Insurer Pricing • Insurance rates, like other prices, are a function of costs. • In insurance, unlike other industries, the costs are not known when the product is sold. • Insurance prices are based on predictions. • A second important difference between pricing in insurance and pricing in other fields is that insurance rates are subject to government control. 11-1
Basic Concepts in Ratemaking Rate
Price charged per unit of protection
Premium
Rate multiplied by the number of units of protection purchased
Gross Rate
Composed of two parts, designed to pay losses and expenses
Pure Premium
Portion of the Gross Rate designed to pay losses
Loading
Portion of Gross Rate designed to cover expenses of operation 11-2
Pure Premium Total Losses Exposure Units
=
Pure Premium
=
$30
$3,000,000 100,000
11-3
Converting Pure Premium to Gross Rate
Expense Ratio:
Expense part of the rate expressed as percentage of the final rate
Permissible Loss Ratio:
1 minus expense ratio
Gross Rate:
Pure Premium 1 _ expense ratio
$ 30 1 - .40
=
30
=
$50
.60 11-4
Advisory Organizations 1. Formerly called “rating bureaus” 2. Operate in property and liability field 3. Gather loss statistics and publish trended loss costs 4. Major Advisory Organizations include ISO Insurance Services Office AAIS American Association of Insurance Services NCCI National Council on Compensation Insurance 11-5
Types of Rates 1. Class rates 2. Individual rates •
judgment rating
•
schedule rating
•
experience rating
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retrospective rating 11-6
Adjusting the Level of Rates Actual - Expected Loss Ratio_____Loss Ratio Expected Loss Ratio
Credibility
X
Factor
=
Adjustment
.90 -
.60
X
.50
=
+.25
.60 11-7
Underwriting 1. Basic purpose: avoid adverse selection 2. Relationship of underwriting to adequacy of rates 3. Exposure that is unacceptable at one rate may be acceptable at another
11-8
Sources of Underwriting Information 1. The application 2. Information from the agent or broker 3. Investigations 4. Information bureaus 5. Physical examinations or inspections
11-9
Postselection Underwriting 1. Postselection underwriting (or renewal underwriting) occurs when the insurer decides whether to continue insurance. 2. Insurer may decline to renew insurance or may offer narrower coverage. 3. Some states limit the insurer’s right to exercise these options. 4. When the option of postselection underwriting is limited, insurers may be more selective in initial underwriting. 11-10
Competition in the Insurance Industry Competition within insurance industry is intense. The competition occurs in two areas: 1. Price 2. Quality
11-11
Price Competition 1. Price competition occurs primarily at the company level, where prices are set. 2. Agents compete on basis of price in selecting the companies they will represent. 3. Price of insurance is a function of costs. 4. To the extent an insurer can reduce its costs below those of competitors, it can offer a lower priced product. 11-12
Costs Common to All Insurers 1. Losses and loss adjustment expense 2. Acquisition expense 3. Administrative expense (company overhead) 4. Taxes 5. Profit and contingencies 11-13
Product (Quality) Competition 1. Insurers compete on basis of quality by offering broader forms of coverage and prompt claim service. 2. Most quality competition occurs at the agency level where the level of service can differ significantly. 3. Service provided by the agent consists principally of advice on coverages, companies, costs, and claims. 11-14
Insurance Shortages •
As in any competitive market, periodic imbalances arise between the demand for insurance and its supply.
•
As a consequence, there are occasional shortages of insurance, which are referred to as “availability problems.”
11-15
Insurance Shortages Insurance shortages or availability problems arise for three reasons. • The absolute supply of insurance is limited. • Some lines of insurance are unprofitable. • The insurance market is highly cyclical.
11-16
Insurance Shortages Absolute Limits in the amount of insurance •
Insurers are limited in the aggregate amount of insurance they may write by regulations that dictate the relationship between premiums written and insurers' surplus.
•
An underwriter who must accept some risks and reject others will accept those that have the greatest likelihood of yielding a profit.
11-17
Insurance Shortages Unprofitability of some lines of insurance. •
Availability problems arise when the price at which insurance may be sold is less than the costs incurred by selling it.
•
There are some lines of insurance that are demonstrably unprofitable for insurers. This usually occurs in markets where rates are rigidly regulated but it can also arise from the intensive competition. 11-18
Insurance Shortages Cyclical Nature of the Market •
the cyclical nature of the insurance industry creates periodic shortages of insurance.
