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960 Study text: 2017

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© The Chartered Insurance Institute 2016

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Print edition ISBN: 978 1 78642 044 2

Electronic edition ISBN: 978 1 78642 045 9
This revised and updated edition published in 2016

The author
Dr Laura Cochran BA, MA, PhD, ACII Chartered Insurance Practitioner. Laura has over 25 years’ experience in general
insurance, mostly in commercial underwriting management but also involving statistical analysis, project and branch
management, systems liaison and international knowledge management. She now provides independent consultancy to general
insurers with a focus on underwriting strategy and governance.

Reviewers
The CII would like to thank:

Helen Hatchek, Independent Consultant in Insurance and Insurance Risk, for updating the 2017 edition.

Elspeth Hackett, Head of Underwriting, Personal Lines, LV=, for reviewing the 2014 edition.

Tim Rourke, MSc, FIA, Head of Pricing, Broker Motor, LV=, for updating chapter 7 of the 2014 edition.

Roland Agard MSc, IRM, FCII, Nick Hankin BA, ACII, MBA, Andy Kean and Jamie McNabb, FCII, who reviewed the first edition.

Acknowledgement
The CII would also like to thank:

the following CII Underwriting Faculty Board members for their assistance: Jeremy Diston, Mark Hynes and Clive Nathan;
the authors and reviewers of CII study text 990, extracts from which are included in this text.
Phil Foley, author of the forthcoming CII study text 995, extracts from which are included in this text.

The CII thanks the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA) for their kind permission to
draw on material that is available from the FCA website: www.the-fca.org.uk (FCA Handbook:
www.handbook.fca.org.uk/handbook) and the PRA Rulebook site: www.prarulebook.co.uk and to include extracts where
appropriate. Where extracts appear, they do so without amendment. The FCA and PRA hold the copyright for all such material.
Use of FCA or PRA material does not indicate any endorsement by the FCA or PRA of this publication, or the material or views
contained within it.

While every effort has been made to trace the owners of copyright material, we regret that this may not have been possible in
every instance and welcome any information that would enable us to do so.

Unless otherwise stated, the author has drawn material attributed to other sources from lectures, conferences, or private
communications.

Typesetting, page make-up and editorial services CII Learning Solutions.

 Using this study text

Welcome to the 960: Advanced underwriting study text which is designed to cover the
960 syllabus, a copy of which is included in the next section.

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Examination syllabus
 960 syllabus quick-reference guide

Syllabus learning outcomes Study text chapter and section

1. Analyse key regulation and legislation affecting the underwriting function.

1.1 Explain the impact of legislation and regulation on the underwriting 1A, 1D, 4C
function.

1.2 Examine the relationship between the underwriting function and 1B, 2B–2D, 3A
solvency requirements

1.3 Examine the issues and implications of underwriting business 1C, 3B

internationally

2. Evaluate underwriting strategy, policy and practice.

2.1 Analyse the relationship between the corporate, reinsurance and 2F, 2H, 3A, 3F, 4D, 8A, 8H
underwriting strategies.

2.2 Explain the impact of various distribution channels on the 3D

underwriting function.

2.3 Explain the implications of using binding authorities. 3D, 4E, 9K

2.4 Explain the research required to ensure effective underwriting policy. 3C, 4C

2.5 Analyse the factors to be taken into account when entering and 2B, 2I, 3A
withdrawing from classes of business and markets.

2.6 Explain the significance of claims reserving policy and practice on 6A, 6B
portfolio management.

2.7 Analyse the impact of product mix, segment mix and cover mix on 4D
portfolio management. .
2.8 Explain underwriting considerations to be taken into account when 2B, 2E, 2G, 3C, 4C, 4E, 5B, 5C
establishing policy terms and conditions.

2.9 Evaluate the importance of risk acceptance, evaluation and control 4B, 8A
on the portfolio mix.

3. Analyse the principles and practices of pricing.

3.1 Examine the internal and external data required for pricing. 7A

3.2 Explain the various components to be taken into consideration for 7C

pricing.

3.3 Explain how the different statistical methods are used in pricing. 6C, 6D, 7B–7E

3.4 Examine the impact of the underwriting cycle on portfolio 3C, 7D

management.

3.5 Examine claims information in relation to setting the price, setting 6B, 7B
reserves and regulatory requirements.

4. Evaluate the management of exposures in the portfolio.

4.1 Explain aggregation and the techniques available to measure exposure 8B, 8C, 8E–8G
to single risks, single events and catastrophes.

4.2 Evaluate emerging risks, including systemic losses. 8D

4.3 Explain the various means of managing exposure and enabling 2E, 2F, 8G–8I
capacity, including reinsurance.

5. Evaluate planning, portfolio monitoring and operational controls

5.1 Explain the process of planning, budgeting and forecasting. 2A, 3A, 4A, 5A–5I, 6B, 9H

5.2 Explain the reasons for monitoring underwriting results 5G, 9 Introduction, 9A
5.3 Evaluate the techniques for monitoring underwriting results 9A–9E

5.4 Evaluate the effect of monitoring and forecasting on the underwriting 9F, 9G
strategy.

5.5 Explain the significance of identifying the underwriting skill-set 3E, 9B, 9H
required, key performance indicators and continuing professional
development

5.6 Evaluate the use of underwriting licences and auditing 9D, 9I–9L
 Introduction

If you are studying the 960: Advanced underwriting Advanced Diploma in Insurance unit, it
is likely that you are already working in the insurance market as an underwriter. You may
aspire to a role in underwriting management or have recently been appointed to such a role.

Through previous study you already understand the fundamental issues relating to
underwriting policy, the legal and regulatory environment in which the general insurance
industry operates and its capital requirements. Through your own underwriting experience
you understand in some detail one or more specific areas of general insurance underwriting
practice. The objective of this unit is to build on your existing knowledge by examining how
underwriting management, working with other areas of expertise, contributes to the effective
management and success of general insurance businesses.

By one definition ‘knowledge is the ability to take effective action’ and, as this unit is
concerned with the application of knowledge, you will be asked to imagine yourself in a
number of different underwriting management roles: for example, responsible for groups of
risks in an underwriting portfolio (product, scheme or branch account) or, as an underwriting
director, responsible to the board for all your company’s underwriting activities and
outcomes.

Irrespective of your level within a company, as an underwriting manager you are responsible
for the activities and decisions of the staff reporting to you and for the achievement of
financial and other business targets set by executive management. Your responsibility for
outcomes and results is mirrored by your role in developing plans, setting standards and
guidelines, monitoring results, auditing work, anticipating issues and taking action to tackle
them. As a member of the management team, you work closely with other professionals in the
actuarial, finance and claims teams, as well as colleagues responsible for compliance, risk
control, distribution/sales, operations/customer service, ICT and marketing. You also work
hard to maintain good relationships with your company’s reinsurers and third-party
suppliers.

Success in the 960 examination will require you to undertake further reading and
private research beyond this core text.

Suggestions for further reading are included in the Reading list at the end of the
Examination syllabus and bibliographies are provided for most chapters. You will also find
a number of research exercises and other activities are included (see the ‘Using this study
text’ section for further detail). Taking time to do these extra activities will not only enhance
your chance of success in the examination/coursework but also increase your effectiveness
in your chosen career.
 1 Regulation and legislation affecting the
underwriting function

Contents Syllabus learning

outcomes

Learning objectives

Introduction

Key terms

A UK financial services regulation 1.1

B Capital and solvency requirements 1.2

C Competition 1.3

D Legal and regulatory constraints on scope of cover 1.1

Summary

Bibliography

Revision questions and answers

Learning objectives
This chapter relates to syllabus section 1.

On completion of this chapter and private research, you should be able to:

explain how the financial services industry is regulated in the UK;

examine the relationship between solvency requirements and the underwriting
profession;
explain the implications of competition legislation on the underwriting function;
explain the impact of the FCA product intervention strategy, the Consumer Insurance
(Disclosure and Representations) Act 2012 and equality legislation on underwriting
decisions; and
explain the implications of the Insurance Act 2015 on the underwriting function.
Introduction
A detailed explanation of the principles of regulation and summaries of the statutory and
legislative issues affecting the underwriting function will have been provided in units that you
previously studied. While this chapter will provide a brief overview of these important topics,
this unit intends not to repeat information but rather to build on it as appropriate to the
management of the underwriting function. For example, we will introduce the link between
the regulatory requirements to hold certain levels of capital and the decisions made by senior
underwriting managers about the types and level of risks their organisations wish to accept.

Throughout this study text you will find references to relevant regulatory and legislative
matters, in particular legal and regulatory constraints on the scope of cover (the
Principles for Businesses (PRIN), treating customers fairly (TCF), the Financial
Ombudsman Service (FOS) and legal reforms, for example).
Many references relate to Solvency II, which became effective from January 2016, as
understanding how this legislation is inextricably linked to many of the decisions made
by the senior managers (including underwriting managers) of an insurance company is
essential.
The topic of competition has become increasingly important since it was included as
one of the FCA’s statutory objectives. Underwriting managers will need to be alert to the
changes made by the FCA and how they affect their organisation.

