The Commercial Lines Roller Coaster

Roller coasters. We all love them. Happy memories of thrilling days at the amusement park, all smiles and fun. The commercial property and casualty industry, however, is on another kind of roller coaster ride that isn’t anywhere near as enjoyable and doesn’t usually have a happy ending. If the past is any predictor of the future, we may be in for a rough ride.

Insurance is one of the few businesses in which you sell your product today, but don’t know your true cost of goods sold for years to come. Nowhere is that more true than in commercial lines. In an industry of estimates, it can be very dangerous when key drivers of profitability are not properly understood; this can lead to significant price volatility for insurers, brokers and, unfortunately, policyholders.

So why is there such volatility in the commercial marketplace? If you exclude some major but generally uncontrollable factors such as interest rates, inflation, catastrophes and regulatory and legal changes, competing rate strategies are largely driven by a combination of financial structure and operational sophistication. Different financial drivers such as return on equity goals, operating and investment leverage and economies of scale can create very different approaches. Likewise, distinct competitive pricing advantages can be derived from an insurer’s level of operational sophistication in areas such as target market and underwriting expertise, data management, commercial claims skills, rate adequacy processes and pricing segmentation. Together, these factors provide a basis for deliberate decision-making and guarantee there will always be commercial insurers offering different prices to consumers, as it should be. But when key elements within the operational environment are weak, specifically rate adequacy processes, the result can be poorly-informed business decisions that can lead to considerable price volatility.

ROOT CAUSES

In the absence of strong rate adequacy processes, companies typically rely on income statement metrics such as calendar year loss and combined ratios to determine account prices. Unfortunately, these are not designed to assess rate adequacy on a given portfolio (let alone account). The result can be a distorted understanding of historical underwriting profitability and the incorrect belief that there is ample room to cut rates or, conversely, a strong need to raise them. Regrettably, the commercial industry has a long way to go before sophisticated commercial rate adequacy processes are fully developed, let alone integrated into underwriting decisions. When done properly, that integration provides powerful tools to support underwriters’ expert skills, judgment and understanding of exposures on individual accounts. Commercial underwriting will always be a blend of art and science, but it can’t work properly without both parts.

THE COSTS OF GETTING IT WRONG

Another critical aspect in understanding rate adequacy is the ability to distinguish between changes in price and rate. Some companies may only be able to measure commercial lines price changes as opposed to true rate changes. A commercial account’s price in premium dollars may increase from one year to the next, but if the true exposure increases, or if terms and conditions weaken, you may actually be left with a rate decrease. Now multiply this by thousands of commercial accounts. How does the insurer add up the true rate changes to see in a timely manner if the portfolio is rate-adequate or not? Without strong rate adequacy processes, an insurer simply doesn’t have the ability to prospectively make the changes to rate levels it needs to ensure it meets its profitability targets.

Compared to personal lines, commercial price volatility can be huge and is one of the leading causes of consumer mistrust and the poor credibility of our industry. Consumers tend to incorrectly assume the insurance industry is made up of large companies that are all equal and infinite in their sophistication. So if one insurer discounts the expiring price of another by 30%, it’s easy to see how the consumer could feel like the incumbent insurer ripped them off. How can a broker explain to their client an insurance company may have unknowingly offered rates far below cost? If an insurer knowingly sells its product below cost for reasons known only to them, that’s a proprietary business decision that fosters healthy competition. However, poor management practices that lead to unintentional underwriting losses can result in serious volatility for policyholders and brokers over time. In addition to seeking substantial rate increases in an attempt to make up for having underpriced their products in prior years, insurers sometimes decline to renew policies. Or worse, insurers have even withdrawn from particular lines of business outright, causing tremendous upheaval in the market.

Anti-selection is another, less obvious risk. Without a proper rate adequacy structure, an insurer won’t know how to selectively apply desired rate changes on an individual account basis to meet their overall portfolio profitability goals. As a result, a common but misguided solution is the implementation of across-the- board rate changes, which generally don’t work well in commercial lines. They usually result in anti-selection, which is, in essence, losing your best accounts due to over-pricing while under-pricing and retaining your poorest performers. In addition to hurting the insurer, it’s easy to see how policy holders may find these underwriting decisions very confusing, ultimately affecting the credibility of the company and industry as a whole.

GROWING AWAY FROM PROBLEMS

All of these issues can be further compounded by an insurer’s desire to deploy excess capital through top-line growth, usually in the form of volume or market share targets. Insurers may choose to focus heavily on the top line for many reasons. They may feel they can better manage their expense ratio by increasing the denominator (premium volume). Unfortunately, this is usually self-defeating: without strong rate adequacy controls, the loss ratio usually rises more than the expense ratio declines. Or, a company may be using growth to improve combined ratios in the short term, as rapid premium growth will, for a while at least, outstrip the claims and expense growth that will inevitably follow. Dangerous practices such as bonuses tied to commercial lines volume or market share growth can multiply the problem even further. Although each of these decisions is up to the individual company, a major impact of not being able to truly manage rate adequacy is undoubtedly increased price volatility. Growing in the insurance business has always been easy, but the ability to effectively manage underwriting profitability is a very different story.

THE VIEW FROM THE TOP OF THE ROLLER COASTER

So how is the commercial property and casualty marketplace doing today? That depends on how you measure underwriting profitability. Many companies have had favourable claims reserve development relating to recent hard market years, significantly lowering current calendar year combined ratios. When you remove the masking effects of the favourable reserve development, the industry may not be nearly as healthy as it appears. This trend may only get worse if the severe competition experienced in the large account segment begins converging on the small to mid segments, as by some accounts it now appears to be doing in the United States.

Increasing combined ratios and declining ROEs may be just the beginning. We’ve had a number of years with lower-than- average claims costs, lulling much of the industry into a sense of calm, but that party seems to be ending. Combined with investment returns that are modest at best, the importance of having the tools to manage underwriting profitability becomes even greater. Many commercial segments are now into multiple years of compounding rate d ecreases, while terms and conditions are starting to weaken. Yet the industry is sitting on peak levels of excess capital and it seems that everyone wants to grow. Remember that sinking feeling you had as a kid at the top of the roller coaster, just before that first dip? Me too.