•
The insurance cycle results in changes in insurers' surplus and profit. When surplus falls, the supply of insurance is reduced and insurers become more restrictive in their underwriting, limiting availability.
11-19
The Insurance Cycle •
The property and liability industry is highly cyclical, and goes through periods of underwriting profit, followed by periods of losses.
•
The insurance market is characterized as “hard” or “soft,” depending on the phase of the cycle.
11-20
The “Soft” Market •
During periods when insurers are earning underwriting profits, the market is said to be “soft,” as insurers engage in price cutting to increase their market share.
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The price cutting includes not only reduction in the absolute level of rates, but the loosening of underwriting standards.
11-21
The “Hard” Market •
This has the natural result of generating losses and reducing surplus.
•
The reduction in surplus and decline in profitability results in a “hard” market, during which insurers increase prices and tighten underwriting standards.
•
Insurance becomes more expensive and more difficult to obtain.
11-22
Responsibility for the Cycle •
The suggestion that the underwriting cycle results from mismanagement in the insurance industry ignores the fact that in a competitive market, competitors do not set the market price.
•
Insurers cut prices not because they want to, but because they are required to by the pressure of market forces. Often, these pressures stem from forces outside the industry itself 11-23
Cash-Flow Underwriting • Dependence on premiums for investable funds led to phenomenon called cash-flow underwriting. • In cash-flow underwriting, insurers price insurance to compete for investable funds. • Cash-flow underwriting is a form of leveraged investment that has benefited insurers. 11-24
Access to the Insurance Market Risk managers who decide to transfer part of the organization’s risks to a commercial insurer will generally access the insurance market through an insurance agent or broker. 1. Most states require that insurance be placed through a licensed agent or broker. 2. Even if this requirement did not exist, risk managers would still access insurers through agents or brokers to access the market knowledge of the agency or brokerage firm.
11-25
Selecting an Agent or Broker •
It is easy to inventory the characteristics one should look for in an agent or broker.
•
It is more difficult to guarantee that the agent or broker selected will have these characteristics.
11-26
Selecting an Agent or Broker Desirable Characteristics • The most important qualities an agency or brokerage firm can offer are a competent staff and access to insurance markets. • In many cases, the selection is made on the basis of the agency’s reputation. • A prudent buyer will investigate the agent’s or broker’s qualifications before making a commitment. One logical step is to ask for references. 11-27
Selecting an Agent or Broker • The main service the agency or broker can provide is technical competence and advice. • Given the importance of technical competence and knowledge, many buyers focus on the education and training of the agency’s staff. • Professional designations as CPCU, CLU, or ARM.
11-28
Selecting an Agent or Broker •
Another indicator of the agency’s technical competence is the types of accounts that the agency currently handles.
•
An agency with many large accounts is more likely to have the technical expertise, market channels, and services that are required to provide the level of service required.
•
Another consideration is familiarity of the agency staff with the buyer’s particular industry. 11-29
The Selection Process • Usually, relationships between buyers and agents or brokers develop over time and continue uninterrupted as long as both parties are satisfied with the arrangement. • Some firms solicit bids for their insurance and select the agent as a byproduct in the selection of the insurance. • Most authorities suggest that the selection of the agent or broker is sufficiently important to warrant separate consideration. 11-30
Compensating the Agent or Broker •
Traditionally, virtually all compensation to agents and brokers was in the form of the commission payable by the insurer.
•
This was logical, since the agent or broker was viewed primarily as a salesperson for the insurer, and like other sales personnel was compensated on the basis of performance.
11-31
The Selection Process •
One approach to selecting an agent or broker is a “beauty contest,” in which a number of agencies and brokers are invited to make proposals to the organization.
•
In some cases, the bidders are asked to submit an insurance program. In other cases, the focus in on the selection of the intermediary, and the structure of the program is addressed separately, after the agent or broker has been selected. 11-32
Fees Versus Commissions • Buyers argued that the commission system was flawed for several reasons. • Under the commission system, the agent’s compensation varies with the insured’s hazard, not with the work that is required of the agency. • Dissatisfaction with the commission system and changes in the rate regulation led first, to negotiated commissions, and then to a fee system for some larger accounts. 11-33
Fees Versus Commissions •
While fixed commissions remain the rule on small accounts, for larger accounts fixed commissions are the exception rather than the rule.