Reinforce
The 960 syllabus refers both to the understanding and application of key regulation and legislation to the
underwriting function. As an insurance professional, you are required to understand and observe relevant legislation
under the terms of the CII Code of Ethics and those of your contract of employment. Given the range of applicable
legislation (relating to many matters in addition to those relating specifically to underwriting), this could appear to
be a potentially overwhelming task were it not for the sources of assistance and advice available to you. Many
suggestions for further reading and useful websites have been included throughout this study text.

Your company’s legal and compliance teams are best placed to explain the precise implications of any planned
course of action and you should not hesitate to seek their advice. You are obliged to be alert to the possibility that a
course of action may have regulatory and/or legislative implications for your company and you must ensure that no
precipitate or unauthorised action on your part brings your company into disrepute or worse.

Key terms

This chapter features explanations of the following terms and concepts:

Capital model Competition Competition and Markets Conduct risk

Authority (CMA)

Insurance Act 2015 Insurance Block Exemption Minimum capital Own risk and solvency
Regulation requirement (MCR) assessment (ORSA)
Product intervention Quantitative requirements Return on capital (ROC) Solvency capital requirement
(SCR)

Solvency II Directive Treating customers fairly

(TCF)
A UK financial services regulation

A1 Financial Services Act 2012

Since 1 April 2013 regulation of the UK financial services industry has been the responsibility
of the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA),
which jointly took over the majority of the duties carried out by the former regulator, the
Financial Services Authority (FSA), under powers granted by the Financial Services Act
2012. The PRA works alongside the FCA to form a ‘twin peaks’ regulatory structure in the UK.
A third body, the Financial Policy Committee (FPC), which sits within the Bank of England, is
responsible for monitoring emerging risks to the UK financial system as a whole and
providing overall strategic direction.

Figure 1.1: Regulatory framework

Source: HM Treasury

A2 The PRA
The PRA is part of the Bank of England and it has a close working relationship with other parts
of the Bank, including the FPC and the Special Resolution Unit.
The PRA is responsible for the prudential regulation and supervision of banks, building
societies, credit unions, general and life insurers and major investment firms. In total it
regulates approximately 1,700 financial firms.

The PRA’s primary objective, as defined in the Financial Services Act 2012, is to ‘promote the
safety and soundness of PRA regulated persons’. In promoting safety and soundness, the PRA
focuses on the stability of the UK financial system by ensuring that authorised persons
operate in a way that avoids adverse effects on the system as well as by minimising the
adverse effect that the failure of an authorised person could have. A stable financial system is
one in which firms continue to provide critical financial services – a precondition for a
healthy and successful economy. The PRA also has an additional insurance objective, which is
to contribute towards securing an appropriate degree of protection for those who are, or may
become, policyholders.

The PRA makes forward-looking judgments on the risks posed by firms to its statutory
objectives. Those institutions and issues which pose the greatest risk to the stability of the
financial system are the focus of its work. The aim is to pre-empt risks before they crystallise.

A2A Threshold Conditions

The Threshold Conditions are the minimum requirements that firms must meet in order to be
permitted to carry out regulated activities. At a high level, the Threshold Conditions require:

an insurer’s head office, and in particular its mind and management, to be in the UK if it is
incorporated in the UK;
an insurer’s business to be conducted in a prudent manner, and in particular that the
insurer maintains appropriate financial and non-financial resources; and
the insurer to be ‘fit and proper’, appropriately staffed, and the insurer and its group
capable of being effectively supervised.

The PRA will want to ensure that at the point of authorisation new insurers hold capital
sufficient to cover the risks they run. Once authorised, firms must continue to meet these
conditions at all times.

A2B Risk assessment framework

The PRA’s framework reflects its additional insurance objective to protect policyholders as
well as the financial system. It captures three elements:

1. The potential impact on policyholders and the financial system of a firm coming under
stress of failing.
2. How the macroeconomic and business risk context in which a firm operates might
affect the viability of its business model.
3. Mitigating factors, including risk management, governance, financial position (including
its solvency position), and resolvability.
Figure 1.2 depicts this framework.

Figure 1.2: The PRA’s risk framework

Source: The Prudential Regulation Authority’s approach to insurance supervision.

Useful website
The PRA’s approach to insurance supervision:
www.bankofengland.co.uk/publications/Documents/praapproach/insuranceappr1603.pdf

A3 The FCA
The FCA is a separate institution and not part of the Bank of England. Although it is
accountable to the Treasury, it operates independently of the Government and is funded by
the firms it regulates.

The FCA regulates over 56,000 firms.

It is the regulator for both the prudential and conduct of business in respect of firms of
limited systemic importance, e.g. insurance intermediaries and asset managers. It also
regulates Lloyd’s members’ agents and Lloyd’s brokers.
It regulates conduct of business issues for the systemically important firms that are
prudentially regulated by the PRA, e.g. insurers, banks, Lloyd’s, and Lloyd’s managing
agents.
The FCA is also responsible for the Financial Ombudsman Service (FOS) and the
Financial Services Compensation Scheme (FSCS).

The Financial Service Act 2012 states that the FCA’s overarching strategic objective is to
‘ensure that the relevant markets function well’. Its operational objectives are to protect
consumers, ensure that the industry remains stable, and promote healthy competition
between financial services providers. This includes acting to prevent market abuse and
ensuring that consumers get a fair deal.
A3A The FOS
The FOS publishes decisions, comments and case studies relating to complaints handled.
Where complaints relate to the interpretation of policy cover, underwriting managers are
well-advised to pay heed to FOS decisions. Although the direct issues being addressed may
relate to sales, claims and complaints handling, underwriting may be impacted through the
requirement to pay claims which would otherwise have been declined and the need to amend
wordings to reflect the insurer’s intention more clearly.

Useful website
www.fos.org.uk. Search, for example, for the FOS approach to ‘keys in cars’ cases.

A4 The regulatory Handbooks

At legal cutover the original FSA Handbook was split between the PRA and FCA to form two
new Handbooks. Most of the provisions were incorporated into either the PRA Handbook or
the FCA Handbook, or both, according to each regulator’s set of responsibilities and
objectives.

The PRA has rewritten the PRA Handbook and created the PRA Rulebook. This ‘legacy’
regulation from the FSA has been simplified and converted into principles. The Rulebook
contains rules and directions made by the PRA, which apply only to PRA-authorised firms.

Useful websites
PRA Rulebook: www.prarulebook.co.uk

FCA Handbook: www.handbook.fca.org.uk

A4A Principles for Businesses (PRIN)

Think back to M80 chapter 1, section C

You will be aware from your previous studies that the PRIN sourcebook, included in both the
FCA Handbook and PRA Rulebook, outlines the fundamental obligations of all firms under the
UK regulatory system. An underwriter should be mindful of all the principles, but when
dealing with a proposer or an existing customer, those that refer to integrity, fairness, skill,
clarity of information and proper standards are particularly relevant.

A4B Training and competence sourcebook

The sourcebook relating to training and competence, included in the FCA Handbook, is
relevant to underwriters. It also links to the second Principle: ‘a firm must conduct its
business with due skill, care and diligence’. The training of underwriters used to be a
combination of informal on-the-job training assisted by formal study. In recent years this has
changed substantially as companies have responded to the demands of increasingly
competitive markets. They recognise that the offer of structured training and related
remuneration is critical if they hope to retain the best staff. As stricter regulation in this area
has been introduced, insurers have had to accept that effective training must be offered to
staff across the company and maintain auditable records to evidence this.

A4C Treating customers fairly (TCF)

Think back to M80 chapter 1, section C2

As you will know from your previous studies, the FSA’s TCF initiative imposed a duty on the
management of a firm to ensure that the principle of TCF was embedded into the firm’s
values, culture, and the way it conducted its business. The FCA continues to monitor whether
TCF has been considered and delivered at every level of the organisation, and that
performance is regularly reviewed against the TCF obligation. Therefore, this theme is central
to the role of the underwriter in ensuring that the customer is given sound advice, and an
understanding of TCF and the six consumer outcomes is in the best interests of all insurers
particularly when creating new products for market.

A5 Authorising new insurers

It is the responsibility of the PRA to assess applicant insurers from a prudential perspective
and determine whether the applicant will meet the Threshold Conditions (outlined in section
A2A) at the point of authorisation and on an ongoing basis. At the same time the FCA will
assess applicants from a conduct perspective. The PRA leads and manages a single
administrative process and is responsible for coordination and transmission of all formal
notices and decisions to the applicant insurer.

The guidance notes for insurance companies demonstrate the scope and depth of information
required, including detailed financial projections and information about management, staff,
systems and controls. The review and evaluation of this mass of information inevitably takes
time: the regulators’ service standard states that they will make a decision within six months
of receiving a complete application. Clearly, more is involved in gaining authorisation than
merely providing financial projections.

Although the authorisation of the start-up company to write general insurance business is
recognised by all concerned as a necessary step, the PRA and the FCA will only consider
granting authorisation once all of the required information has been assembled.

It has often been said that the requirements of the regulatory regime in the UK largely reflect
what good businesses would be doing in any case. By the time the start-up company has
gained authorisation, the underwriting manager would already have access to three- or five-
year forecast revenue accounts for each class of business (on a realistic and two pessimistic
bases), as required in the application. These forecasts (and their explanatory notes) form the
basis of the monitoring which must commence as soon as the business goes live; this
monitoring should extend encompass not only the overall financial results but also all the
assumptions used in the creation of the forecasts.

