A Practical Guide To Commercial Insurance Pricing

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A Practical Guide to CommercialInsurance PricingPrepared by Alina Pettifer and James PettiferPresented to the Actuaries InstituteGeneral Insurance Seminar12 – 13 November 2012SydneyThis paper has been prepared for Actuaries Institute 2012 General Insurance Seminar.The Institute Council wishes it to be understood that opinions put forward herein are not necessarily those ofthe Institute and the Council is not responsible for those opinions. Finity Consulting, The Warranty GroupThe Institute will ensure that all reproductions of the paperacknowledge the Author/s as the author/s, and include the abovecopyright statement.Institute of Actuaries of AustraliaABN 69 000 423 656Level 7, 4 Martin Place, Sydney NSW Australia 2000t 61 (0) 2 9233 3466 f 61 (0) 2 9233 3446e actuaries@actuaries.asn.au w www.actuaries.asn.au

A Practical Guide to Commercial Insurance PricingTable of Contents1. Abstract . 22. Introduction . 33. An Overview of Commercial Insurance . 53.1. What is Commercial Insurance?. 53.2.3.3.Key Roles in Commercial Pricing . 6What is the Small-Medium Enterprise Segment? . 73.4.3.5.What is the Corporate Segment? . 8Product Distribution and Policy Wordings . 93.6. The Dynamics of Pricing in the Market. 114. Engagement with the Business . 144.1.Translating Technical analysis into Business Outcomes . 144.2. Relationship with Claims . 155. The Commercial Insurance Pricing Actuary and Data . 175.1. Why is Data Quality a Key Issue for Commercial Insurance? . 175.2. Key data quality issues . 185.3. Making Best Use of the Available Internal and External Data . 196.Technical Pricing Methods . 216.1. Generalised Linear Modelling . 216.2.6.3.Experience Rating. 22Industry Rating . 236.4.6.5.Alternatives to Competitor Analysis . 26Adding Value to a Corporate Insurance Portfolio . 276.6. Large Loss modelling . 286.7. Rate Index . 306.8. Machine learning. 316.9. Other Modelling . 317. Pricing of Long Tail Classes . 337.1. Estimation of Ultimate Claims Incurred . 337.2. Superimposed Inflation . 347.3. Latent Claims . 347.4. Legislative Changes and Precedence. 358. Complexities around Premium in Commercial Insurance . 368.1. Seasonal Trends around the Sale of Policies . 368.2. Premium Adjustments at Policy Expiry. 368.3. Earnings Patterns . 378.4.8.5.Insurance Taxes . 38Terrorism Reinsurance Cover . 388.6. Burning Cost Premium Model . 399. Conclusion . 401

A Practical Guide to Commercial Insurance Pricing1. AbstractOver the past 30 years, Personal lines pricing has been very attractive area ofpractice for pricing actuaries, as the characteristics of the portfolios align to therequirements of statistical analysis. These include a large amount of data,homogenous risks and a limited exposure to large losses. This has enabled actuariesto deliver significant value to Personal lines insurers through technical analysis andthe development of sophisticated pricing structures.The role of actuaries in Commercial insurance pricing is less established and there isan opportunity for the profession to become an integral part of the Commercialinsurance industry. However this opportunity comes with challenges as a typicalCommercial portfolio will Have a greater variety of the types of risks being insuredHave poor, scarce or incomplete dataBe heavily impacted by large lossesThe purpose of this paper is to provide practical guidance to actuaries currentlyinvolved or looking to be involved in Commercial insurance pricing to ensure thattheir work is targeted so that it delivers more effective business outcomes. Thisincludes recommendations on developing knowledge about the portfolio and thewider market, the need to engage with the business and the application ofappropriate actuarial technical pricing methods to Commercial insurance.Key Words: Commercial Insurance, Pricing, Underwriting, Data, RelationshipManagement, Technical Pricing Methods, Long Tail2

