The Driver: It's Price, Not Risk
July 2003
Has a fundamental understanding of clients’
businesses, risks, and their ability to manage these risks been pushed aside
by a focus on pricing? It seems that underwriters are being forced to focus
on generating underwriting premiums as opposed to relying on investment income.
This trend and its ramfications are examined.
by Gary
J. Bausom
Bausom & Associates, Inc.
Market conditions currently favor the sellers: underwriting firms. The approach
of the moment seems to be, “Don’t confuse me with the details; just send money,
and a lot of it!” Do underwriters approach underwriting with the view that every
risk fits into one of three buckets: good, bad, and ugly, and correspondingly:
expensive, very expensive, and outrageous?
Risk & Pricing
Given historically low interest rates globally, underwriters are being forced
to focus on generating underwriting premiums as opposed to relying on investment
income. At the same time, underwriters’ credit quality has eroded due to lack
of earnings (principally from investments), recognition of off-balance sheet
liabilities such as asbestos or old claims, unsuccessful enterprise diversification
strategies beyond the insurers’ core business, and lack of focus on past qualitative
risks underwritten.
Is the current rate environment and degradation of credit quality causing
underwriting firms to be less risk adverse to survive? Alternatively, are underwriters
now carefully evaluating underwriting specifications and clients’ financial
statements, and asking tough questions regarding the qualitative aspects of
risk management to make better risk decisions? Do underwriters probe to determine
the relationship between risk management and the clients’ leadership group,
or are they merely interested in the exposure/loss data for running their internal
models?
In times when investment income is very low, underwriters may be tempted
to accept higher risks in exchange for the arbitrage of premium income. Are
underwriters accepting higher degrees of risk in their books of business based
on a comprehensive understanding of each client? If so, are they making commensurate
adjustments in their reserve levels?
There are no media reports declaring insureds are going without insurance;
therefore, certain underwriters must be accepting greater risks, providing their
current pricing objectives have been satisfied. Are these insurers maintaining
an adequate balance between risk and premium as well as carefully balancing
the risks in their portfolios to avoid significant losses in any given year?
The corollary, and seemingly unfair aspect of this market, is that good risks
seem to be difficult to place simply because the discounted premiums they deserve
do not measure up to underwriters’ minimum premiums in the current market. Perhaps,
high quality firms are being penalized because of insurer’s credit quality deterioration,
lack of investment income, and incomplete understanding of each risk.
Understanding
It is fundamental to understand clients’ businesses, risks, and their ability
to manage these risks. There is a significant difference between a company that
has been lucky enough to avoid significant claims and one with high quality
risk management practices. If a company has significant risks, restructuring
the credit and doubling the premium is only a short-term solution. Without quality
risk management and clear support from the clients’ senior management, underwriters
are most likely under-pricing the risk because long-term solutions are not in
place.
Are risk managers leading an effective effort, with operating management,
to raise the awareness level of the importance for risk control? For example,
are engineering reports collecting dust or buried in stacks of paper on an operating
manager’s desk? Have specific actions been taken within certain time frames?
From an underwriting perspective, have underwriters asked for and obtained concrete
examples of how a contingency work-around for a critical facility would mitigate
a loss? Are the underwriters satisfied that they have written an account within
the internal underwriting guidelines … price and volume of written premium?
If insurance companies tighten their underwriting guidelines in times of
low interest rates and make a profit, imagine what the results would look like
if interest rates increased 200 to 300 basis points and they maintained the
same standards. Unfortunately, underwriting guidelines tend to become relaxed
when interest rates go up, and underwriting companies act more like investment
firms who are market timers and stock pickers. They might be successful for
1-2 years, but it has been proven time and time again that first quartile results
cannot be achieved consistently for 5 years or more.
It should be recognized that underwriters, like other businesses, have a
defined strategy. The strategy may call for being opportunistic in niche segments
of the market or alternatively, being broadly diversified, multiline underwriters
with firm risk qualification/selection criteria. It is critical to understand
your customers/clients and stick close to what you know and do best.
So…?
Price is important but the critical issue seems to be: Do risk managers know
what to expect from an underwriter? Is there a misunderstanding or confusion
about coverage or intended coverage, and/or potential lawsuits? How are risk
managers and their firms being represented in the marketplace? Remember, insureds
should think that they are buying a forward contract for a 1 in 50- to 100-year
event. Ideally, underwriters will experience perhaps a couple of these events
every year; however, total premium income should allow for the payment of these
catastrophes, expected losses, and expenses, and still generate a profit. Trading
dollars with an underwriter, by "insuring" expected losses, is tantamount to
borrowing money from a bank at over 33 percent interest rates!
Insurance should be a pooling vehicle for collecting premiums and paying
for catastrophic events, not a mechanism for managing cash flow associated with
the expected expenses and losses of a risk management program. It is in the
best interest of underwriters and risk managers alike to work from a platform
of understanding and not just focus on exposure, data, and price.
If underwriters only analyze a particular risk or account for 2 weeks a year
during the renewal process, who is managing the risks 24/7 for the remainder
of the year? Can underwriters assure their leadership group that the clients’
risks are well managed? If not, the claims adjustment process will be even more
problematic.
Opinions expressed in Expert Commentary articles are those of the author and are
not necessarily held by the author's employer or IRMI. Expert Commentary articles
and other IRMI Online content do not purport to provide legal, accounting, or other
professional advice or opinion. If such advice is needed, consult with your attorney,
accountant, or other qualified adviser.