Research activity
To appreciate what is involved in the case of applications for authorisation in the UK it is well worth reviewing the
guidance provided on the PRA’s and FCA’s websites: www.bankofengland.co.uk/PRA and www.the-fca.org.uk.
B Capital and solvency requirements
Think back to M80 chapter 2, section A

All businesses require capital in order to operate. The nature of the insurance business means
that insurance companies require substantial amounts of capital (in various forms) to reflect
its inherent nature – that of uncertainty.

The question of exactly how much capital to hold is a very difficult one. If an insurance
company holds enough to cover all possible future claims, this would tie up a huge sum of
capital. On the other hand, if they would rather free up capital for other uses, they would then
be vulnerable to large unexpected claims. It therefore depends how much risk the company
wants to take; however, they have to bear in mind the minimum level set by regulators. We
will return to this link between an insurance company’s capital requirements and the attitude
to risk set by senior managers throughout this course.

Regulators recognise the need to deal with this uncertainty and set rules for insurers to
maintain levels of capital appropriate for their business activities. This also ensures that
consumers are protected and that the insurance market operates efficiently.

B1 Solvency regulation
Regulation relating to capital is a complex area and there is a large amount of information
available for further reading on this. The following provides a short synopsis of the current
position in the UK.

Prior to 31 December 2015 UK insurers – and those from other EU (and related) states –
were subject to the EU Solvency I Directive, which specifies a minimum capital
requirement (MCR).
The MCR is the higher of two amounts: the base capital requirement (a flat monetary
figure designed for very small insurers) and an amount that applies to the majority of
insurers, calculated from the volume and type of business. This is the general insurance
capital requirement (GICR) or, in the case of a life company, the long-term insurance
capital requirement (LTICR), plus an extra amount called the resilience capital
requirement (RCR) that protects life companies from market risk.
All UK-regulated insurers legally must have capital at least as large as their MCR.
The EU Solvency II Directive, effective since January 2016, includes a Basel II-inspired
risk-based replacement for Solvency I. See section B2 for more details on Solvency II.

Basel II
Basel II is the second of the Basel Accords (now extended and effectively superseded by Basel III), which are
recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision.

Initially published in June 2004, it was intended to create an international standard for banking regulation to control
how much capital banks need to put aside to guard against the types of financial and operational risks banks (and the
whole economy) face.
 After a series of legislative delays it was agreed that Solvency II would be transposed into
law in Member States by 31 March 2015, prior to the Directive coming into effect for
insurers on 1 January 2016.
In preparation for Solvency II, companies undertook some preliminary reporting during
2015 as a ‘dry run’ to test their preparedness and ability to produce reliable reporting.
The FSA believed that MCR specified in Solvency I only represented about half as much
capital as is needed by an insurer in the UK marketplace. As it was not prepared to wait
for Solvency II, it decided to apply its own more stringent rules. These rules are based on
one of the Threshold Conditions for authorisation: that a UK insurer must have capital
resources that are ‘adequate having regard to the size and nature of its business’. Thus
capital adequacy enabled the FSA and subsequently the PRA to set capital requirements
in excess of the Solvency I limits.
Since April 2013 an insurer’s capital adequacy and solvency has been regulated by the
PRA.
As a result, UK authorised insurers have been working to capital requirements that are
about twice the amount applicable for their EU counterparts, even those operating in the
UK market but authorised to do so by other EU states. This anomaly will stop now that
the EU Solvency II Directive has come into force across the whole of the EU.

B2 Solvency II
Solvency II is the EU Directive covering the capital requirements and related supervision for
insurers. The key elements – the so-called framework – were adopted in 2009, originally with
a view to being implemented by EU Member States by 2012. As mentioned above, this was
then postponed and the Directive came into effect on 1 January 2016.

The main purpose of the new Directive is to ensure adequate policyholder protection in all EU
Member States with all insurers holding capital calculated using the same methodology. It
also takes into account current developments in insurance, risk management, financial
techniques, international financial reporting and prudential standards. It is intended to better
reflect the true range of risks faced by an insurer – an accepted criticism of Solvency I.
Solvency II is also intended to recognise the fundamental differences between the risks of
insurance and banking.

The new regime applies to all insurers with gross premium income exceeding €5m or gross
technical provisions in excess of €25m. Some insurance firms will be out of scope depending
on the amount of premiums they write, the value of technical provisions or the type of
business written. Solvency II principles and rules apply to Lloyd’s syndicates in full.

The Solvency II requirements are structured into three ‘pillars’. Each pillar consists of a
grouping of like concepts with the following main headings:

Financial requirements.
 Governance and supervision.
Reporting and disclosure.

Figure 1.3: The three-pillar approach

B2A Pillar 1 – Financial requirements

Solvency II requirements are more comprehensive than those in Solvency I, which
concentrated mainly on the liabilities side (i.e. insurance risks). Solvency II also takes account
of the asset-side risks creating a ‘total balance sheet’ type regime where all the risks and
their interactions are considered. This is more consistent with the economic realities of
insurance operations.

The Directive establishes economic valuation of assets and liabilities in all solvency
calculations. This means they should be valued at the level at which they could be transferred
(exchanged, settled) to a ‘knowledgeable willing party in an arm’s length transaction’.

Useful website
http://ec.europa.eu/internal_market/insurance/solvency/index_en.htm

Minimum capital requirement

Like Solvency I, the regime specifies an MCR, a critical level of capital below which a firm
cannot be allowed to carry on its operations normally and stringent supervisory powers take
effect. The MCR in Solvency II is intended to be a fairly simple calculation that can be
undertaken and reported to the regulator on a quarterly basis.

The MCR is carried over from the Solvency I regime, but there is now an absolute floor of:
 i. €2.2m for non-life undertakings, including captives except for certain risk classes where
it should not be less than €3.2m.
ii. €3,2m for life assurance undertakings, including life assurance captives.
iii. €3.2m for reinsurance except for reinsurance captives where the MCR shall not be less
than €1m.

In addition, the MCR must not fall below 25%, nor exceed 45%, of the undertaking’s solvency
capital requirement (SCR).

Solvency capital requirement (SCR)

A key feature of the regime is a solvency standard for all firms known as the SCR. This must be
calculated at least once a year, reported to the regulator and published. The firm is expected
to continuously monitor its actual capital position against the SCR and also recalculate its SCR
if the risk profile of the firm changes significantly. The SCR has to be covered by an equivalent
amount of assets in excess of liabilities, subject to specific eligibility and valuation rules. If the
SCR is not covered the firm must submit a recovery plan to the regulator.

The SCR includes provision for the following risk categories:

Insurance risk.
Market risk.
Credit risk.
Liquidity risk.
Counterparty risk.
Operational risk.
Group risk (where applicable).

Options for insurers

Insurers have a range of options, varying from the standardised through to much more
tailored calculations:

Standard formula only.

Standard formula with undertaking specific parameters (USPs) for certain categories of
risk (namely underwriting and reserving risk).
Partial internal model (company’s own capital model for some risk categories, combined
with the standard formula for the remaining risk categories, combined with a
diversification credit).
Full internal model – all risk categories are quantified using the model (statistically or
otherwise).

The standard formula is a factor-based method but it is very comprehensive and much more
complex to calculate than the ECR under Solvency I. The capital charge is calculated for each
risk category and then they are combined using a correlation matrix. Operational risk is
added at the end of the calculation.
A capital model is a company’s own mathematical model (or ‘calculation kernel’, as it is often
known) of their business that can be used to generate a range of outcomes, including the
required scenario for the SCR. It usually includes elements that are stochastically modelled,
which means it statistically generates many scenarios using selected distributions and
parameters.

Be aware
There is a distinction between the terms ‘internal model’ (which can be used to calculate the capital requirements
under Solvency II) and a ‘capital model’. Capital model is a general term for any mathematical model that calculates
capital requirements. Whereas the internal model for Solvency II specifically refers to the insurer’s own specific
capital model, together with the additional processes and governance around it (this is explained below). See section
B3 for more on generic capital modelling.

Useful website
www.lloyds.com/the-market/operating-at-lloyds/solvency-ii

Syndicates operating at Lloyd’s must use a full internal model, as outputs from this are used
to parameterise Lloyd’s own internal model for the whole market. Most large UK insurers
have introduced an internal model (full or partial) and this has created a large workload on
top of the demands of ‘business as usual’. Even though most already had models for the
purpose of producing an ICA – a pre-Solvency II requirement of the PRS – these were not at all
standardised and were of varying quality.

There were previously few requirements around model governance, data quality, methods,
calibration and validation, which are now important areas of focus under Solvency II.
Companies have improved their current models or in some cases started again from scratch.
It is an opportunity to select the optimal modelling platform and structure for the business to
get the most use out of the model. Companies have also redesigned processes to be more
efficient.

However, some companies are using the standard formula, particularly smaller companies for
whom an internal model would not be realistic given the time and cost implications.

