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This article originally appeared in the August 2009 edition of ISO Review.
Feature Story:
Back to Basics: Knowing the Risk
by Kevin Kuntz, Assistant Vice President of Product and Services, Risk Decision Services
In this challenging time of financial volatility and market uncertainty, the need is critical for property/casualty insurers to have property underwriting units lower their loss experience and generate underwriting profit. To achieve those goals, each insurer needs to focus on the long-standing underwriting practices of risk selection and proper pricing or, expressed another way, “know the risk” to be insured. The concepts of risk quantification and identification are fundamental to insurers’ enterprise risk management (ERM) efforts.
A review of underwriting performance over the past 40 years indicates that the combined ratio for the industry fell below 100 just eight times. In fact, the industry’s combined ratio exceeded 100 every year during the 1980s and ’90s. The losses have been driven by challenging market conditions, a soft market that placed pressure on product pricing, large and more frequent than expected catastrophic weather losses, and, most recently, major losses incurred by mortgage and financial guaranty insurers. In 2008, the industry recorded a net underwriting loss of $21.3 billion, a $40.6 billion adverse swing from the $19.3 billion in net gains on underwriting in 2007. The combined ratio — a key measure of losses and expenses per dollar of premium — deteriorated to 105.1 in 2008 from 95.5 in 2007. Insurers were able to maintain profitability because of investment gains that typically more than offset underwriting losses.
The financial crisis and recession have had a significant impact on investment gains. The property/casualty industry’s net investment gains plummeted to $31.4 billion in 2008 from $64.0 billion in 2007, as net investment income dropped to $51.2 billion from $55.1 billion and insurers suffered a $28.7 billion swing to $19.8 billion in realized capital losses on investments from $8.9 billion in realized capital gains.
The deterioration in investment results increases the pressure to generate profits on underwriting. To achieve and then sustain a profitable operation, we believe the secret for success is a rekindled focus on the underwriting fundamentals of risk selection and effective pricing. Key to this effort is the collection and processing of quality data about the risk you’re insuring and effectively evaluating the risk using the various analytic tools available today to assist in risk selection. Of primary importance in achieving underwriting profitability is the determination of accurate information about the risk, what goes on in the risk, and what exposes the risk. In particular, for large commercial property business, the ability of insurers to understand the exposures existing at the risk, not just electronically process the policy, is critical. Those principles also align with key ERM strategies. Risk models can be part of the process, but an overreliance on the models is a major reason losses have risen.
Using commercial property insurance as an example, the key rating elements are construction, occupancy, protection (internal and external), and exposure information — also known as COPE. Insurers have a variety of methods for obtaining all or part of this information, including agents, information systems, tax assessor data, and on-site inspections and surveys. The different sources vary significantly in quality, accuracy, and completeness.
You can obtain the highest-quality information (best predictor of loss) by site-verified data collected during surveys and inspections prepared by experienced and trained loss control representatives. Not everyone who prepares on-site surveys has the right competencies to capture complete and accurate information from the risk in question. It is important to assess each inspection company thoroughly in terms of staff skills and competencies. Otherwise, the information acquired may be incomplete, making risk evaluation less successful. As we have suggested, “know the risk.”
Information developed on-site incorporates the technical aspects of national codes and standards and loss control fundamentals in general. Another benefit of basing decisions on data collected through on-site surveys is making the underwriter aware of unusual or imminent hazards at risks in an expeditious manner. To maximize the value and utility of the data and analytics, it is critical that loss control personnel collect, analyze, and transmit the information consistently to the underwriter. Speed is essential, as it will facilitate the assimilation of data into the underwriting process. To that end, robust training and quality development programs must be regular components of inspection and loss control services.
Selection of loss control vendors is critical. There is a real difference between simply checking a box indicating that building management has installed a fire sprinkler system versus providing a detailed analysis that evaluates whether a sprinkler system has an adequate water supply and is suitably designed, installed, maintained, and inspected. Getting the full picture is important for a complete and thorough analysis. That enables underwriters to select the best buildings for insurance. Choosing good risks lessens the chances for loss.
The current financial turmoil amplifies the benefit of accurate, site-verified data. Some issues of concern that can influence the loss history for a risk include:
- occupancy changes
- change in exposures
- vacant building
- deferring maintenance of building, machinery, equipment, and fire-protection systems
- insurance to value
You also need quality data for natural catastrophe models. A recent study indicated a 20 to 40 percent discrepancy between actual and modeled natural catastrophe events. Data collected on-site provides the only truly reliable method available to input into models. Increased reinsurance costs and lack of currently available capital market support make obtaining accurate natural catastrophe exposure data a worthy effort.
In summary, the current economic turmoil and the associated lack of investment income makes underwriting profitability critical. To achieve that goal, insurers need to base risk selection and pricing on sound underwriting principles and ERM while also incorporating quality data and analysis.
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