FAIR, ACCURATE, AND EFFECTIVE
Eliminating “unfair” rate subsidies can improve a program business book
Program managers need to conduct actuarial reviews to ferret out rate subsidies
and develop underwriting guidelines that distinguish
among accounts based on size, complexity, and loss
drivers, as well as homogeneity of risk.
By Art Seifert, CPCU, CIC, RPLU.
The paradox of property/casualty insurance is that providers, buyers, and regulators deliberate and debate over what is a “fair” or “accurate” price before they know the ultimate cost of the coverage being sold. In most other businesses, providers charge a markup over a known cost of goods, and buyers either accept that price, find another source, or go without.
Few commodities other than insurance have their “cost of goods sold” subject to so many variables after the “goods” (policies) have been sold. Loss experience and subsequent rates are impacted by weather patterns, social changes, economic conditions, and legal trends. These factors, in turn, determine the level of underwriting capacity and competition and the general state of the market for insurance buyers.
As a result, small commercial accounts often find that what they pay—make that overpay—for coverage is determined by conditions outside their control, along with others’ subjective assessments of those conditions, rather than their own risk profile and loss experience. Small businesses are unfairly discriminated against on the basis of their size, and the result is often an unfair subsidization of larger enterprises.
This unfair treatment of small commercial accounts is present in many books of program business, some of which cover a supposedly “homogeneous” exposure (cyber, pollution, cargo, etc.), over different types and sizes of companies. Premium revenue generated from small commercial accounts is used to support more aggressive pricing on larger accounts, which benefit from artificially low rates.
In this way, small accounts often subsidize large accounts. It’s not fair, it’s not necessary, and it’s not effective.
Nothing really new
Rate subsidization is nothing new in P-C insurance. It was common for decades in personal lines, where insureds were grouped into relatively crude rating tiers until data analytics allowed for more individualized price points.
Rate subsidies have been a feature of the National Flood Insurance Program (NFIP) since its inception. Now that the Federal Emergency Management Agency (FEMA), which manages the NFIP, is seeking to limit or phase these out with its recently introduced “Risk Rating 2.0” methodology, many insureds under the program face the prospect of enormous increases in their NFIP premium bills.
The pricing challenge for program business is complicated. While a book of business comprised of risks with supposedly homogeneous exposures may be priced “fairly” on an aggregate basis, that does not mean that all accounts in the book are receiving a price that fairly reflects their real cost of risk.
Competition among carriers and distribution channels also has a significant impact on the pricing of a program book and its individual accounts. Again, heated competition for premium volume and commission may result in inadequate pricing of larger accounts, leaving it on the backs of small, unsuspecting accounts to make up the pricing shortfall on an overall book.
Impact of rate hikes
A small rate increases on a small premium yields a small, barely noticeable increase on an individual account basis.
Let’s imagine a program manager administering a program for fire departments. Suppose the program includes 12,000 accounts with an average account premium of $20,000, but that 11,500 of the accounts pay only $17,000 or less. The remaining 500 accounts are much larger, accounting for an average annual premium of $100,000. The program’s chief actuary determines the book needs a 3% rate increase to hit profitability targets.
Now imagine a distribution system that limits distribution to a select few, providing these select few an opportunity to aggregate large books of business—causing a tail-wagging-the-dog effect. Burying the needed rate increase in small account renewals—despite the near-loss-free experience of most small departments—lets distribution push for more competitive pricing on their large accounts where the competition is fierce. No harm, no foul?
Consider the cost to small accounts in the above scenario.
An account paying $17,000 in year one getting hit with a 2% rate increase each renewal will pay nearly $19,000 by the fifth renewal. However, the entire tranche of small accounts will be paying an additional $25 million by the fifth renewal, thus assuming a disproportionate burden of the premium cost that is not indicative of these smaller departments’ experience.
If the pricing was fair—that is, reflective of actual loss experience—the small accounts would be credited 15% and the large accounts debited 6% to 8% a year. But it is unlikely that competition among distributors would allow the market to debit large accounts for fear of driving away business.
