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| Dr. Shaun Wang |
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Robert Faber |
This article was adapted from one section of a paper entitled “Enterprise Risk Management for Property-Casualty Insurance Companies.” That study was jointly commissioned by the Casualty Actuarial Society, the ERM Institute International and the CAS/SOA Risk Management Section. The full paper is available at www.risklighthouse.com and www.ermii.org.
Since Enterprise Risk Management (ERM) came into vogue, thousands of words have been written discussing the concept. For property/casualty companies, much has been written and debated as well on ERM, including the benefits of size and diversification.
Our paper, “Enterprise Risk Management for Property-Casualty Insurance Companies” (available at www.risklighthouse.com) analyzed some of the factors, including company size, that impact the implementation of ERM.
Rating agencies and consulting firms often preach the benefits of diversification as a means to reduce or mitigate risk. The question for us was whether size and diversification are truly beneficial to the management of enterprise risk in a P/C carrier.
Before addressing the question, it is important to recognize the differences between insurance and most other industries.
The fundamental business of insurance is to accept risk from others. This entails establishing the “quality” of a risk, defined as its likelihood of loss in comparison to other risks in its class, and putting a price on it. The pricing of a risk also involves projecting losses occurring under one policy period but litigated in later years.
Even reserving problems, which have plagued the industry, usually start out as inadequately priced business.
Issues discussed as ERM problems in other businesses pale in comparison to the underwriting/pricing risk in the insurance industry.
Insurer insolvencies have almost always been the result of underpriced business or poorly managed catastrophe exposure. Rarely do they result from investments or operational failings.
The real enterprise risk needing to be managed is the one that takes place at the underwriter’s desk.
Diversification in the insurance industry means taking on additional risk that may have significantly different characteristics from what a carrier is accustomed to.
Ideally, a diversifying line of business should have different loss drivers, but unfortunately is often subject to many of the same market conditions, which can reduce the positive impacts. One of the key costs of diversification can be movement away from a company’s knowledge base, increasing the risk.
Diversification and size can affect the underwriting/pricing operations.
Size clearly creates economy of scale and ultimately a larger propriety database, which provides more information for underwriting decisions.
However, the database can only yield better decisions if the decision maker, the desk underwriter, is able to access, understand, and act upon the information.
Large personal lines companies have utilized databases to identify key, distinctive factors between risks, thereby creating an underwriting process that is mostly untouched by individual underwriters. In casualty lines, this has led to very solid, stable results.
The operating results of commercial carriers in the past cycles have been volatile, however, suggesting that diversification and size have not helped in the management of the underwriting risk.
Our analysis of general liability and workers compensation results produced some interesting observations.
We focused on these casualty lines to remove the variability of natural catastrophe losses. As part of our research, we analyzed results from eight large commercial carriers, seven jumbo regional carriers, and 14 smaller carriers.
The smaller carriers consisted of companies that wrote at least $10 million annually in general liability and workers comp, and had been writing for at least 20 years. All of the data utilized was from public databases, including the NAIC database.
The general liability results in Exhibit A demonstrate that the larger carriers actually have a higher loss ratio. Also, there is no improvement in variability or volatility as size increases. In fact the opposite appears to be true.
This seems to contradict the Law of Large Numbers upon which the business of insurance is supposedly based.
Even more striking is the general liability loss development by size of company, shown in Exhibit B.
Given the huge differences in premium volume, staff, and data between the large and small companies, one would expect that larger companies would have a lower variance in loss ratios and a greater ability to predict them accurately. Instead, we see the opposite: Regional and smaller companies show more stable results.
One possible explanation for this unexpected observation is that larger carriers are writing general liability policies with high limits. Perhaps, but a similar analysis of workers comp, a more regulated line with statutory limits, produces almost exactly the same results.
Given this data, several observations come to mind.
Volatility appears to be much less a function of size than might have been previously thought. Even smaller companies with books of only in the tens of millions appear to have the same volatility, or credibility, as companies fifty times their size.
Expressed another way, a company may achieve credibility in a book of business much sooner, at a much smaller size, than generally believed. This may be even more the case when one factors in reinsurance, an added buffer against volatility.
In loss ratios, the smaller and regional carriers outperform the larger carriers in almost every case.
