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By BADRI NARASIMHAN, CEO of Rulester LLC, a company that applies predictive modeling, data analytics and business rules to increase the agility of insurers, and KIM WARD, former chief actuary at American Association of Insurance Services and currently an actuarial consultant

Imagine having to underwrite a fleet. It may be penalized because of the nature of cargo it carries, the weight of the cargo and the average distance of travel.

The result of such an action usually will lead to a much higher price than experience suggests, creating scenarios where the insurer prices themselves out of the market and leaves good risk on the table.

We call this scenario the "double-whammy"--only understanding the individual risk premiums but failing to identify how to price more effectively by understanding the incremental risk.

THE RIGHT FORMULA

A double-whammy is the process of risk adjusting the same risk twice for two different risk factors that may be present at the same time but do not lead to a linearly higher actual risk adjusted price. This leads to overprices quotes--and losing your business to competitors.

The approach to solving this problem often also unearths new variables that affect your losses, which presently may not even be used for rating.

For instance, back to your fleet:

The risk premium of cargo greater than 1000 pounds by itself may be x, and the risk premium of an average travel distance greater than 100 miles by itself may be y. But the risk premium of cargo greater than 1000 pounds and an average travel distance greater than 100 miles is not necessarily x+y.

The right approach is to not only find the individual contribution of each variable to the risk profile but also the "incremental" contribution of the risk to the price.

WHAT DOES THE DOUBLE-WHAMMY REALLY MEAN?

When insurers remove the double-whammy effect, they are able to price right and potentially accept more of the good risk that they today do not accept, which would increase both their revenue and their combined ratios

They can also provide a lower cost option for good risks--say, safe commercial truckers--that need all the help they can to weather the economic storm. And carriers can create a competitive differentiation using insights from their own data to drive decision making

HOW IT'S DONE RIGHT

The best approach to eliminating the double-whammy is to price your risk after first studying your rating factors and seeking to eliminate instances of overlap among them. For starters, begin with the following steps:

1. Review your statistical data. What is the severity and frequency of your book of business? Are the statistical records accurate and complete? If not, adjust or otherwise complete them to make sure the full picture is taken into account before starting.

2. Consider what your target class groups are. An example of such a group may be classes that are traditionally rated very high, but, due to the distribution of risks underlying the average rating factors, there is a profit opportunity if the lower-risk individuals can be attracted to your program

3. What does an overall rate level analysis indicate? Review each factor and coverage individually using standard actuarial techniques. What are the data challenges and shortcomings? What are the results for target class groups?

4. Next, use a tool that can identify the statistical impact of the individual factors and the incremental factors for insights into the interactions and correlations between rating factors. Note that some of the tools also give you a score for how valid the model is, which means that, if you are not including all the factors, you will be alerted to the fact and can include the missing ones to improve your analysis.

5. It is not uncommon for an insurer to discover that the current class plan is not representative of the loss costs or identify that factors they do not rate on presently: e.g., amenities in the truck may have a hidden influence on loss costs. You can see the effect of a double-whammy once you know what to look for. Recommend a new class plan and calculate its rate effect based on the incremental and individual risk patterns. Start planning the transition to the new class plan.

6. Most importantly, you can now help improve underwriting standards. For example, you never underwrite trucks carrying hazmat because there were two large losses five years ago, but after John Smith left the company, no one bothered to question whether that was an anomaly or an indicator of bigger risk. Statistical analysis indicates now that, even though hazmat carrying trucks by themselves have a high severity, further analysis is clear that the class plan adequately covers the risk. No one questioned this for five years; now, you have data to make the case for revised underwriting standards.

7. Coordinate pricing with underwriting guides. For example, there may be underwriting standards that either accepted too much of the bad risk or too little risk because of overpricing (the double-whammy). Create a discussion around those policies.

8. Check up on results periodically. One of the flaws of pricing analysis is that it is touched too infrequently because it is not easy to file for new rates and change them midstream. However, underwriting guidelines can be changed--and you can decrease your exposure on the run. Thus, you can resort to changing underwriting guidelines on a more frequent basis and adjust rates when you can, giving you the most flexibility to adapt your business.

9. Create a practice around continuously checking the data and get alerted if the trend of actual experience is different from expected experience

TIME TO CHANGE?

Identifying the individual and incremental risks, pricing using the right variables and periodically checking the validity of underwriting standards to make sure that the business can adapt itself to reality is indeed a full cycle.

Gone are the days of hard and soft markets that last 7 years. We live in a reality that varies by the year, with 2009 promising to be one with downturns, stiff competition for lower demand and the potential for some brand-name insurers to stumble.

To succeed in this reality, you need to be more nimble than before, identify steps you can take to incrementally solidify your competitive position, even as you make sure that all the steps put together lead you to the right path.

March 3, 2009

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