Not only is the pricing of small commercial accounts in program business often unfair, one could argue that it often violates the Casualty Actuarial Society’s (CAS) Four Principles of property and casualty rate making. Those four principles are:
- A rate is an estimate of the expected value of future costs.
- A rate provides for all costs associated with the transfer of risk.
- A rate provides for the costs associated with an individual risk transfer.
- A rate is reasonable and not excessive, inadequate or unfairly discriminatory if it is an actuarially sound estimate of the expected value of all future costs associated with an individual risk transfer.
How does the pricing of small commercial accounts in program business measure up to the CAS’s principles?
At the outset, the rate initially determined on the basis of a pure projected loss ratio probably fulfills the requirements of principles one and two regarding the expected value of all current and future costs. Under the scenario described above, however, a 2% rate hike, when a rate credit is warranted, would contradict the superior experience of smaller fire station accounts.
In our example, the rating utilized may reflect the overall risk in the book, but it fails to account for the costs associated with individual risk transfer as required under principle three.
Given these deviations from principles one, two, and three in program business, we can conclude that rates imposed by program writers on small accounts often are excessive and unfairly discriminatory.
Rate subsidization produces pernicious effects over time.
Under cross-subsidies, intentional rate subsidies are designed to make insurance more affordable for some at the expense of others. Risks that should pay more pay less, while risks that should pay less pay more. Think NFIP.
An unintended consequence of cross-subsidies is higher insurance costs for all groups. Unfairly discriminatory rates imposed on risks charged “too much,” so to speak, cannot fully make up for the premium lost by charging some accounts too little for their real cost of risk. In program business, additional rate needs to be charged to larger accounts, but the degree of increase needed is not achievable without real pain, so small accounts end up making up the difference.
Eliminating rate subsidies in program business is a worthy pursuit.
One approach is to restrict some programs to accounts of a certain size, a segment inside a segment, as it were, a vein of profitable business allowed to aggregate in its own space. Such a strategy results in fair rating for small accounts, greater underwriting profit for the carrier, and better retention for the program manager.
Let’s look back at the fire department example.
The larger the community, the larger the fire department required to serve that community. The larger the fire department, the greater and more complex its risks. The greater the complexity, the greater the likelihood of loss, especially when you add ambulance and advanced life safety services.
Small communities maintain small fire departments, most of them volunteer. About 95% of the nation’s 19,000 volunteer fire department serve communities with fewer than 25,000 residents; nearly half of them serve communities under 2,500 population. Many of these small departments are “fire only” services.
Servicing a small community greatly reduces the chance of an intersection accident, and not providing advanced life safety services minimizes the potential for medical-related accidents. Also, a smaller population often equates to fewer employment liability incidents.
Top-tier program managers understand that their success is tied to underwriting profitability. It is easy to point to premium as a marker for success. After all, premium is immediate and easier to determine than underwriting profit.
Yet, however compelling the idea of growing to profitability sounds, it is rarely a winning strategy. Focusing on small accounts can be a winning strategy, but it requires advanced technology that reduces transactional cost and speeds delivery of bindable quotes. To successfully write small accounts requires ease of doing business.
Insurance program business is a great success story, but there is still room for improvement. Program managers need to conduct actuarial reviews to ferret out rate subsidies and develop underwriting guidelines that distinguish among accounts based on size, complexity, and loss drivers, as well as homogeneity of risk.
In the end, building program-specific eligibility guidelines will allow the aggregation of fairly priced small accounts generating underwriting profit for the carrier and great retention for the program manager.
Art Seifert has been in the insurance industry for more than 40 years, starting as an underwriter with the Reliance Insurance Company in 1979. He currently is president of Amynta EOB (Ease of Business), a new MGA dedicated to making independents more productive and successful. A graduate of Colgate University with a concentration in philosophy, he has earned the CPCU, CIC and RPLU professional designations. He is a director of the Target Markets Program Administrators Association and has served as its president.