel
  – financial
• SAP Accounting
  – expenses not amortized
  – encourages use of “surplus relief” reinsurance
Underwriting Cycle: Evidence
Underwriting Cycle: Discussion
• Commercial, long-tail lines are subject to alternating
  soft & hard markets.
• In soft markets, insurers cut prices, ease underwriting
  rules, and expand coverage.
• Market does not harden till insurers suffer substantial
  losses that they can longer sustain.
• Loss reserves may be manipulated (shorted) to help
  justify lower prices.
• Cyclical instability drives buyers to ART.
• Why does cycle occur; how can it be mitigated?
Underwriting: Structure & Process
• Structure
  – organization of underwriting units
  – management structure
  – delegation of underwriting decisions
• Process
  –   planning
  –   research, analysis, evaluation
  –   developing strategies, guidelines, rules
  –   assessment of exposures, applicants
  –   underwriting decisions
Process Detailed
• Evaluating loss exposures
• Determining underwriting alternatives
    – Selection, acceptance of risk
    – Pricing
    – Contract terms
•   Selecting an underwriting alternative
•   Determining appropriate premium
•   Implementing underwriting decision
•   Monitoring the loss exposures
Underwriting Decision Considerations
• Underwriting authority
• Supporting business
  – profits on supporting business may offset losses
• Mix of business
• Producer relationships
  – may need to write exposure to keep producer
• Regulatory restrictions
Factors Affecting Underwriting Policy
Property-Casualty                      Staff Functions
                                         •   policy, goals, limits
Staff-Line Structure
                                         •   evaluating experience
                                         •   coverages/forms
         Staff Underwriting              •   rating plans
                                         •   guidelines
                                         •   audits
                                         •   education/training
   Under        Under        Under
                                       Line Functions
  writer A     writer B     writer C
                                         •   classifying risks
                    ?                    •   selecting insureds
Agent role depends                       •   determining coverage
                              Agent
on line & other specifics                •   pricing
                                         •   service
Delegation of Authority
Management     Larger      Higher      Unique
               Exposures   Risks       Exposures




                                      Delegation
                                     Influenced by
                                    Mkt Environment
                                      & Capacity

 Underwriter   Smaller     Lower       Common
               Exposures   Risks       Exposures
Evaluating Underwriting Results
• Contribution of “account” to firm value & risk,
  considering cash flows and timing.
• Measurement Issues            –   lag in claims
   – calendar year vs. policy   –   volatility
     year data                  –   allocating expenses, profits
   – equity in “unearned        –   synergies
     premiums”

                % of
                Ultimate
                Paid
                Loss
Liberty Mutual: CY & AY Loss Ratios
110.0%
                CYLR
                                                             106.1%
105.0%          AYLR

                               98.9%       101.0%
100.0%


95.0%
                           92.7%                    92.7%
          89.5% 89.7%                      92.0%     91.9%
90.0%                              91.4%
                   89.1%   89.4%
                                                                      85.1%
85.0%      84.6%                                             84.1%            85.5%

80.0%

                                                                     74.4%
75.0%
                                                                              75.6%