A Practical Guide to Commercial Insurance Pricing2. IntroductionOver the past 30 years, actuaries have been heavily involved in the pricing ofPersonal lines portfolios but have found the Commercial insurance portfolios to bemuch less accessible. This is due to a number of characteristics of Commercialinsurance including but not limited to The large number of complex products and coversPolicies being highly heterogeneous even within the same productPoor, scarce or incomplete dataHigh level of underwriting judgment applied to pricing of individual risksBe heavily impacted by large lossesThere is a significant opportunity for actuaries to add more value in the pricing ofCommercial insurance and this paper provides a holistic overview of how toapproach the pricing of a Commercial lines portfolio. The paper focuses onproviding the actuary with recommendations on how to positively influence thebusiness outcomes of the insurer by producing targeted analytical outputs. The keyrecommendations in the paper are That the Actuary builds an in depth understanding of the Commercial portfolio sothat they are able to set more informed assumptions, better understand thedrivers behind the results of any analysis and be able translate the analysis intocommercial insights. This will require An understanding of the policy wording Spending time on an ongoing basis with the Portfolio Managers, CaseUnderwriters and Claims Managers Having clarity over the strategic plans for the portfolio Understanding the overall dynamics of the market including therelationship with intermediaries and the market cycle Understanding the impact that case underwriting has on the risks selectedin the portfolioThat the Actuary works in partnership with the Portfolio Manager. This will improvethe quality of the analysis and the likelihood of the analysis being utilised to drivebusiness outcomes and will require Strong engagement with the Portfolio Manager throughout the technicalpricing process The Actuary being transparent over the assumptions made and providesjustification to support the assumptions made The Actuary being aware of the uncertainty around the result andproviding a sensitivity analysis based on the variability of key assumptions The Actuary to be proactive in presenting new ideas and analysis thatcould help the Portfolio Manager achieve the portfolio outcomesThat the Actuary builds an in depth understanding of the data within the portfolioas the quality of data within Commercial insurance presents more challengescompared to Personal lines where actuaries have been using and improving thedata over many years. Being able to understand and enhance the data asset3

A Practical Guide to Commercial Insurance Pricing will enable the Actuary to ensure that their analysis is built on solid foundations.This will require Understanding the availability of key data fields and the quality of thesefields Being proactive around improving the data asset for analysis by cleansingdata available internally and accessing external data Taking a role as a data champion within the insurerThat the Actuary adopts appropriate technical pricing methods which allow forthe characteristics of the portfolio. Some of the key characteristics are High proportion of large losses The use of experience rating to price large accounts The large number of industries IBNR / IBNER Level of Superimposed inflation The legal environment including legislative changes Latent ClaimsThe paper covers 7 main sections An Overview of Commercial Insurance – outlines the key concepts that thepricing actuary needs to know about the Commercial insurance marketEngagement with the Business – highlights the importance of engagementwith the business in being able to provide fit for purpose technical analysisand provide commercially actionable insightsThe Commercial Insurance Pricing Actuary and Data – provides the actuarywith an overview of the key data issues within Commercial insurance andhow they can make the best use of the data available both internally andexternallyTechnical Pricing Methods - provides an overview of the key pricing methodsthat are used within Commercial insurance portfoliosPricing of Long Tail Classes – identifies the key additional complexities thatunderlie the pricing of the long tail classesComplexities around Premium in Commercial Insurance – highlights some keycharacteristics around how premium is treated and earned withinCommercial insurance4

A Practical Guide to Commercial Insurance Pricing3. An Overview of Commercial InsuranceThis section aims to provide the pricing Actuary with an overview of the mainfeatures of Commercial insurance, including the roles of the Portfolio Manager andthe Case Underwriter, the key differences between the Corporate and SmallMedium Enterprise segments of Commercial Insurance and the drivers behind themarket price.3.1.What is Commercial Insurance?Commercial Insurance refers to insurance policies that cover any business orcommercial activity and makes up around 40%i of the insurance market with theremaining 60% being classed as Personal insurance.Commercial insurance is sold to businesses of all sizes from small to mediumenterprises such as the corner milk bar or a local building (typically referred to asSmall-Medium Enterprise or SME) through to very large corporations such as the top500 ASX companies (referred to as Corporate). We note that the definition of whatfits into each category can vary significantly by insurer.We have grouped the key Commercial portfolios in the below table into threesegments - SME, Corporate and Speciality Classes based on the target customer forthe portfolio. A portfolio that is not typically targeted towards either the SME orCorporate customers has been allocated to the Speciality Classes segment.Small-Medium EnterpriseCommercial MotorBusiness PackagesFarm PackagesCropDomestic StrataCorporateFleetISR (Industrial Special Risks)Stand Alone LiabilitySpeciality ClassesWorkers’ CompensationProfessional RisksMarineConstructionExtended WarrantySome of the above portfolios are sold in the market as a number of distinct products.For example, the products within the Professional Risks portfolio include MedicalMalpractice, Directors and Officers Insurance and Professional Indemnity. Someportfolios also may have a number of very distinct sections with different riskcharacteristics. For example, a single Business Package policy may include Fire,Public and Products Liability, Burglary, Machinery Breakdown, Consequential Loss,Tax Investigation, Theft and Money, Employee Dishonesty, Glass Breakage,Computer and Electronics and General Property sections.Recommendation 1: That the Actuary reads the policy wordings and spends sometime with the Case Underwriters, Claims Managers and Portfolio Managers to ensurethey understand the products that they work on including the covers offered andthe policy characteristics that drive claims. This additional understanding will enablethe Actuary to set more informed assumptions, to better understand potential driversof analytical results and to better translate the analysis into commercially actionableinsights.5