For insurers to have their internal model approved for Solvency II it must satisfy a large
number of requirements. The regulator must be satisfied that it appropriately reflects their
risk profile and is embedded in the risk management framework. This is very onerous, but is
intended to produce models that are robust, well understood and used.

Essential features of internal models

To be approved by the regulator, an internal model must:

provide an appropriate calculation of the SCR;

be capable of being calibrated to 99.5% in one year, i.e. a 1 in 200 probability;
be an integrated part of the insurer’s risk management process and systems of
governance; and
satisfy the requirements set out in Articles 120–125 of the Solvency II Directive.
Article 120 relates to the Use Test: ‘Undertakings shall demonstrate that the internal model is
widely used in and plays an important role in their system of governance’. In the level 2
requirements, there is the following foundation principle:

The undertaking’s use of the internal model shall be sufficiently material to result in
pressure to improve the quality of the internal model.

In reality, this means that the internal model should be used as much as possible in the
running of the firm, as this generates ideas and requests from senior management and the
board for more development:

Economic and solvency capital assessment, including calculation of SCR.

Risk management processes; for example, by regular production of specified risk
metrics.
Management decisions, such as purchase of reinsurance, business planning, investment
decisions, product pricing, ALM, mergers and acquisitions.
Capital allocation; for example, by calculating the capital charges to individual lines of
business. This aids management understanding of the true profitability of the business,
taking into account the cost of holding capital.

To satisfy this test, management must show tangible evidence of the model’s use. This could
take the form of model output documentation discussed at meetings, including those at board
level, and minutes showing the decisions that were taken as a result. To achieve this usually
involves providing some training for management, so that they understand the key features
and limitations of the model, and can interpret the output. Typically this involves the
actuaries who build, parameterise and develop the model. In addition, it means producing
meaningful management information from the model.

Companies who already have and use a model are at an advantage, as management will be
already aware of it. Otherwise it needs a significant investment of time to fully adopt and
show genuine use. The PRA can ask to meet with management and so will expect a level of
explanation suitable to their role.

Articles 121–125 relate to more technical standards for the model.

Statistical quality standards.

Calibration standards.
Profit and loss attribution.
Validation standards.
Documentation standards.

While these contain lengthy and detailed requirements, it is nevertheless intended that the
model is very much ‘live’ and run as frequently as required by the business, with transparent
and easy to use outputs. Balancing these needs is a challenge for companies and involves
embedded model change control processes and governance, robust statistical design and live
documentation.
Regulators have the power to impose a capital add-on regardless of the firm’s chosen
approach. The capital add-on might be used if the risk profile deviates significantly from the
assumptions underlying the SCR, or regulators are concerned about the governance or risk
management of the firm.

B2B Pillar 2 – Governance and supervision

There are four ‘building blocks’ of governance that reflect the best practices that should
already exist within firms. These must be well integrated and clearly tie various aspects of the
ongoing governance of the business to risk and capital management. These ‘building blocks’
are:

own risk and solvency assessment (ORSA) and capital management;

risk management system;
policy, processes and procedures; and
key functions.

What is an ORSA?
ORSA
The ORSA lies at the heart of Solvency II.
Source: The European Insurance and Occupational Pensions Authority (EIOPA)

The ORSA is a road map for a forward looking assessment of capital and solvency position across a wide range of
risks and is designed to ensure that an organisation’s solvency needs are met at all times. Since this is the
organisation’s own view of economic capital, the ORSA report also plays an important role in rating agencies’
financial strength evaluations.
Source: Unlocking the ORSA, Ernst & Young, 2010

The ORSA is owned by the board and is a process. Activities that form part of the ORSA take
place on a ‘business as usual’ basis throughout the year. Therefore, the ORSA is a living
document and a key driver for the business, from the board down.

Solvency II requires every firm to produce a written report (the ORSA report) to the
regulator providing an economic view of the capital needed to run its business going forward,
independent of the regulatory requirements.

The ORSA represents good business practice but perhaps its most immediate value aim is to
convince the regulator that the board understands the firm and the risks and challenges it
faces, and the firm has adequate capital to achieve its strategic plans.

The ORSA requires a description of the risks based on the business model, assets and
liabilities with a strategic perspective, e.g. 3–5 years (compared with the twelve month
horizon used for the SCR). The ORCA must be written from the perspective of the firm’s board
and cannot be outsourced.
The ORSA does not have a pre-defined format but it should include the:

overall solvency in qualitative and quantitative terms (i.e. economic capital), including
stress testing and reverse stress testing;
possible future scenarios;
details and analysis of the strategy, business environment and business plan;
assumptions used for the capital calculations, which must not be inconsistent with those
used to calculate the SCR;
outline of how the firm intends to comply with the capital requirements on a
continuous basis – both with and without the use of matching volatility adjustments and
other transitional measures; and
summary of changes to the internal model, its use and its validation; and
control and governance policy.

The ORSA should evaluate all material risks to the firm that may impact its ability to meet its
obligations under insurance contracts (e.g. whether it has sufficient capital to continue in
business for the current year and over the strategic plan period). This includes allowing a firm
to take account of risk mitigation, including through the use of reinsurance. The ORSA should:

be reviewed regularly and approved by senior management and the board;

be based on adequate measurement and assessment processes; and
form an integral part of the firm’s management process and decision making.

Finally, the process and outcome should be internally documented and independently
assessed by the internal and external audit functions.

ORSA guidelines
Lloyd’s has produced a useful ORSA report template for its members in Solvency II Own Risk and Solvency
Assessment (ORSA) Guidance Notes (May 2012), which may be found on the Lloyd’s website.

The PRA, however, has implied that it does not intend to publish specific guidelines to firms on how to write an
ORSA as these might be interpreted as a standard template and thus inhibit boards’ thinking about risk.

Figure 1.4: Factors leading to ORSA

Source: © Reputability LLP www.reputability.co.uk

Figure 1.5: The European Insurance and Occupational Pensions Authority

(EIOPA) perspective on ORSA
Source: © Reputability LLP www.reputability.co.uk

Useful article
Towers Watson. (2011) Insights: own risk and solvency assessment. Engaging the business in Solvency II. May 2011.
Available from www.towerswatson.com/en-ZA/Insights/Newsletters/Europe/solvency-ii/2011/Insights-Own-
Risk-and-Solvency-Assessment-ORSA.

PRA and Solvency II

The PRA maintains a Solvency II website: www.bankofengland.co.uk/pra/Pages/solvency2/default.aspx.

This provides the UK insurance industry with information on the implementation of the Solvency II Directive in the
UK. More information on the Directive, European Insurance and Occupational Pensions Authority (EIOPA)
regulations and timescales can be found on the website for the European Commission and EIOPA.

The Solvency II pages are divided into the following sections:

Solvency II news includes the PRA’s latest information to the UK insurance industry on its work regarding
the Solvency II Directive. This includes: updates; PRA events; PRA policy publications; letters to firms; and
surveys and data collection exercises. Solvency II materials includes information and materials published on
the PRA’s Solvency II pages before Solvency II came into force on 1 January 2016.
The Insurance supervision section provides information on the PRA’s approach to insurance supervision.
The Approvals and waivers under the Solvency II Directive page provides information regarding the
approvals and waivers firms should use to make a formal application under the Solvency II Directive.
B3 Capital modelling
As explained, with the implementation of Solvency II, it is intended that the extensive use of
internal (PRA-approved) capital models in decision-making, more rigorous approaches to
risk management and greater transparency in reporting will better reflect the true risks faced
by insurers. These will change both external perceptions and internal insurance company
behaviours, which involves members of the board and every underwriter with an authority to
accept risks. This has led to insurers developing internal capital models.

Inevitably it has also led to third parties creating their own software models for sale to the
insurer market. There is much debate surrounding uniform models and it is recommended
that a keen eye is focused on further developments. These capital models have involved
thousands of potential scenarios being produced to reflect a range of possible outcomes for
economic and insurance risks.

Within each of these scenarios the insurer revalues its balance sheet. The solvency capital
requirement is then set as to ensure solvency in all but a ‘one-in-a-200-year’ event.

B4 Reactions to Solvency II
The reactions to Solvency II have been mixed. Everyone can see the benefit of having a
modern, risk-based regulatory system operating across the EU but the resulting complexity,
costs and delays have brought criticisms. However, some firms that have invested time and
money in setting up their systems to comply with Solvency II do foresee some competitive
advantage being gained over those who have postponed their preparations.

The ABI has suggested that Solvency II will bring the following benefits:

Consumers:
Solvency II should reduce the risk of failure or default by an insurer, with improved
identification and monitoring of risk.
A more consistent and open regulatory framework should make it easier for companies
to sell across different markets, promoting competition.
A more sophisticated assessment of insurers’ capital should mean insurers are no longer
required to hold excess capital, which increases costs and makes insurance and
investment contracts more expensive than they need to be.

Insurers:
The new regime will have a much greater focus on effective governance and risk
management which become hard, tightly defined regulatory requirements for the first
time, rather than fairly loosely defined obligations.
Market consistent valuations of assets and liabilities will improve transparency and
enable both firms and regulators to better understand the underlying financial position
of the insurer.
 Solvency II will see a much greater role for firms’ own internal risk capital assessments,
including their own internal capital model to provide a significant input to the regulators’
assessment of the firm.
A more streamlined and proportionate regulatory regime should reduce burdens on
insurers, reducing costs and increasing flexibility.

