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Price Isn’t Everything

Michael Gertsch, chief underwriting officer at Gulf Re, comments on the lost art of underwriting and calls for a revision of current practices in his regular column.

There is a lot of talk about the current insurance pricing levels in this region and how that would prevent a continued profitable growth of our industry. Sure, rates are low across all product lines compared to most areas of the world, but then what are we actually comparing? Premium rates are, in essence, made up of losses, acquisition costs, expenses and profit margin. While the latter three are relatively easy to work out, it gets a little more complicated with the loss part. To analyse the true loss cost of a given product you need a great number of homogenous contracts within a similar environment and look at the loss frequency and severity over a relatively long period of time.

In an emerging market such as ours, that is sometimes almost impossible to achieve as either the number of contracts within a certain class is not large enough to give credible data or the observation periods are too short to draw meaningful conclusions. So we have to either revert back to data from developed markets or try to adjust our own data for insufficient credibility. Using loss data from developed markets for energy-related risks, for example, would not do justice to most of the accounts in the region that have been built up over the past couple of years. The overall higher risk quality, which ultimately leads to a lower loss ratio, would not be appropriately reflected. Looking at the losses that have occurred in our region, on the other hand, would produce ratios that are way below anything reasonable as the exposure and potential for large losses are still there. If history tells us one thing then it is that bad things do happen, no matter how much care is taken. The question is just when. Bearing that in mind, the challenge is to be prepared for it and price for it. But if the sum of small, attritional claims takes up most or all of the loss ratio priced for within a premium rate, then there is no margin for significant losses, which our industry really should respond to.

The natural conclusion then would be to either increase rates, reduce expenses or underwrite for no profit and use the cash generated to invest in financial markets and hope for the best. Cash-flow underwriting certainly is not an option these days; it’s what got us in this situation in the first place. Managing expenses is always advisable but often interpreted as an excuse to lay off staff, which really is a double-edged sword. While people are the biggest expense contributor of any insurance or reinsurance company, they’re also the biggest assets and without them, how should one continue operating and service clients?

So what’s left is increasing rates which, as we know, is one of the most difficult changes to implement in a market that is saturated with capacity. And whenever market forces dictated rate increases in the past, such as after the events of September 11, it usually only lasted for one year or two until revived competition led to an erosion of pricing levels and the industry was back to square one. At a recent conference there was a lot of debating and finger-pointing as to who was responsible for these developments – the insurers for undercutting each other’s terms or the reinsurers for blindly supporting these behaviours with an ever-increasing amount of capacity. Probably both. And the only ones profiting are the policy holders.

But why leave the insured out of the equation and not hold them accountable for the protection of their assets? The most effective corrections that can be made are increasing the deductibles and consumer studies have shown that someone is much more likely to accept a higher deductible than a higher upfront cost.

Those insureds who have proper risk management measures in place and are therefore able to afford higher deductibles, will not only benefit from a greatly reduced loss probability as a consequence of their actions, but also deserve to enjoy lower rates. But those who don’t will have to contribute towards higher premium rates and retain higher deductibles until they achieve a level of risk quality where reductions are justified. The direct effects for insurers are not only decreasing loss ratios, but also reduced expenses as the administration of all these losses is very labour intensive. Both contribute to an immediate higher technical profitability.

The Scandinavian market adopted and perfected that model in the early 1980s following a series of significant losses, which caused the leading insurance companies to almost collapse and premiums to sky rocket. These high rates hurt the economy badly and the only way to reduce them was to impose higher deductibles. Major investments were then made to improve risk quality, and consequently pay less premiums, but at a higher profitability. Yes, it is today one of the most competitive markets in pure rate terms, but it since had an outstanding performance in terms of loss frequency and severity.

It’s a very simple approach, but one that works.