A Practical Guide to Commercial Insurance PricingThe large number of very distinct sections offered under some Commercial productscan make it challenging for the Actuary to be across all of the analyticalrequirements of the portfolio. For example, an Actuary would require experience innatural perils, short tail commercial and long tailed commercial pricing to be able tofully deliver the pricing requirements for a business package portfolio.Recommendation 2: That the Actuary is aware of the skills that are required acrossthe portfolios that they have responsibility for, and seek specialist expertise asrequired in order to best support the portfolio. Where specialist expertise is notavailable, the Actuary should make the Portfolio Manager aware of the potentiallimitations in the analysis3.2.Key Roles in Commercial PricingIn a typical Commercial insurer, there are three key roles which have responsibilitiesfor the different aspects of the pricing process. These roles are Pricing Actuary – has the responsibility for providing technical analysis to supportthe strategic direction of the portfolio. This includes Calculating the technical premium which is the amount required to meetthe financial targets of the organisation at a granular level Providing recommended book premium changes and assisting portfoliomanagers to understand the likely result of the proposed changes Monitoring of the key performance metrics of the portfolio including theunderlying profitability, movements in volumes and the impact of pricingchangesPortfolio Manager – has the responsibility for looking holistically at the portfolioand uses financial and management information reports, actuarial advice andan understanding of industry trends to make business decisions about thestrategy and pricing of the portfolio. The key responsibilities of the PortfolioManager include Developing and driving the overall strategy for the portfolio Setting the book premium for the portfolio; calculated by applying analgorithm based on a number of risk characteristics. The book premiumtakes into account the technical premium with an overlay based onunderwriting judgement and the state of the market Identifying target segments for growth Setting underwriting standards and auditing individual policies to ensurethat case underwriting is aligned with the standards Providing advice to Case Underwriters in relation to difficult or high riskpolicies Monitoring the overall performance of the portfolioCase Underwriter – considers the risks inherent in an individual policy and makesa judgement on whether the level of risk of the policy is acceptable, and if sothen sets the actual charged premium based on: The book premium set by the portfolio manager6

A Practical Guide to Commercial Insurance PricingThe individual characteristics of the risk based on analysis of historicalinformation on the policy, an on-site investigation of the risks being insuredor surveys performed by Risk Engineers The relationship with the intermediaryCase Underwriting is significantly more common on larger and more complexrisks, with close to 100% of Corporate policies being case underwritten comparedto only a small proportion of SME policies. To successfully implement a portfolio strategy, the three above roles need to have astrong transparent relationship to ensure that there is a consistent view on thestrategic direction of the portfolio.Recommendation 3: That the Actuary who is working on a portfolio that has a highlevel of case underwriting spends some time shadowing a Case Underwriter to get abetter understanding of how the case underwriting process works. In particular,what the Case Underwriter considers on an individual policy level as part of the riskacceptance process. This will provide the Actuary with a better understanding ofthe risk drivers of the portfolio and an end to end understanding of the pricingprocess.Recommendation 4: That the Actuary considers the level of discounting in theportfolio when recommending changes to book premiums based on technical work.3.3.What is the Small-Medium Enterprise Segment?A portfolio in the Small-Medium Enterprise (SME) segment of the market is likely tohave a number of characteristics which are similar to the standard Personalinsurance portfolios. These characteristics include Large amounts of dataReasonable data qualityAutomatic Premium RatingLimited Case UnderwritingLimited Facultative ReinsuranceStandard product wordings that may be customised by distributor or to thetarget market rather than to each individual insuredAs such, many of the standard actuarial pricing concepts and techniques that areused for personal lines are also be able to be applied to the SME commercialportfolios with only minor modification.For some SME portfolios, a strategic decision may be made, in alignment with theinsurer’s risk appetite, to case underwrite a small sub-set of policies which exhibit ahigh level of risk typically identified by the industry or geographic location of thepolicy. As the Case Underwriter is likely to select the better risks in the segment, theloss ratio performance of the segment may be better than expected based purelyon the risk characteristics7