Regulators:
Regulators will have a better understanding of the firms they are regulating. The
information they receive will more clearly identify the key risks in the business. This will
ensure that regulators can take earlier action where risks emerge.

Useful website
www.abi.org.uk > Publications > Solvency II

What will be the practical effect of Solvency II on underwriting?

There still remains a fair amount of uncertainty surrounding this question and it will vary
according to the class of business being written. However, it is certain insurers will need to
reconsider their underwriting strategy in the light of Solvency II requirements.

Underwriting managers need to have a better understanding of the capital required to run
each class of business. Some classes are more volatile than others and, therefore, require
more capital and will need to generate more profit to achieve the required return on capital
(ROC). For example, long-tail classes such as liability are more volatile than homogeneous
portfolios such as pet insurance.

Product design and use of technology may well also come under the microscope to ensure
delivery of required returns on capital employed.
C Competition
One of the FCA’s main statutory objectives is to promote effective competition in the
interests of consumers. It also has a new duty to promote effective competition when
addressing its consumer protection and market integrity objectives. This new duty means
that the FCA is looking to achieve its desired outcomes using solutions that promote
competition regardless of which objective it is pursuing. This involves looking at several
factors, such as:

the needs of different consumers who may use those services, including their need for
information that helps them make informed choices;
how easy it is for consumers to access those services, including consumers in areas
affected by social or economic deprivation;
how easy it is for consumers to switch suppliers;
how easily new businesses can enter the market; and
how far competition is encouraging innovation.

It is clear, therefore, that this new mandate will play an important part in the activities of the
FCA in achieving its regulatory objectives.

The FCA uses ‘thematic reviews and market studies’ as its main tools for examining
competition (and other conduct risk issues) where it believes ineffective competition is
leading to poor outcomes for consumers. Examples of studies already carried out include the
well publicised PPI investigation and, more recently, general insurance add-on products have
gone under the spotlight, along with delegation of underwriting authority.

As the FCA moves forward with this programme, it is essential for underwriting managers to
be alert to the focus of FCA activities to ensure that they can assess the relevance to their own
organisation. This is not only to avoid punitive intervention, but – more importantly – to
manage their underwriting strategies, products, use of technology and distribution channels
in ways that place the consumer at the heart of their business models.

Research activity
Each year the FCA produces a Risk Outlook report, which sets out their views on the main drivers of risks to their
statutory objectives as well as signalling the types of forward-looking areas they will focus on. Find the most recent
report, which is available from the FCA website, and see which areas are likely to have an impact on insurers and
specifically the underwriting function.

The FCA works closely with the financial services competition authority: the Competition
and Markets Authority (CMA).

Be aware
The Financial Services (Banking Reform) Act 2013 gave the FCA ‘concurrent competition powers’ within the
financial sector, effective from April 2015. This means the FCA is able to enforce competition law in the financial
sector in the same way, and with the same sanctions and decision-making powers, as the CMA.
C1 Competition and Markets Authority (CMA)
As part of the Government’s recent reforms to the arrangements for competition, consumer
protection and consumer credit regulation, the Office of Fair Trading (OFT) closed on 31
March 2014, and its work and responsibilities passed to two different bodies.

Competition and consumer protection was assumed by the CMA, which brought together the
Competition Commission (CC) and certain consumer functions of the OFT in a single body.
The CMA will promote competition, within and outside the UK, for the benefit of consumers.
The CMA works with HM Treasury and the FCA as an independent public body to ensure that
competition between companies in the UK remains fair for the benefit of business,
consumers and the economy as a whole.

The CMA has responsibilities for:

investigating mergers that could restrict competition;

conducting market studies and investigations in markets where there may be
competition and consumer problems;
investigating where there may be breaches of UK or EU prohibitions against anti-
competitive agreements and abuses of dominant positions;
bringing criminal proceedings against individuals who commit the cartel offence;
enforcing consumer protection legislation to tackle practices and market conditions that
make it difficult for consumers to exercise choice;
cooperating with sector regulators and encouraging them to use their competition
powers; and
considering regulatory references and appeals.

The new CMA has five strategic goals:

1. Delivering effective enforcement: to deter wrongdoing, protect consumers and

educate businesses.
2. Extending competition frontiers: using the markets regime to improve the way
competition works, in particular within the regulated sectors.
3. Refocusing consumer protection: working with its partners to promote compliance and
understanding of the law, and empowering consumers to make informed choices.
4. Achieving professional excellence: by managing every case efficiently, transparently
and fairly, and ensuring all legal, economic and financial analysis is conducted to the
highest international standards.
5. Developing integrated performance: through ensuring that all staff are brought
together from different professional backgrounds to form effective multi-disciplinary
teams and provide a trusted competition adviser across government.

Useful website
www.gov.uk/government/collections/how-the-cma-investigates-competition-and-consumer-issues
C2 Competition legislation
In the UK anti-competitive behaviour is prohibited in two main ways:

Anti-competitive agreements (for example, cartels) between businesses are prohibited

by Chapter 1 of the Competition Act 1998 (CA98) and Article 81 of the EC Treaty.
Abuse of a dominant position in a market is prohibited by Chapter 11 of CA98 and
Article 82 of the EC Treaty.

C2A The Competition Act 1998

What is the objective of competition law?

Effective competition between businesses delivers open, dynamic markets and drives
productivity, innovation and value for consumers. The objective of competition law is to help
businesses provide these benefits by deterring them from engaging in anti-competitive
agreements or conduct.

What is prohibited by competition law?

The Competition Act 1998 is comprised of two prohibitions:

The Chapter 1 prohibition: agreements between businesses that prevent, restrict or

distort competition to an appreciable extent in the UK.
The Chapter 11 prohibition: conduct amounting to an abuse of a dominant position.

What are anti-competitive agreements?

Examples include, but are not limited to, the following:

Price fixing an agreement between two or more businesses in which all parties agree to sell a certain
product or service at the same price.

Limiting production an agreement between two or more businesses which has the aim of limiting production and
output so that demand can be driven up allowing prices to rise.

Carving up markets an agreement between two or more businesses in which all parties agree to share a market,
whether it be by territory, type or size of customer.

Sharing commercially the exchange of information relating to the parties’ pricing policies or elements of them, such as
sensitive information discount levels or timing of planned price increases or decreases.
with one or more
competitors

It is important to understand that the above list is not exhaustive and that agreements can be
formal or informal, verbal or written.

Example 1.1
In 2010 the OFT investigated the exchange of broker pricing information between six insurance companies in the
motor insurance sector. This investigation identified an increased risk of price coordination among these insurers
through the use of a specialist market analysis tool. The OFT warned the firms that as each of the insurers was able
to access their competitor’s future pricing intentions, there were concerns that the software could be used to
coordinate on price, which would be a potential breach of competition law.

Example 1.2
In the London Market during the early 1990s, it was common for Lloyd’s syndicates not to quote on a fellow
syndicate’s business. There were similar agreements in the composite insurer market. These were verbal, implicit
agreements, which would now be seen as infringements of the Competition Act.

What are cartels?

In short, they are agreements between businesses not to compete with each other. They are
often verbal and, therefore, difficult to uncover.

The Chapter 11 prohibition – abuse of a prominent position

Holding a dominant position is not unlawful but it is unlawful to abuse that position. The
prohibition therefore relates to the conduct of the company, not its position in the market.

When considering a complaint it is necessary to first establish whether a business holds a

dominant position, and if it does, determine if its actions amount to abuse.

What is a dominant position?

Assessment is not based solely on the size of the company. While market share is important
(a company is unlikely to be dominant if its market share is less than 40% of the market), it
does not determine on its own whether a company is dominant.

A business is only likely to hold a dominant position if it is able to behave independently of

the normal constraints imposed by competitors, suppliers and consumers.

What amounts to abuse of a dominant position?

Examples include:

charging excessively high prices;

offering different prices or terms to similar customers; and
refusing to supply an existing or long-standing customer without good reason.

Insurance Block Exemption Regulation

On 1 April 2010 the European Commission’s new Insurance Block Exemption Regulation
no. 267/2010 (‘new IBER’) came into force and will remain valid until 31 March 2017. Under
the new IBER specific types of agreement commonly used within the insurance industry are
exempted from normal competition laws on the basis that cooperation in these areas
increases efficiency and benefits consumers.
The Commission has acknowledged that the calculation of risk is an issue specific to the
insurance sector and that access to past statistical data is vital for pricing insurance. In order
to facilitate and safeguard cooperation in this area, the new IBER renewed the exemption for
agreements related to the joint compilation of tables and studies of statistical data. However,
the information that may be exchanged has been limited to that which is strictly necessary to
allow an accurate calculation of risk. Consequently, insurers are still prohibited from
exchanging data regarding the level of commercial premiums, and all shared data must be
anonymous. The new IBER also sets out the conditions that compilations, tables and studies
must be made available to customer and consumer organisations pursuant to a ‘duly justified’
request which is only excepted on grounds of public security.

