Confidence and Consistency

This article explores underwriting cycles and the importance of changing underwriting behavior from that of “extrospection” with decisions based on external pressures, to one of “introspection” where decisions are determined solely on the best judgment of the underwriter. If we can understand and manage underwriting behavior we can significantly blunt the ruinous impact of the underwriting cycle.

Insurance cycles exist around the world in countries with developed and emerging insurance industries. However, as seen by the accompanying chart, the average length of p&c insurance underwriting cycles varies by country.

The p&c insurance industry’s cyclical nature is clearly seen in the second chart shown, which depicts changes in industry capital (as measured by surplus). Surplus is severely eroded when underwriting results are poor. A common measure of cycles has been the relationship between premium growth and underwriting results. After rates go up, results improve and the temptation increases to write more business.

There is also an interesting correlation between interest rates and underwriting results, originating the phrase “cash flow underwriting.” Vincent “V.J.” Dowling, president of analysis firm Dowling and Partners, tracks the correlation between insurer stock valuations, as measured by their price to book value ratio, and the insurance cycle.

While it is accurate to say that these economic factors encourage or incubate poor underwriting results, they do not drive cycles. Cycles are created and driven by the actions and behavior of management and underwriters.

HISTORIC TRENDS

The importance of understanding cycles and how to manage them has increased significantly over the past 25 years. Historically, the major p&c insurance markets in the world were tariff markets. In the 1950s the rating bureaus established the fire tariffs in the U.S. to protect companies from undue competition. The same was true in Germany until the mid-1990s, as well Japan until the late 1990s. In all three markets the tariff in effect leveled the talent playing-field. A company that had excellent underwriting skills and tools really could not differentiate its results.

Today everything has changed. The opening up of market economies and reductions in barriers to free trade has created a true global marketplace that is very competitive. The impact on the insurance industry is profound. The need for underwriting skills – and more importantly an underwriting culture – is critical. Change, however, has brought into play other market drivers:

Capital is fluid and without boundaries-it moves where the opportunities are;

The insurance business is a global business;

The barriers to entry are extremely low;

Insurance buyers are more sophisticated about their business and retaining and ceding risks from their portfolio; and

Our notions about correlations between various risk classes and geographies are changing.

What hasn’t changed? The external pressures to follow the market are enormous, resulting in the following:

Managements do not want to “disappoint” owners and analysts who worship the growth/premium volume dial;

It is hard to ignore what competitors are doing;

Brokers and agents sell price most of the time;

Companies do not want to lose an insured/client; and

Clients want their “bank” back.

As such, today’s external pressures make understanding management and underwriting behavior absolutely critical.

MANAGEMENT FACTORS

Management behavior, even more than underwriter behavior, is influenced if not driven by external factors, including analysts’ expectations, owners’ short-term versus long-term time horizons, share price and growth. And since management behavior ultimately drives underwriter behavior, all the underwriting processes, initiatives and controls in the world will fail if the senior management’s focus, message and the compensation system are flawed. Cycles will exist until senior management teams refrain from:

Setting strict premium volume goals or “budgets”;

Undermining underwriting decisions;

Underestimating parameter and model risk; and

Under-investing in skills.

Cycles will also exist until underwriters make rational economic decisions on each and every risk they underwrite as well as making rational portfolio or book of business decisions. Confidence is the critical element: the bedrock. Underwriters must develop the confidence and emotional fortitude to make rational economic decisions in spite of the global changes, external pressures and management inconsistencies that create confusion. Confidence requires discipline on the part of each underwriter, relentlessly reinforced by management to create, nurture and live an “underwriting company.”

DEFINING CONFIDENCE

So how do we build and sustain the institutional resolve, the underwriter confidence and the emotional fortitude to break away from the pack – to make rational economic decisions? How do we change behavior in a business where the outside stimuli are very strong?

First we must remember that we are selling a product that we do not know the cost of today. We use various tools and models, we make assumptions about risk and exposure, and ultimately we make judgments, underwriting decisions about the trade off between risk and reward. How do we build the requisite confidence in these determinations? And, just as importantly, how do we guard against overconfidence in our decision-making and our underwriting judgments? To quote Confucius, “to know that we know what we know, and that we do not know what we do not know, that is true knowledge”.

Behavioral theory is the key to making good underwriting decisions, particularly in a softening market where the outside negative stimuli are so pervasive they challenge the confidence/overconfidence equation.

SOFT CHALLENGES

There are a number of soft market phenomena that challenge our confidence or encourage over-confidence and impact underwriting execution, underwriting principles and ultimately even underwriting culture.

Calendar year versus accident year results. The complexities of insurance accounting and scorekeeping can lead to significant misinterpretations of book performance. Obviously calendar year results (the official scoreboard) are impacted positively and negatively by prior accident year reserve movements. These variations can be significant at the line of business and account level and can be difficult to interpret.

In a soft market, the psychology is to manage for the short term and the income statement versus managing for the long term and the balance-sheet. A rigorous “numeric” approach to the analysis of results is the only defense. The interplay between accident year and calendar year results and accident year trends must be clearly understood and the impact on underwriting behavior minimized. A thorough understanding of results is critical to maintaining confidence and avoiding overconfidence.