•
For very large accounts, the insurer may quote coverage on a net basis, without an allowance for the agent’s commission. The agent then negotiates directly with the client, usually for a fixed annual fee for handling the account. 11-34
The Excess and Surplus Lines Market •
Under certain specified conditions defined by state instance laws, nonadmitted insurers are allowed to write insurance in a state where they are not licensed.
•
When a buyer cannot obtain needed coverage from a licensed insurer, such coverage may be placed in the nonadmitted market under laws relating to Excess and Surplus Line Laws. 11-35
The Excess and Surplus Lines Market •
Coverage may be placed only with nonadmitted insurers approved by the state (or not “black-listed.”),
•
All states require the payment of an excess and surplus lines tax, which is collected by the agent and paid to the state.
•
Agents must usually hold a special “excess and surplus lines license” to place business in nonadmitted insurers. 11-36
Access to the Non-Admitted Market The non-admitted market abroad can be approached in several ways. • A buyer can go directly to a London broker or a non-admitted insurer and buy coverage. • The insurance may be placed with any agent or broker holding an E&S license. • Insurance may be placed with a managing general agent (MGA), who acts as a wholesaler in the E&S market. 11-37
Access to the Non-Admitted Market •
Normally, a buyer accesses the E&S market through an agent that is specifically licensed to place business in the E&S market.
•
An excess and surplus lines license is required for placement in the nonadmitted market.
•
Specialty agents and brokers known as managing general agents (MGA) serve as wholesalers for the E&S market.
11-38
Consent to Rate Laws •
One reason nonadmitted insurers are willing to write business that admitted insurers reject is that the nonadmitted insurers’ rates are not subject to filing and approval.
•
To create equity, many states have enacted “consent to rate laws,” under which an admitted insurer can charge a higher rate than the filed rate at the request of the insured.
11-39
Selecting the Insurer •
The insured may receive assistance from the agent in selecting an insurer if the agent represents several companies.
•
In choosing an insurer, the major consideration should be financial stability.
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In addition, the company’s product line and ancillary services (claims, loss prevention)are important.
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Finally, cost is a consideration. 11-40
Insurer Rating Services •
Alfred M. Best Company
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Standard and Poor's Corporation
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Moody's Investors Service, Inc.
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Duff & Phelps/MCM Investment Research Company
•
Weiss Ratings, Inc.
11-41
Insurer Rating Services •
Each of the rating services uses a slightly different classification system, and the categories have slightly different designations.
•
All rating services, however, distinguish between insurers whose financial condition is deemed adequate and those insurers that are classified as vulnerable or weak. 11-42
Insurer Rating Services •
When properly used, the ratings assigned by rating services can be effective tools for avoiding delinquent insurance companies.
•
The ratings should be checked for a period of years.
•
If there has been a downward trend in the rating, further investigation into the cause of the change is warranted. 11-43
Competitive Price Quotations •
•
•
Usually, the agent or broker who handles an account will shop the market and obtain quotes from insurers the agency represents. Occasionally, a buyer wants to seek bids more widely, either for a particular line of insurance or for its entire account. Obtaining bids is a reasonable way of fostering price competition among insurance agencies, but attempting to obtain bids whenever a policy comes up for renewal is impractical. 11-44
Competitive Price Quotations •
A company that requests bids annually is likely to find that after the first few years, few insurers are willing to prepare serious proposals.
•
As a general rule, requests for bids should not be undertaken more often that every three to five years.
11-45
Approaches to the Bidding Process Two basic approaches in a bidding process. •
Selected agencies are asked to propose a program, and are given flexibility in the design of coverages they recommend.
•
Under the second approach, the agencies are asked to quote a specific package of coverage, in which the coverage specifications are tightly defined.
11-46
Agent of Record Letter •
Insurers decided long ago that they did not want to be put in the middle of two of their agents, both of which want to bid on a particular account.
•
To eliminate the dilemma they might face in choosing one of their agents over another, insurers devised the Agent Letter of Record, a letter from a prospective buyer instructing an insurer to recognize a particular agent as its agent “of record.” 11-47
Agent of Record Letter Once a particular agent has been so designated, the insurer will not entertain applications for the account from other agencies unless and until the insurance buyer has changed the agent of record.
11-48
Agent of Record Letter •
In a bidding process, the organization seeking bids must name each of the bidders through an agent of record letter for the insurers they propose to use.
•
Usually, each agent or broker submits a list of insurers he or she plans to use, listed in order of preference. The risk manager then gives letters of authorization to each broker for those companies he or she appears best able to represent. 11-49