Agreements which set up co-insurance and co-reinsurance pools also continue to benefit
from exemption provided that they cover ‘new risks’ or fall below certain market share
thresholds where the risks are not ‘new’. The Commission recognised that risk sharing is
crucial to ensure coverage of certain types of risk where insurers are unwilling to insure the
entire risk themselves. The new IBER also establishes a broader definition of ‘new risks’. This
aims to help foster cooperation between insurers for products such as agricultural and
natural disasters, the nature of which are fundamentally changing as a result of climate
change, and risks arising from new technologies and new legal provisions.

Research activity
In response to a high level of public concern, the OFT investigated concerns that insurers were behaving in an anti-comp
when the prices for liability insurances increased markedly across the UK market in 2002. See, ‘The UK liability insuranc
2003, OFT659. Available at:
http://webarchive.nationalarchives.gov.uk/20140402142426/http://www.oft.gov.uk/shared_oft/reports/financial_p

All insurance company employees who have any contact with competitors, whether
professionally or socially, must be advised of the seriousness of breaching competition
legislation. Any discussion or exchange of current information on pricing (or on other similar
commercially or competitively sensitive subjects) is entirely unacceptable. Strict rules
surround the exchange of insurers’ historical data via independent bodies for presentation in
aggregate form and discussion of industry trends and current affairs are also limited.
Underwriters dealing with co-insured risks must be specifically advised regarding
appropriate behaviour, in order to ensure that customers have access to the most
competitive terms and other insurers have unrestricted access to the market.

The consequences of breaching the Competition Act are severe and include the entity being
fined up to 10% of its group global turnover, director disqualification and the possibility of
criminal proceedings being brought.
D Legal and regulatory constraints on scope of cover

D1 The FCA product intervention strategy

A major feature of the FCA’s approach to regulating financial markets is its plan for product
intervention. It has developed a range of tools which it will use to ensure firms develop
products that are right for their consumers, and which allow it to directly intervene where it
sees potentially harmful products.

The FCA’s approach to product governance will examine a firm’s strategy for bringing
products to market. It will encompass product design itself, and how the firm establishes a
target market for the product and selects routes to market (such as which intermediaries to
use). It will also look at how firms review their products to make sure that in practice they are
not reaching the wrong customers.

Where necessary, the FCA also uses product intervention rules. These interventions include
issuing warning about:

risky products, banning or mandating certain features;

restricting sales or marketing to certain groups of consumers; and
for the most extreme cases, the possibility of outright product bans.

The FCA is keen to point out that product intervention does not equate to product pre-
approval, but it is clear that providers can expect more challenges on areas such as value for
money, the design of charging structures and how sales staff are remunerated. Underwriting
managers, along with other senior managers, will clearly have to focus their thoughts in these
areas at every stage of product design and marketing.

The FCA will be particularly alert to products that:

meet the needs of intermediaries rather than the end users, which can result in retail
customers bearing an excessive amount of risk;
are so complex that neither customers nor intermediaries can properly understand the
risks; and
have such large fees attached, or are so unlikely to pay out on any claim, that customers
would be better off buying almost any other product, or no product at all.

Useful article
CII Policy and Public Affairs. (2013) ‘Product intervention in financial regulation: keeping the customer’s interests at
heart’, Think Piece 100, 18 September 2013, updated April 2014.

D2 Impact of legislation
In addition to the conditions implied by law that apply to all insurance contracts, significant
legislation, case law and regulations also apply with:

legislation enacting requirements for compulsory insurance covers; and

legislation and case law defining policy cover interpretation.

D2A Consumer Insurance (Disclosure and Representations) Act 2012

Think back to M80 chapter 2, section C7

A general principle of insurance is that the proposer must disclose all material facts to the
insurer. The duty of utmost good faith has applied since the Marine Insurance Act 1906; this
has now been replaced by the Insurance Act 2015 (see below). The duty is to disclose
voluntarily, and the proposer cannot withhold a material fact because no specific question
was asked at the proposal stage. The duty of utmost good faith applied to commercial
contracts up until 12 August 2016, but the Insurance Act 2015 replaces this with a duty to
make a fair presentation of risk. The duty of utmost good faith ceased to apply to consumer
contracts with the introduction of the Consumer Insurance (Disclosure and
Representations) Act 2012, effective from 6 April 2013.

Underwriters must now ask specific questions about any material facts if they are to rely on
non-disclosure as a reason to repudiate a claim and/or avoid a policy. This switches the onus
from consumers having to volunteer the required information to the insurer having to ensure
that the right questions have been asked.

Under the Act, insurers can no longer avoid policies for honest or reasonable
misrepresentations, which must be honoured in full. Insurers have a compensatory remedy
for ‘careless’ misrepresentations based on what it would have done if the consumer had
answered with reasonable care. Insurers can avoid the policy altogether (and retain the
premium) if the misrepresentation qualifies as ‘deliberate or reckless’. In each case the
insurer must be able to show that it would have acted differently had there been no
misrepresentation. As a result of these changes, underwriters must ensure that question sets,
policy wordings, other documentation and processes offer them and the customer the protect
intended under the Act. On occasion these items may not be within the insurers control, for
example, question sets on aggregator or other external systems there may be a consideration
of making changes to the pricing of products, i.e. where the likely impact may be an increase
in claims costs or re-evaluate the product offering.

Although it is said that the Act simplify codifies existing market practice, the new provisions
have certainly created fertile ground for consequential disputes. The Act is the first new
measure arising from the Law Commission’s ongoing review of insurance contracts and it is
likely that there could be a further shift in the balance of power in favour of insureds.

D2B Insurance Act 2015

The Insurance Act 2015 is the second piece of legislation arising from the joint review by the
Law Commission and the Scottish Law Commission on insurance contract law. It came into
force on 12 August 2016 and applies to contracts placed or varied after that date, The Act
reforms:

post-contractual issues for both consumer and non-consumer insurance contracts; and
pre-contractual obligations on commercial policyholders.

These latest reforms represent what the UK Government has described as ‘the biggest reform
to insurance contract law in more than a century’ and are intended to bring the market into
the twenty-first century.

Be aware
The Enterprise Act 2016 relates to the late payment of insurance claims and received Royal Assent in May 2016.
The Act comes into force on 4 May 2017 and contains clauses that were originally part of the Insurance Act 2015 but
were removed to make that Act’s passage through Parliament less controversial.

The Enterprise Act will introduce a contractual requirement on insurers to pay claims within a ‘reasonable time’;
failure to do this may result in the insurer having to pay damages to the policyholder.

The key provisions of the Act relate to disclosure, warranties, conditions and fraud as follows:

Duty of disclosure and representation: the duty of disclosure is replaced by the wider
‘duty to make a fair presentation of the risk’. The duty is satisfied if either all material
circumstances are disclosed or sufficient information is provided to put the insurer on
notice to make further enquires. The term utmost good faith is replaced by ‘good faith’.
Remedy for failing to make a fair presentation of the risk: if a business fails to make a
fair presentation of the risk, the insurer’s remedies must be proportionate – except
where non-disclosure of information is either fraudulent or reckless – and based on what
the insurer would have done if it had received a fair presentation of the risk.
Basis of contract clauses (warranties): basis of contract clauses are abolished for all
classes of insurance. These are clauses that incorporate all statements made in the
proposal form as warranties in to the insurance policy. Where these existed prior to the
Act, insurers could avoid a claim if they found that any information on the proposal form
was inaccurate, regardless of materiality.
Remedy for breach of warranty: All warranties can be remediated. If a business
breaches a warranty, the insurer’s liability is suspended only for the duration of the
breach. If the breach is remedied before the loss, the insurer is required to pay the claim.
Previously a breach of warranty could result in the policy being cancelled by the insurer
ab initio.
Remedy for breach of terms designed to reduce particular risk types: Where an
insured breaches a term of an insurance policy that is designed to reduce the risk of a
particular type of loss, the insurer cannot refuse to pay the claim if the insured can
demonstrate that the breach did not increase the risk of the loss.
Remedy for fraud: the option to avoid the policy ‘ab initio’ has been removed.
Therefore, the insurer is still on risk for claims made before the fraudulent act occurred.
The insurer has the option to terminate the policy from the date of the fraudulent act.
 Useful websites
For information on practical changes for insurers, see:

BIBA/Mactavish implementation guide: www.ageas.co.uk/documents/commercial/insuranceact/09_BIBA_-

_Mactavish_Implementation_Guide..pdf

IUA/LMA quick reference guide: www.lmalloyds.com/act2015

Pinsent Masons: www.out-law.com/en/topics/insurance/insurance-regulation/the-insurance-act-2015-practical-

changes-for-insurers-to-consider/

Activity
Investigate what actions were taken to comply with the Insurance Act 2015 in the company where you work.

D2C Equality Act 2010

The primary purpose of the Act was to codify the array of Acts and Regulations which formed
the basis of anti-discrimination law in the UK. The Equality Act 2010 was introduced from
October 2010 but some aspects did not come into effect until 2013. The Act aims to ensure
that all individuals have equal access to employment as well as private and public services
regardless of the protected characteristics: age, disability, gender reassignment, pregnancy
and maternity, marriage and civil partnership, race, religion or belief, sex, and sexual
orientation.

