Shocking though it may seem to those who think actuaries are pointy-headed geniuses, building technical pricing models isn’t pricing. The price is determined by the underwriter, or often just by what the market can bear. In retail insurance the rating factor relativities do affect price, but even here great levers up and down are deployed to change the level (if not the relativities) of the prices.
Not only is TP distinct from Actual Price (AP), but TP itself is sometimes deficient. Problematical datasets, or not enough data to inform all the complexities we must allow for, mean TP is sometimes not a good predictor of the future claims outcomes.
What is important is the discipline that calculating TP brings. And doing it consistently and each year. And comparing it to AP to deliver a key measure of rate adequacy: AP/TP ratio. And improving it as new information and data emerge. And monitoring rate changes.
Insert TPs and AP:TP ratios into a control process that calibrates results to expectations and refines this over time. This is the sharp end of actuarial work, where analytical insights drive profit (and it is the core of what Calibrant does).
TP is the backbone of professional pricing discipline, even if it’s not how an insurer should actually set their prices. And for this reason, it mustn’t be undermined. External influences (e.g. from premium-hungry underwriters) trying to manipulate TP can be an unedifying sight. “Remove this outlier”, “that claim won’t happen again”, “10% inflation: you’re crazy!”, “the market will never take that price”, and my favourite “can I have an underwriter judgment factor in my pricing tool please?”
These phenomena undermine the value of TP. Accept the weaknesses in TP without subverting it, and allow data and experience to improve it over time. It isn’t the immaculate utterance of a divine oracle. But provided underwriters are engaged, it will help the business monitor and then improve performance.
This question sometimes doesn’t even arise as settled processes are often not challenged. Should the analysis of claims cost and required margins be gross or net of reinsurance (RI)?
Both are possible. If you price net of RI then:
An equivalence is to cover gross claims in (a) and just the margin to reinsurers in (c) – this useful shortcut is sometimes a great simplifier if an assumption like “reinsurers typically make a 50% loss ratio” is reasonable.
If you price gross of RI then reinsurance doesn’t appear anywhere in the (technical) pricing formula and you need to ensure the profit-margin component of TP is based on gross (not net) capital.
One often sees net-of-RI pricing, because capital modelling teams deliver allocations of net-of-RI capital. The assumption here is reinsurance is fixed, a permanent part of the capital structure of the company, in effect.
Well, this is great news for reinsurers! Cedants are buying the cover you sell whatever happens because their processes are geared around it.
If it can be done, it’s sometimes preferable to set gross technical prices and then allow the outwards reinsurance process to make its own evaluation of whether the offered RI is worth the money. Theirs should be a “reverse” technical pricing exercise. For example, even if cat RI is strategically important, its terms aren’t set in stone. Things like the deductible can certainly vary as RI market conditions change and make ceding risk more or less attractive economically.
Failure to hold reinsurers’ feet to the fire will lead long term to greater costs to the cedant.
All lines of business, everywhere, are subject to the underwriting cycle (indeed, each has its own cycle). Capital and appetite respond imperfectly to changes in the supply/demand situation in any given market. This means wider swings in conditions than would happen if markets were perfect.
One thing should be clear: TP must be unaffected by the cycle. The state of the underwriting market does not affect the theoretical calculations of appropriate long term average prices. (I would mention that changes in macroeconomic conditions may affect TP: interest rates, inflation, equity risk premium, etc.)
What should change through a cycle, however, is acceptable AP/TP ratios. To ride the cycle smartly, a good insurer will recognise the need to write less business in the downswing and more in the upswing. Some strong specialty insurers explicitly raise capital after a large cat event to be able to exploit to the full the anticipated few years of rich pickings. And they can return surplus capital to their shareholders (usually to a lesser degree! Nobody likes to shrink) in various ways in downswings.
What is going on is this: where AP/TP ratios are high, write more business; when AP/TP ratios are low, write less. This is where robust AP/TP and rate change analysis informs strategy.
How to write less business when rates are soft? Generally this is focusing on the core business where the greatest franchise value is held. Cutting back on line sizes, tiering the portfolio and trying to exit the least attractive business.
Well diversified insurers may also be able to tweak the balance of their portfolios from areas where the (local) underwriting cycle is in a soft phase to those where it is harder.
In any event, the AP/TP ratio should be an indicator for insurer appetite: when it’s high, be hungry, and vice versa. Insurers where pricing strategy informs business strategy will anticipate these movements, operationally prepare for them, and actually think about forecasting the underwriting cycles.
Imagine you have a nice portfolio of business making reasonable profits. Covering all expenses, including overheads. The portfolio AP/TP is 1 or greater.
Along comes an opportunity that covers its claim costs, required profit margin, and direct expenses – but only half the overhead expenses.
It’s irrational to fail to write this business. The overheads are fixed (in the short term, at least) and one more bit of business doesn’t increase overhead expenses. So it will improve profitability.
But it has AP/TP ratio below 1. If overheads amount to 6% of premium, its AP/TP is 0.97.
It is valuable at the margin, but not on a standalone, absolute, evaluation. Some insurers evaluate business on this basis, and call the concept “contribution to overheads” (CTO) – here, we would have a CTO of 3% as the business covers 3% part of the 6% overheads.
Suppose we hold this piece of business to this standard: it’s surely not fair to hold the rest of the portfolio to a higher standard. But down this path madness lies: taken to its logical conclusion, we will find we are targeting an AP/TP of 0.97 overall.
Squaring this circle isn’t easy. Should we literally hold different standards for business depending on when they join the portfolio? Is it fair then to propagate these different standards through renewal cycles? Should we have a core/ancillary approach to the portfolio? Should we accept business into the portfolio at a lower profit standard, then expect higher standards at renewal? (This latter is a solution that the UK regulator has banned for personal lines business: it rewards customers who seek the cheapest price each year, constantly being a new customer, at the expense of those whose inertia binds them to one insurer.)
Of course, in the medium term overheads are not fixed. As you grow your business you need more staff to oversee it and you need bigger premises. So perhaps in anticipation you should require a full overhead load to be included in the price. But then that profitable opportunity goes tantalisingly begging…
One could argue that the same argument applies not only in the overhead load but in the cost of capital too. If a proposed deal generates a positive return less than the overall target (say 2.5% return when 12.5% is the target) one could again argue that the short run effect despite profit shortfall is to improve performance. The parallel to the argument “overheads are fixed in the short term” would be “capital is fixed in the short term”.
But I think this is much more dubious. While actual balance-sheet capital is fixed in the short run, risk-based capital is not, and such business will dilute returns on risk-based capital. This is a metric that is closely monitored (at least by proxy: solvency capital ratios are routinely reported). Best to avoid this approach.
A really smart insurer would include an articulation of its approach to these subtle challenges within its overall pricing strategy. I must confess I haven’t often seen this done! I think pricing is generally too rough-and-tumble in practice to address these kinds of refined strategic points.
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