One of the basic premises behind insurance is the Law of Large Numbers. This holds that “as more exposure units join the statistical group, losses become more predictable.” In other words, insurance companies attempt to spread the losses of a few among the many who pay insurance premiums.
I had a recent conversation with my own insurance agent concerning a dramatic 35% increase in my homeowner policy price. He said that the insurer had experienced several catastrophic losses during the year and that they needed to increase prices in order to stay solvent. This is the Law of Large Numbers at work.
Insurance companies attempt to write policies insuring risk exposures that will not have losses, hoping to earn an underwriting profit. An underwriting profit occurs when premiums paid into the insurance company total more than the losses paid out by the insurance company, plus expenses incurred. It does not include other sources of income, such as investment income.
Here’s the rub. The typical insurance consumer doesn’t know whether he or she is adequately covered or whether they are paying a fair price in the marketplace for what they have purchased. They rely almost exclusively on what their insurance agent or insurance company tells them. That can be a big mistake!
Insurance companies tell agencies that represent them, and management at these insurance agencies pass along to their sales force the message that no one should “leave money on the table.” This means insurance agents should try to sell insurance policies at the highest possible price while still closing
the deal. In personal lines (automobile and homeowners) there are typically pricing “tiers” that customers may qualify for. These are controlled by underwriting guidelines, for the most part, but exceptions can be made to give customers a better deal than they would normally qualify for. Equate this to paying the sticker price for an automobile rather than obtaining a discount for the car you purchase. Most consumers have no idea that they may be able to qualify for a better price with the same company. Remember, it is in the insurance company’s best interest to charge the highest possible price for their products since this helps improve their bottom line.
In commercial lines (businessowners, commercial property and general liability coverage) there is even more rate (price) flexibility. Technically, underwriters are charged with looking at the characteristics of a particular business and applying “credits” or “debits” to the particular business. However, policy pricing can depend upon non-risk characteristics. One such non-risk characteristic is the market cycle. In soft markets, most policies have some type of credit, and much pure underwriting credibility is lost. Credits tend to be applied haphazardly with little regard to the actual risk characteristics of a business. Instead, bottom line pricing rules.
In hard markets, the pendulum swings the other way and consumers are often charged more than their individual risk characteristics merit. As mentioned in the last chapter, this may be due to the increased price of reinsurance, or perhaps due to the fact that the insurance company previously had a bad year (for example, their combined ratio, defined as the ratio of income to expenses, was over 100%).
Sometimes, pricing a new business account amounts to nothing more than an underwriter asking their agent (or the client directly) how much the client is currently paying with their incumbent company—and then releasing a quote at a slightly lower price. The lower price is typically low enough to entice the prospective customer to move their insurance, but generally is not as low as the company could go.
There are special tools available to underwriters when they price accounts. Experience rating allows certain lines of commercial business to be further discounted, depending on an individual account’s past loss history.
A-rates are judgment rates applied to certain general liability codes which allow the underwriter to price this line of business however they wish (using their best judgment). For instance, if I want to insure 1,000 acres of real estate development property (land),the judgment rate could be anywhere
from .01 per acre to $100 or more per acre.
Loss costs are additional rating factors that are used by underwriters during the premium rating process. Loss costs are typically applied to commercial business policies and reflect the insurance company’s profitability on certain segments within a line of business. For instance, loss costs can be applied separately to commercial automobile liability, automobile comprehensive, automobile collision, and other factors that make up the total premium for commercial automobile insurance. Generally, insurance companies are able to apply additional credits through the use of loss costs. However, if debits result from loss costs the resulting price may be adverse, thereby becoming uncompetitive.
General liability rates are usually based on sales (receipts), units, acres, or such similar measurement. General liability rates are filed with state Departments of Insurance based on “class codes,” which differ according to the type of business being insured. As an example, a frozen food distributor has a class code of 13049, while a restaurant with no sales of alcoholic beverages—without a dance floor—a code 16814. Different types of businesses have different corresponding base rates.
Property rates are usually developed from Insurance Services Office (ISO) inspections. ISO physically inspects properties and provides insurance rates for insurance company use. These rates are based upon factors such as the building construction (i.e., frame, masonry, non-combustible), and fire protection (i.e., less than five road miles from the responding fire department or more than five road miles from the responding fire department). The developed rates are then accessed by insurance company underwriters who make an educated guess as to the probability that this particular property will be a good risk for the insurance company to insure.