A Practical Guide to Commercial Insurance PricingRecommendation 5: That the Actuary work with the Portfolio Manager to form ashared understanding of how the level of case underwriting on a segment hasimpacted the historical performance of the segment and that this is taken intoaccount in their pricing recommendations. For example, it may not be viable togrow a highly case underwritten segment of a portfolio without relaxing theunderwriting standards applied to the segment, potentially resulting in a significantdeterioration in the loss ratio of the segment.Recommendation 6: That the Actuary encourages the capture of data whichidentifies whether a policy has been case underwritten, who has case underwritteneach policy and their level of underwriting authority at the time they underwrote thepolicy. This information can be used to Enable the monitoring of case underwritten vs. automatically rated businesswith regards to business performance and renewal ratesAllocate more expenses to policies that have been case underwritten toenable sharper technical prices.Identify the correlation between discounting and portfolio performance at aCase Underwriter levelUnderstand if there is a differential in performance by Case Underwriter whichmay be due to a skill gapUnderstand whether the Case Underwriters are discounting within theirunderwriting authority3.4.What is the Corporate Segment?The Corporate segment relates to the Commercial insurance policies sold to verylarge corporations such as the top 500 ASX companies. The insurance needs andthe risk exposures of these businesses can be very different and coupled with largeinsurance premiums has meant that insurance companies typically offer moretailored products and adopt a different underwriting and pricing approach for theCorporate segment. Some of the key differences between the Corporate and theSME segments which have a significant impact on the pricing and the financialperformance of this segment are: A very high level of case underwriting for Corporate businesses, which canresult in exclusions or high deductibles for risk exposures which are consideredto be undesirable. This may mean that two large businesses of similar sizeoperating in the same industry may have a very different insurance risk,depending on the coverage, limits and exclusions placed on each policy.This also may be reflected with a significant premium adjustment from thestandard book premium to allow for the individual risk of the insured. As such,the performance of a portfolio is heavily driven by the skill of the CaseUnderwriters.8

A Practical Guide to Commercial Insurance Pricing The quality of the data is significantly worse for the Corporate segment thanfor the SME segment for the following reasons The limitations of the core insurance system to record all of the relevantrisk information Corporate risks are manually rated, so missing or incorrect informationwill not have a direct impact on the premium charged The large number of individual risks that could be insured under a singleCorporate policy making it administratively expensive to enter all of theinformationCorporate businesses generally have a lot more capital and hence are ableto retain more insurance risk which is reflected in greater claim deductibles oraggregate deductibles. For some Corporate portfolios, the majority of claimcosts are therefore likely to come from infrequent large claims with theinsured retaining the smaller or working claimsA range of complex and unique businesses which mean that the type ofclaims observed in the past are often not reflective of the types of claimswhich may occur in the future. It is therefore challenging to form a viewabout price by analysing portfolio level historical claims experienceSome Corporate policies will have a gross written premium in excess of 1million. Thus the writing of a single policy may have a material impact on theoverall size and viability of the portfolio. When the market premium is at anunprofitable level, the insurer needs to balance whether it is better from along term perspective to retain the business and potentially take a loss duringa soft market cycle, or to reduce the size of the portfolio thus reducing theexpense base for the portfolioA high level of reinsurance on Corporate portfolios. On some individualpolicies, this could be in excess of 90% of the gross premium and can meanthat there is a significant difference between the net and gross performanceof the portfolioRecommendation 7: That the Actuary understands the dynamics of the Corporateinsurance market and the implications on actuarial pricing. Section “6.5 AddingValue to a Corporate Insurance Portfolio” provides some examples of Corporatespecific pricing techniques3.5.Product Distribution and Policy WordingsOnly a small proportion of the Commercial SME market is sold direct to the insured,with around 80%ii sold through brokers, authorised representatives, underwritingagencies and other intermediaries. Over the past 20 years, the consolidation ofbrokers and the growth in the broker cluster groups has resulted in brokers having agreater influence over the products they offer their customers.Recommendation 8: That the Actuary is aware of the market dynamics of sellinginsurance through an intermediary and how this impacts the ability of the insurer tomake pricing changes or to collect additional information about the risk.9