EU Gender Directive
Following a ruling made by the Court of Justice of the European Union (CJEU), insurers can no
longer use gender as a means of determining the premiums for all types of insurance. This
rule came into effect on 21 December 2012 and the terms were detailed in the Equality Act
2010 (Amendment) Regulations 2012.

Prior to the Directive, motor insurance for females generally cost less than for their male
counterparts (especially for younger drivers). This is because, statistically, they are safer
behind the wheel – that is, they produce less claims costs. Government estimates at the time
of implementation suggested that females aged between 17 and 25 would pay between 15%
and 25% more for motor insurance once the Directive was in force.

The implication for motor insurers was that rating models needed to be changed in order to
comply with the Directive. Some insurers, for example those who specialised in providing
policies for female drivers only, had to rethink their underwriting strategy.

D2D Consumer Rights Act 2015

The Consumer Rights Act is a major piece of legislative reform that applies to consumer
insurance contracts. The majority of its provisions came into force on 1 October 2015. While
many of the measures reflect much of the FCA best practice in terms of policy wording and
treating customers fairly, insurers should be aware of the following changes.
 The introduction of new rules to ensure that digital content is fit for purpose, e.g. the use
of apps and downloads.
New laws for ancillary contracts, for example when travel insurance is sold alongside the
purchase of a holiday.
Changes to consumer cancellation rights.
The requirement to make all potentially onerous core terms ‘prominent’.

Underwriting managers should review their product and distribution strategies in the light of
these changes.
Summary
The main ideas covered by this chapter can be summarised as follows:

The Threshold Conditions are the minimum requirement that firms must meet in order
to be permitted to carry out regulated activities.
It is the responsibility of the PRA to assess insurers from a prudential perspective and
determine whether they will meet the Threshold Conditions. The FCA will assess
applicants from a conduct perspective.
Solvency II is the EU Directive covering the capital requirements and related supervision
for insurers.
The Solvency II requirements are structured into three ‘pillars’: capital requirements,
systems of governance, and supervisory reporting and public disclosure.
Solvency II implementation with its extensive use of capital models in decision-making,
more rigorous approaches to risk management and greater transparency in reporting,
means that the true risks faced by insurers are better understood and addressed.
The FCA uses thematic reviews and market studies as its main tools for examining
competition and other conduct issues where it believes ineffective competition is
leading to poor outcomes for consumers. The FCA works closely with the CMA.
In the UK, two main types of anti-competitive behaviour are prohibited: anti-competitive
agreements and abuse of a dominant position.
The Insurance Act 2015 has introduced major changes to the obligations of insurers and
policyholders. It has been described as ‘the biggest reform to insurance contract law in
more than a century’.
In addition to the conditions implied by law that apply to all insurance contracts,
significant legislation, case law and regulations also apply with:
legislation enacting requirements for compulsory insurance covers, and
legislation and case law defining policy cover interpretation.

Bibliography
Baker, B. (2013) Recent development in Solvency II, 29 April 2013. CII Fact File.*

Collins, C. (2012) The regulatory framework, 6 August 2012. CII Fact File.*

Davies, H. and Green, D. (2008) Global financial regulation: the essential guide. Cambridge: Polity.

Doff, R. (2011) Risk management for insurers: risk control, economic capital and Solvency II. 2nd edition. Risk Books.

Youngman, I. (2013) Regulation of general insurance business, 4 April 2013. CII Fact File.*

Whittingham, P. (2009), Unlocking the mystery of the risk framework around ORSA. Ernst & Young.

The Insurance Act: bringing commercial Insurance into the twenty-first century. CII Policy briefing. April, 2015
*CII Fact Files available to CII members only via the Knowledge Services website (www.cii.co.uk/knowledge).

 Revision questions

1. What is the primary objective of the PRA?

2. What are the essential components of the ORSA policy?

3. Name the three pillars of Solvency II.

4. What are the CMA’s five strategic goals?

5. What are cartels?

6. What are the main changes introduced by the Insurance Act 2015?
 Revision answers

1. The primary objective of the PRA is to promote the safety and soundness of PRA-regulated firms.

2. The ORSA policy is a reference document detailing the processes, data, risk, measures and limits that make up the risk
profile of the firm.

3. The three pillars of Solvency II are:

Pillar 1 – Financial requirements.

Pillar 2 – Governance and supervision.
Pillar 3 – Reporting and disclosure.

4. The CMA’s goals are to:

deliver effective enforcement;

extend competition frontiers;
refocus consumer protection;
achieve professional excellence; and
develop integrated performance.

5. Cartels are agreements between businesses not to compete with each other.

6. The Insurance Act 2015 reformed:

duty of disclosure and representation;

remedy for failing to make a fair presentation of the risk;
basis of contract clauses (warranties);
remedy for breach of warranty;
remedy for breach of terms designed to reduce particular risk types; and
remedy for fraud.
 2 Start-up scenario

Contents Syllabus learning

outcomes*

Learning objectives

Introduction

A The business plan 5.1

B An underwriting perspective 1.2, 2.5, 2.8

C The investors 1.2

D Financial projections 1.2

E Risk management 2.8, 4.3

F The reinsurers 2.1, 4.3

G Risk appetite 2.8

H Go-live 2.1

I Start-ups versus established insurers 2.5

Summary

Bibliography

Revision questions and answers

 * Throughout most of this unit, the context is that of an established general insurance company. In this chapter the issues of underwriting authority and
strategy, as well as key responsibilities and relationships, are introduced in a context uncomplicated by decades of corporate history and culture,
namely, that of a business start-up.

This provides a common starting point for the discussion of the unit’s syllabus topics in the context of an industry based on a very wide range of
existing (and changing) business models. The start-up scenario also places emphasis on the source of an insurer’s underwriting authority; an emphasis
which is not only appropriate but necessary, with the implementation of Solvency II.

Learning objectives
This chapter relates to syllabus sections 1, 2, 4 and 5.

On completion of this chapter and private research, you should be able to:

identify an underwriting director’s key responsibilities and relationships; and

identify the source of underwriting authority within a general insurance company and
explain how the extent of that authority is determined.
Introduction
Many insurance professionals would be attracted, almost instinctively, to the thought of
working in a new, start-up insurance company. Their motivation might spring from a range of
desires: to introduce a new product; to achieve better results by avoiding the perceived
errors of existing companies; to exploit new technology or distribution channels; to utilise
specialist knowledge to provide a more tailored service or to take advantage of a particular
stage of the underwriting cycle. These are only a few of the possible reasons why a group of
senior professionals might agree to develop a business plan and seek support from investors
to establish a new insurance company.

Consider this…
Think of other possible reasons why an insurance professional would want to be part of a start-up insurance
company or department.

Fundamental to all such initiatives is the identification of the means by which the proposed
business will produce/source, sell and service a product valued by its intended target market.
The aim would be to generate sufficient profit to gain the support of investors and the
regulators’ authorisation to commence business. In other words, what’s the plan?

Key terms

This chapter features explanations of the following terms and concepts:

Authority Complaints procedure Reinsurance Risk appetite

Regulatory requirements Statement of risk appetite Target operating model Underwriting audit
(TOM)
A The business plan
A great deal of research and other development work may already have gone into the
formulation of the business idea and plan; a core team may have already been formed and
potential investors identified. A basic plan with key set-up costs and a draft revenue account
may have been drawn up to help form an outline business case. Even if these documents are
in a very rudimentary state, they will already include key assumptions (possibly implicitly)
about the business – notably its target customers, products, method of operation, assumed
growth prospects, capital required and profitability – that are critical to the evaluation of the
proposed business from an underwriting perspective. There will also have been
consideration of the target operating model (TOM) that the business will use, and how
underwriting and portfolio management will be part of that.

An operating model provides a high level view of how processes, people and systems interact to support the
business. A target operating model describes how those processes, people and systems could be arranged to achieve
optimum efficiency for the future business and identifies where to prioritize change activity to achieve the greatest
benefits.
Source: PricewaterhouseCoopers. (www.pwc.com.tr/en_TR/tr/advisory09/assets/target-operating-model.pdf)

Useful article
KPMG. (2013) How to drive value through your target operating model. Available from:
www.kpmg.com/CN/en/IssuesAndInsights/ArticlesPublications/Documents/insurance-target-operating-model-
201212-v2.pdf

This is not the appropriate place to discuss the evaluation of business ideas and general
methods of business planning. As an experienced professional you will undoubtedly have
views about the desirability and viability of many aspects of the proposition but your focus
will be on those aspects which have a direct bearing on underwriting.

In this instance, let us assume that you are considering the opportunity to act as the
underwriting director in the start-up team.

Consider this…
What information is needed to convince you that the business proposition is sound and that it can deliver a
sustainable underwriting result?
B An underwriting perspective
As prospective underwriting director, here are some of the questions you might ask the
originators of the business proposition – or reflect on after the initial discussion.

Products What are the intended insurance product(s) and any associated services?
Is this a well-established existing product, a standard product with some novel features
or a radically different product? Are the risks that the product addresses well-known or
emerging?
Are any aspects of the product and its associated services to be provided by third parties?
What are their costs and requirements?
Is there a draft prospectus (providing information on maximum sums insured, limits of
indemnity, benefits and standard excesses) and a policy wording?