Actual versus normalized result. Actual loss experience often bears little resemblance to “normalized” experience where we define normalized as the “correct” technical price for the exposures insured. As an aside, years ago an insurance executive quipped, “the insurance business is an easy business, all you have to do is charge the right price”. Unfortunately, there is no “right price”, but that does not translate into “any price is the right price”. It is a technical business – not rocket science – that requires sound mathematical and statistical knowledge and skills. Risk assumption is not a marketing business, it is an analytical business, not dissimilar from investing where the same confusion between marketing and decision analytics is common.

Since actual results can be misleading, a benchmark and/or “walk away” technical pricing discipline is critical to managing undue rationalization during soft cycles. Establishing a floor price tied to an average exposure price that is not influenced by recent results or the market price for risk establishes a technical discipline that will help counter the “herd mentality” to follow th
e market down.

Dissecting results into frequency, severity and catastrophic components is equally important. All too often short-term shifts or “anomalies” (that are statistically rational) in frequency, severity or catastrophic experience drive behavior anchored to current experience that results in pricing below the technical rate or the right price for exposure.

Confidence in the technical or expected results must be maintained in spite of the challenges in a softening market.

Experience versus exposure pricing. Related to benchmark pricing is the debate over the appropriateness of experience (loss cost) versus exposure rating methodologies. The debate is centered on the credibility of a loss cost against the appropriateness of an estimate of the average distribution of losses for pricing insurance and reinsurance. The debate is of particular importance in excess layers.

Underwriting is a mix of science and art. Good underwriting will be largely based on science (various mathematical and statistical models), but also requires judgment (i.e., art). The challenge is to get the mix right. Historically, the art side dominates in soft markets, often to the point of decisions becoming detached from any sound analytical framework, namely pure guesses or rationalization that trumps expertise and reason. Experience rating is only appropriate where the loss experience is credible and reliable.

Unfortunately, our perspective of credibility changes during the cycle and the quality and reliability of loss information deteriorates in soft markets. I like to say that good underwriting is 80% science/20% art. Keeping a similar relationship in mind forces the underwriter to deal honestly with the different credibility challenges associated with exposure and experience rating approaches.

Inflection points and trend. Inflection points are the nemesis of the insurance industry. Changes in trend, either severity or frequency, both positive and negative, are difficult to detect until they have affected several accident years.

A reserving philosophy must be driven from the top. The CEO and chief financial officer must encourage a forward looking, conservative approach to setting reserves. The actuarial reserving processes must be unbiased, sensitive to the uncertainty around point estimates and mindful of the historic “mis-estimation bias”. The anecdotal, “results are good on this account, okay to renew as expiring” overlooks many factors. For example, an account where the premium was “right” for exposure last year, in a world with a trend of 5% renewing at expiring means falling behind on an inflation adjusted basis. Underwriting must be proactive not reactive. It should focus relentlessly on exposure, not just recent experience.

Economic inflation can be estimated, and while not perfect, those estimates are fairly reliable. Insurance inflation is more difficult to measure. It is a combination of economic, social and medical inflation. In recent years while economic inflation has been low, insurance inflation has been rampant. Social inflation, the increased cost of claimant compensation and thus the positive trend in average settlements (i.e., severity trend), has reached double digits for some liability classes. U.S. tort cost increased 13.3% in 2002 and 14.4% in 2001. Medical inflation trends are in double digits in many parts of the U.S., driven by increased costs, new treatments and increased utilization.

Identifying, analyzing and selecting trend assumptions and embedding them into a disciplined underwriting process is critical. Establishing trend assumptions in an improving environment is just as critical as in a deteriorating, inflationary environment – here, inflection points must be treated with great care.

Wordings. Wordings and contract documentation always suffer in soft markets. How many industries would make a commitment of a hundred million dollars without a signed contract that has been carefully reviewed by both parties? Can you imagine walking into a bank asking for a loan and suggesting the contracts be signed at some date in the future? How do you think bankers would react to the “NAIC Nine Month Rule”?

Confidence in our decision processes, particularly contract documentation, must be maintained in a soft market. Similarly, terms and conditions and breadth of coverage are an integral part of structuring an economically rational transaction. Contract language and drafting is an integral part of the underwriting process and must be done by underwriters, not brokers.

KEEPING CONFIDENCE

The market, competitors’ actions and client expectations may be constraints to a company’s top-line growth. They do not have to determine underwriting profitability, but they can create challenges to making rational economic management and underwriting decisions.

Cycles destroy confidence. The confidence void erodes discipline. Cycles create many challenges that can only be countered with supreme confidence in an underwriting culture, a set of underwriting principles and consistent execution, which means disciplined thinking, decision-making and processes.

Cycles will impact revenues, although they do not have to drive underwriting results. In the long run, clients of both insurance and reinsurance are better off with consistency of product. Consistency demands confidence. Confidence requires a fundamental approach to the business: pricing for exposure and disciplined underwriting irrespective of the market, competitor actions and clients’ short-term wishes.