Tag Archives: loss ratios

3 Warning Signs of Adverse Selection

The top 25 insurers consume 70% of the market share in workers’ compensation, and, as the adoption of data and predictive analytics continues to grow in the insurance industry, so does the divide between insurers with competitive advantage and those without it. One of the largest outcomes of this analytics revolution is the increasing threat of adverse selection, which occurs when a competitor undercuts the incumbent’s pricing on the best risks and avoids writing poor performing risks at inadequate prices.

Every commercial lines carrier faces it, whether it knows it or not. A relative few are actively using adverse selection offensively to carve out new market opportunities from less sophisticated opponents. An equally small crowd knows that they are the unwilling victims of adverse selection, with competitors currently replacing their best long-term risks with a bunch of poor-performing accounts.

It’s the much larger middle group that’s in real trouble — those that are having their lunch quietly stolen each and every day, without even realizing it.

Three Warning Signs of Adverse Selection
Adverse selection is a particularly dangerous threat because it is deadly to a portfolio yet only recognizable after the damage has been done. However, there are specific warning signs to look out for that indicate your company is vulnerable:

  1. Loss Ratios and Loss Costs Climb – When portfolio loss ratios are climbing, it is easy to blame market conditions and the competition’s “irrational pricing.” If you or your colleagues are talking about the crazy pricing from the competition, it could be a sign that your competitor has better information to assess the same risks. For example, in 2009, Travelers Insurance, known to be utilizing predictive analytics for pricing, had a combined ratio of 89% while all of P&C had a combined ratio of 101%.
  2. Rates Go Up, and Volumes Declines – As loss ratios increase along with losses per earned exposure, the actuarial case emerges: Manual rates are inadequate to cover expected future costs. In this situation, tension grows among the chief decision makers. Raising rates will put policy retention and volumes at risk, but failing to raise rates will cut deeply into portfolio profitability. Often in the early stages of this warning sign, insurers opt to raise rates, which makes it tougher on both acquisition and retention. After another policy cycle, there is often a lurking surprise: The actuary will find that the rate increase was insufficient to cover the higher projected future losses. At this point, adversely selected insurers raise rates again (assuming their competitors are doing the same). The cycle repeats, and adverse selection has taken hold.
  3. Reserves Become Inadequate – When actuaries express signs of mild reserve inadequacy, the claims department often argues that reserving practices haven’t changed, but their loss frequency and severity have increased. This leads to major decreases in return on assets (ROA) and forces insurers to downsize and focus on a niche specialization to survive, with little hope of future growth. The fundamental problem leading to this occurrence is that the insurer cannot identify and price risk with the accuracy that competitors can.

Predictive Analytics Evens the Playing Field
The easiest way to prevent your business from being adversely selected is starting with the foundation of your risk management — the underwriting. Traditional insurance companies rely only on their own data to price risks, but more analytically driven companies are using a diversified set of data to prevent sample bias.

For small to mid-sized businesses that can’t afford to build out their internal data assets, there are third-party sources and solutions that can provide underwriters with the insight to make quicker and smarter pricing decisions. Having access to large quantities of granular data allows insurers to assess risk more accurately and win the right business for the best price while avoiding bad business.

Additionally, insurers are using predictive analytics to expand their scope of influence in insurance. With market share consolidation on the rise, insurers in niche markets of workers’ compensation face even more pressure of not only protecting their current business, but also achieving the confidence to underwrite risks in new markets to expand their book of business. According to a recent Accenture survey, 72% of insurers are struggling with maintaining underwriting and pricing discipline. The trouble will only increase as insurers attempt to expand into new territories without the wealth of data needed to write these new risks appropriately. The market will divide into companies that use predictive models to price risks more accurately and those that do not.

At the very foundation of any adversely selected insurer is the inability to price new and renewal business accurately. Overhauling your entire enterprise overnight to be data-driven and equipped to utilize advanced data analytics is an unreasonable goal. However, beginning with a specific segment of your business is not only reasonable but will help you fight against adverse selection and lower loss ratio.