Even more striking is the accuracy of regional and smaller carriers in predicting their loss ratios, virtually avoiding the under-reserving problem associated with the soft markets of the 1990s.
This accuracy in predicting loss ratios is done often with minimal assistance from in-house actuarial staff. Often, the smaller companies only employ outside consulting actuaries to establish reserve levels.
Since the loss ratio selections are usually within a relatively tight band and a year’s expiration, the best explanation for this sound performance is that regional and smaller carriers preserved adequate pricing levels through the soft market.
Our analysis found some softening in rates by smaller and regional carriers but, unlike their larger counterparts, they did not engage in significant under-reserving. The worst case seems to be the smaller and regional carriers losing what redundancy they may have had in their loss ratio picks during a soft market.
One should be able to infer from the data, particularly the loss development exhibits, that smaller carriers and jumbo regionals maintain a strong pricing discipline.
We acknowledge that large companies often write the most volatile risks, and that we did not study smaller carriers that compete directly with large carriers for complex risks and more volatile business.
Weighing against that, however, is the fact that large carriers have made a big investment in developing sophisticated pricing models, assembling strong actuarial teams, and hiring experienced underwriters to transact more challenging business. Clearly, these investments were not up to the task of rate adequacy in the softening market.
Perhaps broad diversification in larger companies has diminished the level of underwriting risk knowledge, limiting the intrinsic advantages of size and databases.
In our paper, we suggest several issues that may be negatively impacting the larger companies:
- Larger, more diversified companies write much more heterogeneous business.
- Pricing of the risks is much more complex due to deductibles, self insured retentions, and other factors.
- True exposure pricing is more difficult, given the diversity of exposures within a large risk.
- Underwriters do not see the same risk over a period of years. As a result, underwriters may become quite experienced in the business generally, but not in the company’s particular book of business.
- Large clients have more bargaining power.
- Larger risks may draw more competition, creating the dangers of “winner’s curse.”
Based on our interviews, smaller companies seem to have several intrinsic advantages:
- Pricing options are more limited and controlled at the underwriter’s desk.
- Pricing relies very heavily on exposure rating rather than experience rating.
- Higher deductibles, self insured retentions, composite ratings are sparingly employed.
- Underwriters seem to understand their own book of business more thoroughly, even if they are less “market savvy” than their counterparts in large carriers.
- Turnover appears to be lower for both underwriters and policies.
When reviewing the structural differences between large and small companies, we were struck by the contrasts in underwriting as a career path.
In larger companies, the principal career path for underwrites is to move into underwriting management. In smaller companies, an individual that shows a talent for underwriting can occupy an underwriting desk for a decade or more and be considered a very valuable asset to the company.
Perhaps while a company is reviewing their asset management program, an insurer should look to protect that rarest of assets: an underwriter that has a very strong track record on a particular book, and has underwritten that book long enough to live with their own development tail.
Such people are distinct from resume-heavy underwriters that may think they have underwritten every book they touched at a profit, but never stayed at a desk long enough to find out.
Perhaps the time has come to reconsider the emphasis on size and diversification in the evaluation of the strength of insurance companies.
While it is easier to analyze quantitative results, the qualitative aspect of the underwriting and pricing process may be even more critical to the strength of P/C carriers.
Most companies have had rate tracking models in place for quite some time. Ideally, these tracking models should reduce the volatility in loss ratio fluctuations, and enable carriers to avoid writing under-priced business. Given the under-reserving on the part of large companies in the late 1990s, these models failed in their task.
Whether an insurer writes $10 billion or $10 million of premium, the risk that is most critical is the risk that is written every day at each underwriter’s desk. Under-pricing leading to under-reserving, does not take place on giant books of business, but on one risk at a time.
Risk Lighthouse, Inc is a consulting firm specializing in enterprise risk management for insurers. With our combined underwriting and actuarial expertise, we help insurers to holistically evaluate and monitor their enterprise risk exposure by employing our leading indicators and risk metrics. Our goal is to help clients to implement best underwriting, pricing and reserving practices, and to achieve better financial performance.
Dr. Shaun Wang can be contacted at swang@ermii.org or at 678-524-9222.
Robert Faber can be contacted at robert.faber@risklighthouse.com, or at 847-207-5188.
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