It is widely recognized that the insurance loss ratio serves as a key performance indicator for evaluating the effectiveness of property and casualty insurance companies. Underwriting tier is an example of a traditional approach and one of the strategies to assess risk and determine policy rates. The main goal of the paper is to highlighting the enhanced effectiveness that results from combining these two crucial elements. This article analyses the loss ratio by underwriting tier.
Loss Ratio
One important metric used by insurance firms to assess the profitability of their underwriting operations is the loss ratio. It is calculated by dividing the total amount of claims incurred (including loss adjustment expenses) by the total amount of earned premiums. A loss ratio of 100% means that the insurance company is breaking even, while a loss ratio of greater than 100% means that the company is losing money on its underwriting operations.
Understanding the breakdown of loss ratios is crucial for this article. There are two parts to the loss ratio.: a) Pure loss ratio b) Loss adjustment expenses ratio. The calculation of the pure loss ratio does not include loss adjustment costs. This loss ratio serves as a gauge for how effectively underwriting is working.
Underwriting Tiers
Let us turn our focus on underwriting tier and recap what it means. Underwriting tiers are used by insurance companies to classify policyholders into different risk categories, which in turn determines the premium rates they pay. These tiers are based on various factors, including the individual’s risk profile. Let us look at some examples of underwriting tier used by a P&C insurance company for business owners’ policy. There are several ways a tier can be established and what is described here are just examples.
Preferred Tier: Business owners with a low-risk profile, excellent loss history, well-maintained properties, and good safety practices may qualify for the preferred tier. These policyholders typically enjoy lower premium rates due to their strong risk profile. Example a shop with no claims before and situated in a low-risk prone area, with good safety features in the business premises.
Standard Tier: This tier typically includes businesses with average risk profiles. These businesses meet the general underwriting criteria but may not qualify for the most favourable rates. The standard tier represents a middle-ground risk category. Examples a restaurant with a fire accident before.
Substandard Tier: This tier is for businesses with higher risk factors. They might have a history of claims, operate in high-risk industries, or have subpar safety practices. Policies in this tier may come with higher premiums due to the increased risk. Examples are a property situated in a wildfire risk area.
These underwriting tiers are different from underwriting segments. Underwriting tiers are usually used to assess risk profiles and underwriting segments are used to group policyholders based on shared characteristics.
Drilling down loss ratio by underwriting tier for better insights
When assessing the loss ratio overall is important, it is important to drill down the loss ratio to take actions to improve. Analysing the loss ratio by underwriting tier for each line of business helps to identify two major segments:
- Identification of unprofitable insurance risk profiles by lines of business:
A high loss ratio in a specific underwriting risk profile indicates that the insurance company is paying out more in claims and expenses than it’s collecting in premiums for that particular group of policies. This suggests that the underwriting process for this risk profile may need to be refined or that the pricing structure may be inadequate.
- Detection of premium inadequacy in specific underwriting risk profiles
When the loss ratio is consistently high for certain underwriting risk profiles, it signifies that the premiums charged for those policies might not be sufficient to cover the associated losses and expenses. This situation could lead to financial losses for the insurer in the long term. Adjusting premium rates or reevaluating underwriting guidelines may be necessary to address this issue.
- Identification of risk profiles for reinsurance treaty:
Loss ratio by underwriting tier and breaking it down further segments helps in providing insights for reevaluating reinsurance arrangements. While other factors are important for deciding reinsurance arrangement, loss ratio also helps in identifying those segments of risk and tweak the reinsurance arrangement that is mutually beneficial to reinsurer and insurer.
What is incurred losses?
Incurred losses refer to the total amount of paid claims and loss reserves associated to the specific time period. In other words, sum of all claims that have been paid and the estimated claims that are yet to be paid, for the specific time period.
To be precise: Claims paid for the specific period + (Claims outstanding at the end of the period minus Claims outstanding at the beginning of the period). IBNR (Incurred but not reported) has also to be included as part of incurred losses.
Calculation of pure loss ratio by underwriting tier
The underwiring tier may vary by line of business. It would be good to take into account the following factors for calculating the loss ratio for underwriting tier for line of business. Pure loss ratio is closely associated with the risk profile as it takes into account the losses only and excludes loss adjustment expenses which is more of operational part. The elements required for calculation of pure loss ratio are: Incurred losses of a specific underwriting tier (For example, incurred loss from the policies underwritten as ‘Preferred tier’) and 2. Earned premium from a specific underwriting tier (For example, earned premium from the policies underwritten as ‘Preferred tier’).
So, the formula for calculation of pure loss ratio for specific tier would be:
This provides specific advantage of evaluating whether a tier is profitable. Breaking down the underwriting tier by segment provides the insights required. Let us look at some examples: –
If you look at the example above, even though the commercial property overall has a positive loss ratio, there are improvements can be considered in underwriting guidelines and rating for Construction, Healthcare, Education and Hospitality industry segments of commercial property insurance
Analytics in pure loss ratio analysis
Analytics and predictive analytics play a pivotal role in the analysis of loss ratios by underwriting tier in the field of Property and Casualty (P&C) insurance. These advanced analytical tools allow insurers to not only assess the overall loss ratio but also drill down into specific underwriting tiers, shedding light on otherwise hidden trends and patterns.
Predictive analytics empowers by P&C insurers to identify profitable or unprofitable business profiles by combining line of business, underwriting tier and underwriting segments and using relevant factors, by predicting future losses by underwriting tier. Risk assessment, pricing strategies can be improved using this analysis. Moreover, the analysis also aids in identifying suitable reinsurance treaties, helping insurers manage risk and financial stability more efficiently.
In conclusion, pure ratio loss analysis using undewriting tier and underwriting segments is a powerful tool for P&C insureres, providing greater insights of the risk.