Insurance underwriters use simple loss ratios (losses divided by premiums) as one of the tools with which to gauge a company's suitability for coverage. In many cases, a high loss ratio—meaning one where the losses approach, equal, or exceed the premium—is considered bad.
The underwriter's first impulse is to reject the applicant due to poor loss experience. No one would seriously find fault with this. As the saying goes, "Figures don't lie." The corollary to this truism is of course that "liars figure."
Okay, so you may be wondering where I'm going with this. How about this? The underwriter who summarily rejects an applicant based on a high loss ratio should be sent to a reeducation camp for a decade or so, but only the nicest possible reeducation camp, mind you. If you're a successful insurance underwriter, this article will provide little insight into how you should do your job; analyzing loss ratios is an integral component. For the rest of us, however, this might be rather interesting.
Turning our attention back to the high loss ratio, could it be that the loss ratio might not be the result of an insidious infection of wantonly excessive and out-of-control losses metastasizing throughout the company but merely indicative of woefully inadequate premiums? The soft property and casualty insurance market has persisted for a decade now. (Soft means that premiums are extremely low.) Look at the composition of the losses; are they composed of a large number of small- and medium-sized losses or a few small losses and a couple of very large "shock" losses?
Wouldn't it be interesting if that once-rejected applicant could be rehabilitated, so to speak? Also, wouldn't it be wonderful if your close underwriter-trainee friend, the Wiley Coyote of insurance underwriters, managed to avoid the falling boulder and was able to turn an apparent "dog" account into a happy camper, and at the same time make his boss smile and immediately recommend him for a promotion, a mid-year bonus, and a company Jaguar? Okay, let's just settle for the smile, shall we?
Many savvy insurance buyers think of their ridiculously high loss ratio as an indication of their business acumen. For example, a 95 percent pure loss ratio (not including expenses) exemplifies extremely valuable insurance; all but five cents on the dollar of premium was used to pay for losses. Conversely, a 10 percent loss ratio might indicate that the premium is far too high given the exposures to loss. (This is when they begin to think about captives, etc.) In the first instance, the insurance company most assuredly loses money as it must pay expenses along with the losses. In the second example, the insurer is making quite a bit of money, much of it perhaps undeserved.
Is there a potential solution to the 95 percent loss ratio conundrum? Yes, but your underwriter-trainee friend, Mr. Coyote, must be ready, willing, and able to dispel the notion that this loss ratio is good for the client and forthrightly address the causes of this problem. First, if the ratio is due to a small number of severe losses, Mr. Coyote and the client might brainstorm various ways to mitigate future losses of this sort. However, if loss frequency is the problem, the client will have to be administered the insurance facts of life sermon. While the client may think she's getting good value for her insurance premium with a sky-high loss ratio, she's just "whistling past the graveyard," as the saying goes. The old insurance adage, "frequency leads to severity," remains as true today as the day it was coined. Loss frequency is the real problem.
Two forces conspire against this client. First, at some point, few underwriters will accept the risk without severe program modifications; a very large deductible or self-insured retention comes to mind. Second, unless remedial action is taken sooner than later, the loss frequency will eventually spawn one or more severe claims. Underwriters who recognize this pattern—high frequency of noncatastrophic losses leading to one or more huge losses—know that it didn't have to turn out this way if the underlying issues causing the loss frequency had been addressed.
Insurers have what they call "acceptable loss ratios." As acceptable loss ratio is one that is just short of producing an unprofitable account. For example, one insurer's workers compensation acceptable loss ratio might be 65 percent, meaning that, when it adds its expense load, the combined loss ratio will be below 100 percent. While few of us feel very much sympathy for the insurance industry, simple math tells us that if an insurer has a preponderance of clients with loss ratios exceeding 100 percent, its ability to pay losses might become impaired.
So, let's get back to our prospective client with the 95 percent loss ratio. If the insurer's acceptable loss ratio is 65 percent, this prospect must understand that, in order for it to be considered for coverage (at a reasonable premium), it must find a way to shed at least 30 percent from its loss ratio. While easier said than done, there are ways in which the insurer and the client can successfully emerge from this situation, but each must be willing to work toward that goal.
What might Mr. Coyote recommend as a reasonable strategy? A combination of financial incentives (or disincentives) and an investigation into the cause(s) of the loss activity, assuming a root cause or a trend is discernable, might save the day. Financial measures might entail a "carrot-and-stick" approach. First, the loss history should be stratified into ranges designed to reveal the total value of losses falling between $5,000 and $10,000, $10,000 and $20,000, and so forth. This will reveal several acceptable attachment points between the deductible and the insurance.
For example, if, based on the range analysis, the loss ratio drops to 70 percent when the deductible is significantly increased and drops another 10 percent when the premium is moderately increased, the underwriter may have found a workable compromise. (This analysis is only valid when a credible amount of historical loss data is available.) A final addition to the formula may be a limited dividend or return premium plan that rewards the client for hitting the formula-driven 60 percent loss ratio goal.
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.