The market determines the price of gasoline, toys, and cars. The market, not actuaries, determines the price of insurance, too. Chris Burand examines whether insurance shouldn't be treated any differently than other products whose prices are based on the market.
“Do insurance rates have an actuarial basis?”
An insurance client might respond, “They damn well better!” A company person might think, “Of course they do. That's why we pay actuaries.” And, depending on their point of view, one actuary might say, “Absolutely! Actuarially based rates are the solid foundation on which the entire insurance industry is built!,” while another might respond, “Nope. Not even close.”
On a macro level, consider this: Commercial Lines rates have jumped by 30% to 200% during the past two years (depending on the line). Because insurance companies have been insuring the same roofers, nursing homes, manufacturers, and contractors for the past 20 years, they have an adequately sized population on which to base rates. They also have strong loss trends, so they should be able to predict losses fairly accurately. Logically it would seem these loss trends would, if graphed, show a fairly smooth line and definitely not one where losses jump 30%-200% for a specific two-year period. After all, we're dealing with a large sample in which some years' results will be slightly better than indications, while in other years results will be slightly worse — but the overall trend will resemble a relatively straight line (barring very large catastrophe losses).
The industry-wide consensus seems to be that the significant increase in rates was caused by historical underpricing. What, then, caused this underpricing? There are two possibilities:
1. If prices were based on actuarial work, then this work must have been poor; or
2. Prices were not primarily based on actuarial work.
Most agents have encountered the situation in which a competitor was trying to take away a client with a 60% five-year loss ratio by offering a rate 20% less than their prior year's premium. My bet is that companies, for all practical purposes, abandoned actuarially based sound pricing during the soft market.
I recently wrote an article about how an agent convinced a company that their pricing on an entire class was 75% too high. The agent did so without even using a competitor's price as an example, by simply showing the company their own profit margin on the class. Another agent responded that it seemed very unlikely a company would have missed its actuarial basis by 75%. This is a good point, which leads me to wonder that if companies didn't base their rates on an actuarial basis in a soft market, what makes anyone think they're doing so in a hard market? I'm convinced that market capacity and appetite are far more important to pricing than an actuarial basis. Given the long history of our markets, if prices were based primarily on actuarially sound logic and the desire to make an underwriting profit, we wouldn't have such drastic price changes. But because we do have huge highs and low lows, perhaps it's time to face the truth. Insurance should not be treated any differently than other products whose prices are based on the market. The market determines the price of gasoline, toys, and cars. The market, not actuaries, determines the price of insurance, too.
Agents who understand that company rates aren't set by actuaries can use this knowledge to manage their companies and clients pro-actively. They can determine which companies are in the best position to thrive in a given pricing environment. For example, during the current environment in which increases are moderating, the most stable companies will be those that don't need rates to keep increasing to maintain their rating, or even to survive. Why these companies? First, as the market softens, they can withstand lower rates without endangering their profitability. Second, their finances will be so strong that they won't need operational changes to maintain their financial well-being. They can hold their course, maintain capacity, and not cut commissions. Weaker companies will have to cut costs drastically if rates don't keep rising rapidly enough to generate substantial profits at their current cost level.
The bottom line: Avoid companies that can't withstand lower pricing. Begin moving business from these companies slowly so that when they begin cutting commissions, selling parts of their companies, or even worse, being significantly downgraded, your agency won't be caught by surprise — you'll already have begun the moving business.
Markets, and sometimes crazy competitors, set prices in all industries. Keep this in mind and use it to your advantage.