70.0%
         1995    1996   1997    1998   1999    2000     2001     2002        2003
Non-Financial Measures
•   Selection
•   Product Mix
•   Pricing
•   Accommodated Risks
•   Retention Ratio
•   Success Ratios
•   Service to Producers
The Process in P-C Insurance
• Personal Auto               • Work Comp
  – application                 – NCCI
  – MVR             Role of     – inspection?
                     Agent/
  – C.L.U.E.        Broker?   • Standardized
• Homeowners                    Policies for
  –   application               common needs.
  –   C.L.U.E.                • More Unique
  –   ISO reports               Risks &
  –   inspection?               Contracts for
                                special needs.
“COPE” Model
•   Construction
•   Occupancy
•   Protection
•   External Loss Exposures
Construction
• Construction Classes (ISO)
   –   Class 6: Fire-Resistant
   –   Class 5: Modified Fire-Resistant
   –   Class 4: Masonry Non-Combustible
   –   Class 3: Noncombustible
   –   Class 2: Jointed Masonry
   –   Class 1: Frame
• Homeowners
   – frame
   – masonry
   – fire resistant
Occupancy
• Categories
  –   habitational
  –   office
  –   institutional
  –   mercantile
  –   service
  –   manufacturing
• Contents
• Hazards
  –   housekeeping practices
  –   heating equipment
  –   electrical equipment
  –   smoking
Protection
• Public Protection
  – fire services (10
    classes)
• Private Protection
  – Prevention
  – Detection (e.g., alarm
    systems)
  – Suppression (e.g.,
    sprinkler systems)
External Loss Exposures
• Risk created by
  adjacent/nearby hazards
• Single-Occupancy
  Exposures
• Exposing Buildings
• Other Loss Exposures
• Multiple-Occupancy
  Exposures
Homeowners: Special Considerations
• Type of Construction
• Roof Materials (e.g., wood shingle)
• Hazard Mitigation
  – Wind: storm shutters, roof clips, shape
  – Earthquake: reinforced walls
• Location
• Fire & Police Services
• Special Hazards
  – swimming pool, dogs, etc.
• Home Business
Issues in P-C Underwriting
• As insurers continue to seek to gain an edge, they use
  factors that may encounter public & regulatory
  resistance.
• Examples:
   – location, gender, credit score in auto insurance
   – location, age of home, mkt. value, prior claims, credit score
     in homeowners insurance
   – fewer issues in commercial insurance but there are some,
     e.g., rejections of certain types of businesses
• Use of new information sources
• Use of technology, e.g., GPS monitoring
Credit Scoring in Personal Lines
 • Should insurers use insureds’ credit scores in
   underwriting of auto and home insurance?
How Does Life Insurance Differ?
• Reliance on mortality tables with other factors
  and adjustments.
• Use of medical exams when amount of
  insurance is sufficient to be cost effective.
• Transparency of personal information?
• Individual vs. group underwriting.
• Long-term nature of some contracts with
  provisions to counter adverse selection.
• Concerns about lapse rates, policy terminations
Principles of Life Underwriting
•   Large Standard Group
•   Balancing Size of Substandard Groups
•   Balance within Each Class
•   Equity Among Insureds
•   Social Acceptability
•   Recognize Underlying Loss Assumptions
•   Issues involved with broader versus more
    refined risk classification.
    – credibility and classification costs
    – actuarial equity and competition
Group Underwriting:
Controls on Adverse Selection
• Insurance incidental to
  group
• Flow of persons through
  group
• Automatic determination of
  benefits
                                            • 3rd-Party sharing
• Minimum participation                       of costs
  requirements                              • Simple and
  – Non-contributory = 100% participation     efficient
  – Contributory = 50-75% participation
                                              administration
Factors Affecting Insurability
Life Insurance            Health Insurance
 –   Age                   – Age
 –   Sex                   – Sex
 –   Physical Condition    – Medical Aspects
 –   Personal History         – Medical History
 –   Family History           – Physical
 –   Tobacco Use                Condition
 –   Alcohol/Drugs            – Mental Factors
 –   Occupation               – Family History
 –   Activities            – Financial Status
 –   Residence                – Insurance Plan
 –   Financials               – Insurance to
                                Loss
                           – Occupation
Issues in Health Insurance
• Rising costs encouraged new options & more
  refined risk classification & pricing.
• “New” competitors took lower risk groups &
  individuals from Blues and other plans.
   – ERISA plans subject to less regulation
• “Community Rating” became less sustainable.
• “High-risk” individuals and small groups
  encounter higher rates.
• Federal & state governments seeking solution 
  high risk pools?
• Insurers may be willing to ease underwriting in
  response to new federal health insurance policies.
Genetic & Other Information in
Life and Health Insurance
• Should there be any constraints
  on the acquisition or use of
  genetic information in
  underwriting life and health
  insurance?
• How should electronic access
  to health records be handled?
    How would you gain an
    underwriting edge in:
•   Auto Insurance?
•   Homeowners Insurance?
•   Workers Compensation?
•   Disability Insurance?
•   Term Life with $100,000
    Coverage?

                  Dick Cheney
How will underwriting change in
the future?
• Personal Lines Property-Casualty
  – auto
  – homeowners
• Commercial Property-Casualty

• Health Insurance

• Life Insurance

				
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