Do Actuarial Models Influence P/C Underwriting Cycle?

December 9, 2011

Property/casualty insurance is noted for the sharp rise and fall of its rates – the underwriting cycle. As actuaries have developed more sophisticated statistical and computer models to help understand complex insurance problems, what has been their effect on the underwriting cycle? Do the models flatten it or make it more volatile?

The answer isn’t entirely clear, as attendees learned at the Casualty Actuarial Society’s annual meeting this week in Chicago.

Three casualty actuaries discussed how model improvements have affected the cycle and may affect it in the future: Stephen Mildenhall, chief executive officer, Aon Benfield Analytics; John Beckman, senior vice president and chief underwriting officer, CNA Commercial Insurance; and David Bassi, chief underwriting officer, The Plymouth Rock Co.

Good models can help companies better understand and manage their risks, which would reduce the cycle. But if models miss a major event, it creates uncertainty, which would exacerbate the cycle.

Actuaries routinely use several newer types of models:

  • Catastrophe models, which estimate the likelihood and the size of natural disasters like hurricanes and earthquakes.
  • Predictive models, which use factors like credit scores to help determine an accurate rate to charge customers.
  • Economic capital models, which try to show how changes in the business and economic environment could affect an insurer’s health.

Mildenhall said that a model that projects off the previous year’s losses and the premium collected over the past two years explains 90 percent of the cycle.

According to Bassi, local factors, including state regulatory changes and reinsurance, also drive price adequacy.

Beckman said flexible capital management and better underwriting tools make a difference, too.

All of the newer models have elements that could flatten the underwriting cycle, or could accentuate it, they said.

Catastrophe models, for example, have been getting better over the years, lending stability to the market. However, if those models come up short – as they did in 2005 with Hurricane Katrina – the ensuing uncertainty can create a spike in prices. Even changing the model can roil the market. That happened this year, after a leading catastrophe modeling firm [RMS] updated its model.

Still, catastrophe models and their predecessors have done an excellent job of containing catastrophe risk, the actuaries said. Catastrophes cause less than 10 percent of insurance company insolvencies, according to Mildenhall, while under-pricing and under-reserving cause five times that amount.

Predictive models have not been around for as long. They have become well-established in personal lines, particularly in private passenger auto, but they are only now emerging in commercial lines pricing. Panelists agreed that predictive modeling will continue to grow, starting with pricing small commercial risks, then later in pricing larger risks.

As the models become more widespread, actuaries will have to help underwriters understand what the models do well and what they don’t. “Underwriters need to understand how well the models capture key risk factors and the role of judgment,” Bassi said.

Underwriter understanding is also crucial to a company’s relationship with agents and policyholders. The underwriter needs to know why a predictive model is behaving as it does.

“We can’t say [to a policyholder], ‘You get a rate increase because we have this new predictive model,'” Beckman said. “That won’t create a satisfied customer.” The underwriter needs to know and be able to communicate what characteristics drive the model indication for each insured, he said.

Economic capital models recreate an insurance company’s risk portfolio – the risks it underwrites and the investments it makes – and show how that portfolio would react to a wide variety of economic and industry scenarios. That lets management know where the company is weak. Managers can then shore up the weakness or be prepared in case a threat emerges.

A capital model also helps regulators and rating agencies understand the company’s strengths and weaknesses. Capital models will play an important part in Europe’s Solvency II, which is a more rigorous system of monitoring insurers than the EU previously had under Solvency I and scheduled to come into effect on January 1, 2013.

However, the models sometimes reflect what management already believes, the panelists said. That’s a weakness in some ways, but it can turn into a strength. When the model reflects management’s point of view, it is easier for managers to ‘buy into’ the model’s output, Bassi said. Then, they will find it hard to discount any discouraging news coming from it in the future.

Beckman noted as regulators better understand a company’s capital model, their understanding of the company itself improves. That, too, is valuable.

Sometimes, however, management relies on the model without a full understanding of the inherent uncertainties. Then when it fails, they over-react. Over-reacting — raising or lowering prices too much — drives the underwriting cycle, Bassi said. As a result, “It has the potential to create less frequent but more severe cycles,” he said.

Though models will become more important to the business, they won’t be the only thing that’s important.

“We’re still a people business,” Beckman said. The models will play important roles, but the ability to explain the model – to managers, underwriters, investors, regulators and rating agencies – will be critical.

“The people who are the best at communicating this will be the ones who use the model best. And the ones who use the model best are the ones who will succeed.”

The CAS session on actuarial models was webcast and can be viewed via the CAS Web Site (

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