Seeking Underwriting Perfection (Part I)

Posted at Sep 22, 2015 8:00:00 AM by Ivan P. Maddox

The assignment of a price to a risk is the core activity of insurance, and underwriting is the fulcrum on which risk and money balance. Any difference between perfection and reality in that balancing act is called underwriting leakage. Let’s explore two results of that leakage:
  1. Premiums become volatile after a natural catastrophe event
  2. A coverage gap in the risk pool occurs

1. Volatile Premiums

Underwriting leakage for natural catastrophes becomes obvious after a bunch of claims are paid: prices go up within a year or two. While these premium increases are considered a necessity by insurers, it is a source of frustration to consumers and anxiety to regulators. Consumers don’t like premium rises, and regulators don’t like unpredictable pricing because they don’t like unhappy consumers (i.e. voters). 

This “catching up” by insurers happens across all natural perils after an event, and the response is predictable:

  • The biggest nat cat event (globally) of 2015 so far has been the winter storms in eastern North America, with $1.8 billion in claims (courtesy of Munich Re, page 26). Sure enough, here is an article from Swampscott, Mass., about the rising rates on home insurance.
  • Over the past six months, western US and Canada wildfires have been rampant on an historical scale. Here is an article from Santa Cruz, Calif., about the effects of those fires on homeowner’s coverage.
  • Flood insurance rates, especially in Florida, are never far from the headlines. Here is an outraged editorial from Bradenton, Fla., decrying the effects of higher flood insurance premiums on the state and its real estate market. There is extra vitriol here because they believe they are paying for Katrina and Sandy.

Three perils, in three different regions, united by a common outcry: insurance rates are rising after an event.

These increases need to be defended by the insurers to consumers and regulators. To justify increases to the regulators, insurers supply recent claims history and a summary of future exposure – both are reasonable requests, and the process is understood on both sides. Meanwhile, justifying rate hikes to customers is not so easy because the pricing of insurance policies is opaque. It is safe to say the average policy holder does not understand how risk is priced, and it is difficult to explain a price increase when the original price is only a number, and is not attached to anything of tangible value. I want to be careful and clear here, though: the security offered by insurance is absolutely valuable; however, that value is abstract, unlike other stuff a couple thousand dollars can buy. A typical property insurance shopper buys the lowest priced policy, without any further consideration.

The need to raise rates comes from a combination of not having collected enough premium over the years and inadequate risk diversification to handle a big event. To glimpse a simple and perfect world, the rates charged for the coverage would have matched the cost of the claims paid (plus the overhead, profit, etc. needed to run a business). In this perfect world with no underwriting leakage, there would be no future premium increases to justify, no regulators to satisfy, and no customers to placate. Such price stability would be value that policy holders could covet, and insurers who use better risk assessment analytics to stabilize their pricing could differentiate themselves on something other than price.

2. Coverage Gap

Later this week, we’ll explore the coverage gap found in nat cat coverage everywhere around the world. It, too, is a result of underwriting leakage (along with a bunch of other factors).

Topics: Insurance Underwriting, Natural Catastrophe

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