A Practical Guide to Commercial Insurance PricingMost of the broker cluster groups and major brokers have drafted policy wordings forthe larger portfolios and require insurers to comply with the wordings in order tosimplify the processes of the broker and to provide the broker with a competitiveadvantage. The differences in the policy wordings can have a significant impact onthe overall claims cost of the policy. To illustrate the point, we have compared thewording around peak period increases or seasonal increases in cover from theMoney section in the Business Package policy for ANZiii to the Steadfast policy coverivboth underwritten by QBE. The clause in the ANZ policy wording increases the sum insured taken out onthe section by 50% for 60 days before Christmas Day, 30 days before EasterSunday, for bank holidays and a few days after each of these periods up tothe next banking day.The clause in the Steadfast policy wording has a 50% increase on at least 126days around Christmas and Easter, with an additional 49 days for a festive,religious or ethnic celebration as well as the lesser of an extra 100% or anextra 75,000 for bank holidays up to the next banking day.This example only relates to a single clause on a small section of the policy, butillustrates the differences that do exist and which, over a whole policy wording, canhave a material impact on the overall claims cost. Similar differences also occur inthe wordings between different insurers.Recommendation 9: That the ActuaryUnderstands the proportion of the portfolio insured under each of thedifferent wordings and where this information is captured in the systemHas discussions with the Portfolio Manager to gain an understanding of themost significant differences between the wordings and the expected impactof these differences on claims costsIncludes a flag into any modelling to identify the different wordingsIntermediaries can also create schemes which are typically tailored to meet thespecific insurance needs of companies in a particular industry or members of aprofession or organisation. Schemes are available across most of the Commerciallines of business but are very common in the Professional Risks product whereprofessional organisations will often set up a scheme for their members. In generalschemes will have some or all of the following Specific policy wordings to ensure that the policy is more applicable to thetarget groupPreferential pricing over a similar standard product sold by the insurer due tothe collective buying power of the schemeA strong oversight from the intermediary limiting pricing changes and impactto the end customerGuaranteed acceptance of cover for end customers who meets predefinedguidelines10

A Practical Guide to Commercial Insurance PricingRecommendation 10: That the Actuary understands whether the difference in thepolicy wordings, price and risk acceptance of each scheme to the remainder of theportfolio is such that the scheme should be excluded from the analysis of theportfolio to ensure that the scheme does not skew the analysis of the portfolio.Recommendation 11: The actuary should also be proactive around being involvedin the pricing of the larger schemes including understanding of their underlyingexperience and contribution to expenses.3.6.The Dynamics of Pricing in the MarketThe actual premium that is charged for a Commercial insurance policy is typicallybased on a combination of analytics, relationships and judgements by the Actuary,Portfolio Manager and Case Underwriter and the amount charged can varysignificantly depending on how insurers approach the pricing process. Some of thefactors that drive this variation include Different assessment of profitability: Different methodologies used by insurers tomeasure the profitability of a portfolio such as Using the profit and loss account The actual current year experience, or An assessment of the underlying experience.These methods can provide a different view of the profitability of a portfolio dueto a difference in the treatment of Prior Year Releases which have had a significant impact over the last 10years on the Commercial long tail classes Profit and Loss – Included. Current Year Experience – Excluded Underlying Experience – Excluded Natural Peril Events and Large Claims where the actual experience istypically very volatile and is likely to be significantly different to theunderlying experience in any one year. Profit and Loss – Actual experience Current Year Experience – Actual Experience Underlying Experience – Long term average viewThus two insurers with the same experience may then have a very different viewof the profitability of a portfolio depending on the methodology used. Thisdifferent view is likely to then lead to different pricing decisionsDifferent assumptions in technical pricing: There are a number of factors whichcan result in different but valid assessments of the technical premium. Thesereasons can include Differences in Corporate Strategy – the level of capital adequacy, targetreturn on capital, investment strategy and level of expenses will all impactthe premium charged to the end customers T

A Practical Guide to Commercial Insurance Pricing 2 1. Abstract Over the past 30 years, Personal lines pricing has been very attractive area of practice for pricing actuaries, as the characteristics of the portfolios align to the requirements of statistical analysis. These include a large amount of data,

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