The higher the probability of loss (i.e., a wooden building located fifteen miles from a responding fire department), the more premium on a “rate per
$100 of value” basis the business or homeowner will pay. Alternately, the better the risk from a fire protection standpoint, the lower the rate per $100 that will be charged, such as when a business building has a masonry exterior and is located two blocks away from the responding fire department.
underwriters look at motor vehicle records of all persons who will be driving vehicles for the business. Again, the application of “credits,” pricing tools such as experience rating, loss costs and IRPM (internal rate premium modification), can be applied to reduce the “manual” rate developed. Underwriters use their judgment when applying IRPM. Some insurance companies have internal guidelines concerning when, and how much, IRPM can be applied.
However, in nearly all cases, exceptions can be given by management to bring pricing down even further through the application of higher credit percentages.
Many Worker’s Compensation policies offer dividends as an incentive for a business owner to write his work comp with a particular insurance carrier. While dividends are not guaranteed, they have a strong history of being paid on a regular basis. In addition to offering various dividend plans, some states allow companies to discount their rates through use of IRPM credits.
While covering the area of pricing it is important for you to understand that there are factors that can impact your personal or business insurance pricing that are beyond your control. One such factor is the decision by either insurance companies or insurance agencies, or both, to respond to their policyholders based on certain characteristics that you cannot change. For instance, an insurance company may decide that it no longer is interested in providing insurance coverage for a certain type of business—I’ll use restaurants as an example.
Perhaps because a senior manager who is new to the insurance company has had a bad experience with restaurants at a previous employer, he decides that it is no longer in the best interest of his current insurance company employer to insure restaurants. As a result, an edict is sent to all underwriting staff to begin to “run off” restaurants that the company insures. This can be done in different ways, but usually involves applying significant price increases at renewal. Nothing about the restaurant has changed; its only sin is that it is no longer considered desirable from the insurance company’s viewpoint. Eventually, the insurance company’s restaurant policies may be sold to another insurance company that does not harbor similar negative feelings about restaurants.
A similar circumstance can take place at an insurance agency where through no fault of your own you begin to be treated differently. For example, an insurance agency may want to improve their profitability so they
hire a 3rd party strategist (consultant). One of the consultant’s suggestions may be for the agency to begin segmenting their business by premium volume (or commissions earned). One school of thought holds that insurance agencies need to spend more time with accounts that pay higher premiums and that the smaller accounts are a distraction. Therefore, the agency picks a number, say accounts that generate above $25,000 annual premium for commercial lines of business. Accounts that generate less are handled strictly by customer service representatives and are given no accommodations. The idea is to give them the very least amount of time possible and if the customer happens to leave, that is perfectly okay with the insurance agency.
As a business strategy, the insurance company and insurance agency’s actions cannot be faulted. They are entitled to run their businesses the way that they desire. My issue with this type of insurance company and agency actions is that they seldom tell their customers about the new strategy. Therefore, if you do not pay attention to how you are treated by your insurance company and/or insurance agent, significant changes may be taking place that can cost you money.
As an insurance consumer, it is in your best interest to stay alert, notice when significant changes are made to your insurance coverages and/or pricing, and to ask questions. Things change over time and purchasers of insurance become complacent and wrongly have the opinion that their insurance company and insurance agent always have their best interests at heart.
If you find that your business is no longer welcome at your insurance company or agency, shop around. You are likely to find another insurer and agent who will happily provide insurance to you.
One last thing before we leave the topic of pricing. Return to the example of the automobile industry and how cars are sold. Manufacturers need to obtain a bottom-line price on models they sell in order to cover their expenses and to remain a going concern. Similarly, dealerships need a certain amount of profit (typically a percentage of gross revenues) to keep the doors open. However, the sale price varies from vehicle to vehicle, even for the same model. There are still people who pay sticker price for their cars and there are people who are ferocious negotiators. In the end, dealers net out all sales for their bottom line. Some pay more, some pay less, and the dealership makes enough money to cover their expenses and margin of profit.
It is much the same for insurance companies and insurance agencies. Some
people accept whatever pricing their insurance company and insurance agent deliver, while others negotiate every single insurance policy premium. Overall, both the insurance company and insurance agency make enough money to stay in business even though prices paid may differ from customer to customer.
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