The bleedin’ obvious: your price should cover expected claims costs. Actuarial pricing mostly focuses on this topic.
The starting point is often claims history, but this is subject to judgement (was it light or heavy? Has anything changed? What’s inflation doing? Is frequency or severity driving things? Is the history a complete reflection of possible future outcomes? Are there any product or coverage changes? Is the market environment consistent? Have I properly allowed for IBNR? Etc).
Often external data is used to enrich or inform expected losses. With “big data” capabilities widely spread and the digitisation of huge public databases we now find that there is far richer insight from purchased data on risk exposures than insurers can generate internally. (The actual claims history is another matter: insurers generally have to generate this themselves.)
Personal lines pricing focuses particularly on the relative impact of different rating factors. And at the other end of the spectrum heavy specialty risks (excess liability, oil platforms etc) are about ensuring the full extent of the policy limit is allowed for in the price: you’ll often find zero claims history which on its own is clearly not a good guide to the possible outcomes.
In any event, the first building block for pricing is “what is my expected claims cost arising from the prospective coverage period?”
While everyone understands the need to cover direct costs like commissions and claims expenses, other expense items are sometimes underappreciated.
The salary costs of the direct underwriting and actuarial teams doing the work. The salary costs for the functions supporting the business (finance, capital modelling, regulatory and compliance, etc). The overhead costs: every insurer has premises and is managed by a number of quite expensive people! The treatment of things like levies, reinsurance costs, and other regulatory fees. The list is long and your CFO knows it well.
It can get tricky deciding fixed vs. variable, and how a single expense lump should be allocated to individual policies for pricing. But be that as it may it’s a simple concept that expenses need to be considered.
Almost all insurers exist to make a profit, an appropriate return for their shareholders given the risk they take. They hold risk capital on their balance sheet to absorb volatility. The more volatile the business, the more risk capital. Capital must be rewarded (eg 12.5% return on capital to shareholders). And so the more volatile the business, the higher the return margin required.
The tricky bit is allocating the amorphous lump of capital to the sources of volatility in the business. It tends to go a bit like this:
– Risk capital = insurance risk capital + other risk capital
– Insurance risk capital = cat risk capital + other
– Then further allocated to different cat perils, different lines of business, etc.
I’ll give you a made-up example of a company that has material local windstorm exposures. It only operates in this locality, so it cannot diversify its windstorm (catastrophe) risk. For £100m of capital, £65m may be for insurance risk, of which £40m is for cat risk. Suppose this business writes £100m of premium (a 1:1 capital to premium ratio), all equally exposed to the risk of storms. And finally suppose the company has a 12.5% target return on capital for shareholders. Then each policy must have a margin of 5% of premium to cover the return for catastrophe risk. And a 7.5% margin for the rest of the risks. I’m hoping you can see how these margins are calculated.
And, just to be crystal clear, this 5% margin within the premium is purely for the volatility due to catastrophes. It does not include the “long run expected windstorm cost”, which is in the expected losses in section (1) above.
Items (1) to (3) above deliver what we might call the “technical price” (TP) that covers all costs and delivers a return if projected claims are accurate. But no insurer charges the technical price everywhere (or, sometimes, even anywhere). It is a crucial yardstick but in reality the price you charge is the price you can get.
So TP informs decisions like “shall we take this policy on at the offered price?”, and it helps track rate adequacy and rate changes. But this is like the ballast in a ship that is rolling on the waves. The underwriting cycle by line of business, the “invest to grow” challenges, cross-subsidies strategically taken, and accommodation business to invest in a relationship at short term cost: these are all reasons why short run pricing may be inadequate. But over the long term the TP needs to be met and so when opportunities arise good insurers seek to exceed TP: low levels of competition, customer demand exceeding insurance supply, niche products, the upcycle of the underwriting curve, and genuinely insightful risk selection. These are the opportunities to seize counterbalancing the times when pricing is soft.
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