This article first appeared on wci360.com.

Why Low Loss Ratios Can Be the Wrong Goal

Many agency owners take great pride in generating low loss ratios year after year. These agencies are often very, very profitable — they are the perfect cash cows, in business school parlance. But, in my experience, their growth is painfully slow. Often, their agencies are not managed closely, beyond the focus on loss ratios. And the agencies are often small. 

These agency owners are not happy with the many carriers who have deemphasized loss ratios. They cannot fathom why any carrier would not LOVE their good loss ratios. The result has become stressed, or even fractured, agency/company relationships.

These agency owners do not understand that loss ratios that are too low (and each company will define “too low” differently) are not in some companies’ best interests. How can too high a profit margin be bad?

  1. When loss ratios are too good, it may mean rates are too high, resulting in too little growth. Companies, particularly stock companies, need to show growth, especially after the softest market in industry history.
  2. If growth is too slow, companies may be losing market share. Company management often has considerable pressure to attain specific market share.
  3. Loss ratios that are too low may also mean that profit is not being maximized.

Maximizing profit is not the same thing as achieving a high profit margin. The former is in dollars, and the latter is in percentages. This is a crucial difference between running a company and running an agency, and agency owners are well-served to understand it. If a company wants to maximize profit, it might want to increase revenue by lowering rates even though that would mean higher loss ratios. For example, if a company has a 35% loss ratio and $100 million in premiums, its gross profit (excluding expenses) might be $65 million. However, if it decreased its rates and subsequently increased premiums to $125 million at a 45% loss ratio, it would generate $68.8 million in gross profit. That is a $3.8 million improvement.

Many agency owners would like to increase their books 25% and go from a 35% loss ratio to a 45% loss ratio, too, but those that focus on low loss ratios probably will not get their share of that 25% growth, yet their loss ratios will still increase.

Frustration at agencies greatly increases when companies price to a 55% , or higher, loss ratio. The company still makes plenty of profit at a 55% loss ratio (if it does not, then the company has serious expense issues that go far beyond the points of this article). However, agency owners make most of their money in contingent bonuses from carriers for growth, retention, low losses and so on, and profit sharing by carriers declines precipitously at 55%. The agency owners' lifestyle is curtailed. The value of their agencies is impaired. Their business model is in shambles.

If a company is truly pricing to a loss ratio in the mid-50s or even higher, agency owners might consider doing business with different carriers whose philosophies more closely match theirs. Easier said than done, obviously, so maybe a better solution is updating their business model. Growth is more important today to many carriers. Sitting on a cash cow annuity for a decade or more is not as feasible as it once was, and wishing otherwise will not help.

Many companies desire fast growth because:

  1. Some executive bonuses are tied to fast growth.
  2. The company is being set up to sell.
  3. The company has reserving issues and needs the extra premium to dilute the effect of a reserve increase. Growth is only a temporary solution, but companies have used it forever. The fast growth, which makes executives look heroic, is almost always created by low, unsustainable rates that eventually result in higher loss ratios. Nonetheless, growth is initially far more important than profit. (The smartest executives are gone by the time the problems arise, leaving their successors to sort out the mess.)

Agents doing business with companies that emphasize growth may want to evaluate whether there is risk to the agency and its clients. If so, creating a plan to offset these risks can create excellent opportunities.

Agents can fight reality, and fighting will feel good for masochists, but few will be able to avoid doing business with at least a few growth-focused carriers. Don’t keep telling carriers how short-sighted they are. Capitalize instead by understanding their perspective and using your resources to deal with the carriers you choose.

NOTE: None of the materials in this article should be construed as offering legal advice, and the specific advice of legal counsel is recommended before acting on any matter discussed in this article. Regulated individuals/entities should also ensure that they comply with all applicable laws, rules and regulations.