Target customers What are their characteristics and requirements? What has been done to validate
assumptions about customer requirements?
How well can target customers be identified and enumerated?
How and from whom do they currently purchase insurance? What will persuade them to
change insurer?
What do you know about their claims experience? High frequency/predictable average
cost or low frequency/unpredictable average cost?
What level of premiums do you expect to be able to charge? Without historical data, how
will the company know what to charge?

The competition Has a ‘gap’ in the market been identified or is it an area with lots of competition? What’s
happening to current pricing levels?
How will the new company differentiate its offering?

Environment and timing The business proposition does not exist in a vacuum: external issues will affect its
viability/attractiveness at different times. Is the timing right – the economy, expected
rate of return on investment, stage of the underwriting cycle?

Delivery and service What type of service do the target customers require? Highly impersonal/automated or
highly bespoke/expert?
Will sales be direct or intermediated (agent, broker, affinity group, other)?
Type of advertising: specific or brand awareness; which media?
Serviced through a branch network, call centres, internet or mix?
Technology support to staff: automated, highly functional or basic with a high degree of
manual intervention?

Projections What are the sales projections for the first three to five years? Beyond that, what are the
new company’s medium- to long-term objectives?
Are there ways in which a critical mass may be achieved more quickly (for example,
targeting affinity schemes or through acquisition of existing businesses)?
Will the type of business written in the first few years be representative of the ‘mature’
business or will the early business be skewed in some way?
How quickly will the business break even and then produce a profit?
 People How credible are the senior members of the team and what relevant qualifications do
they hold? Will they be considered acceptable by the regulators?
Does their explanation of the business proposition make sense?
Do they appear to place an appropriate emphasis on the role of underwriting?
How confident are you that your professional advice, as underwriting director, will be
valued?
What are the values of the business in terms of ethics and treating customers fairly?
How will capability be developed? For example, through setting up an underwriting and
pricing academy to advance learning and development.

Regulation Are there any regulatory or legislative issues affecting the writing of the business?
Is regulation in this area of business likely to become more stringent in the future?
Are there any opportunities which a new entrant would benefit from?

Capital How much capital is required?

Who are the investors and how secure are they?
What is the planned return on capital?
How is the return on capital factored into the premium?

It is highly likely that the underwriting director, once appointed, would be responsible for
formulating answers to many of these questions and/or developing more detailed answers.

Refer to chapter 3 for more on MGAs

The evaluation of the proposition from an underwriting point of view is not simply about
your decision whether or not to accept the role: many others will also evaluate the
proposition from an underwriting perspective and will ask the same or similar questions.
Potential investors (which may include existing insurance companies) will seek the advice of
underwriters. If the new business is a managing general agency (MGA), potential carriers will
be advised by underwriters, as will reinsurers and the Financial Conduct Authority, when they
become involved.

Remember that, as underwriting director, you will be responsible for forecasting

performance, determining pricing and underwriting guidelines, formulating reinsurance
strategy, recruiting and supporting underwriters and – along with other members of the
management team – achieving the financial plan. What other questions would you ask?
The underwriting director is a key member of any start-up team: focusing on all of the issues
affecting underwriting but also heavily engaged in supporting other members of the team as
they develop and refine the overall proposition. They will be highly influential in discussion
with other stakeholders (particularly reinsurers and potential underwriting staff).
C The investors
The start-up team is preparing to make formal presentations to different groups of potential
investors. As well as ensuring that the business proposition can be articulated clearly and that
the financial projections are credible, the team has to think about the different capabilities
and preferences of the potential investors.

As well as providing start-up and ongoing capital investment, some of the investors may be
able to offer technical assistance (from the experience of other companies already owned by
them) which could prove invaluable, particularly in the early days of the new company. In
order to balance their own portfolios, some investors may favour certain classes of insurance
business over others (for example, long- or short-tail) and a particular combination of
investors may be required to provide the specific backing the new company needs. The start-
up team might have to think again and reformulate their proposition in order to achieve a
viable balance between the proposed business and willing investors.

Figure 2.1: The business proposition

D Financial projections
Although actuarial and finance colleagues (on the team or acting as professional advisers) will
be primarily responsible for creating the financial plans, determining capital requirements
and considering issues around cash flow and investment returns, they need the underwriting
director’s input. As underwriting director, you have to check that the exposure and premium
income projections and the assumed split in the income for different classes of business are
credible and fit with everything else you know about the proposition.

Be aware
Inevitably you will be using many assumptions as you assess the projections: it is essential that you record your
assumptions, their source and your rationale.

Similarly, as the projected loss ratios are critical to the viability of the proposition, your
careful consideration and validation are required when populating the plan. Bear in mind that
a new business stream cannot rely on possible, historical releases on outstanding claims to
‘smooth’ the first year loss ratio.

D1 Assessing costs
After claims costs, the largest business costs generally relate to staff, reinsurance and ICT. You
will be directly involved in agreeing those costs relating to the service that underwriters will
provide and the governance of that service. The type of service required (potentially servicing
intermediaries as well as target customers) and the agreed delivery mechanisms will dictate
how the service is to be established (levels of expertise, location and type of systems-
support) and the appropriate type of control mechanisms (for example, automated
monitoring and/or auditing of individual underwriting files).

The type of product(s) and the characteristics of the customers will also influence other costs,
such as those associated with risk control. Your claims colleagues will ask you to predict the
number, cost and type of claims which will be received during the first year and thereafter, to
enable them to estimate the appropriate number and type of claims handlers required, and to
cost and establish appropriate loss adjusting and solicitors’ contracts. In addition to
assessing these costs, you will need to review the expense base and allocation of expenses by
line of business and understand the commission mix. The commission will include any profit
commissions payable, based on the performance of the business.

D2 Capital requirements
All of this information, and much besides, needs to be fed into the projections that will
indicate how much capital the start-up business needs to secure from investors:

what the new company needs to spend before it even starts to trade;
what it will cost to trade for the first few years before a profit can be generated; plus
 that level of additional capital, specified by the Prudential Regulation Authority (PRA),
required to ensure the insurer’s solvency.

As you will know from your previous studies and chapter 1, the PRA requires all UK insurers
to take an increasingly sophisticated approach to assessing their own solvency requirements.
Although not simply the result of the application of a standard formula, in broad terms the
capital requirement is based on premium income projections, adjusted for all the perceived
risks associated with running a business, including how the risks interact. The capital
requirement may also be adjusted to reflect the amount and type of reinsurance purchased
(see section F).

A critical assumption made by the start-up team is that the required amount of capital can be
raised at a cost (the required annual return on the investment) the proposed business can
support and that investors will continue to support the business with their capital through its
early, unprofitable years. Securing the correct amount of capital is important: too little capital
will constrain growth and could undermine the new company’s position in the market; too
much capital will increase the amount of profit required in order to provide the necessary
return to investors and could make the company’s products uncompetitive. Bearing in mind
the significant level of expenditure required to establish a general insurance business, any
new venture is unlikely to achieve break even in less than two or three years.

Consider this…
How soon will the level of profit achieved provide adequate overall recompense for the investors’ faith in the new
business?

Clearly the more novel or innovative the business plan, the more difficult it may be to provide
acceptable projections (due to lack of precedents/experience) and thus to gain support.
Investors may demand a higher return for what they perceive to be a more risky investment.

While the issues around the financial projections and the required capital investment can be
complex, it is clear that the accuracy of the underwriting assumptions (exposures, level of
income, mix of business, claims ratios) and the actual achievement of the plan are
fundamental to the ability of the business to gain and maintain investor support.
Underwriters in established businesses can fail to appreciate that their authority is
underpinned and therefore constrained by assumptions and requirements relating to the
business’s continued access to capital. By contrast, the requirement to match actual results to
planned exposure, income, business mix and underwriting result will never be far from the
consciousness of underwriters in a start-up company.
E Risk management
In any sector, investors in a new business will want to be assured of the start-up team’s grasp
of the risks around the venture. In an uncertain business such as general insurance, potential
investors (as well as reinsurers and regulators) will require specific information about the
start-up team’s assessment of risk and how consideration of risk and its management has
been built into the business plan and the financial projections.

Consider this…
From an underwriting perspective, what risks might apply to a new business? And, if you are responsible for
monitoring these risks, what might be suitable courses of action?

Common risk examples:

Claims projections prove inaccurate.

Adverse economic conditions occur.
Court judgments impact typical level of claims settlements in respect of bodily injury.
Poor-quality business is written.
Management information is corrupted.
Business flows from delegated authority brokers prove intermittent.
Recruitment targets for underwriters are not achieved.
The business experiences exceptional weather-related losses in the first year.
Rates rise more steeply than expected: capital inadequate to write available, targeted
exposures.
Rates decrease more steeply than expected and volumes or margins cannot be achieved.
Pricing models are based on incorrect assumption: for example, rates of inflation.
Inability to change ICT systems in a timely manner.

If they occur, these risks might prove to have limited applicability or impact. Alternatively,
they might significantly undermine the performance of the business in its first year and
thereafter. None of the risks mentioned are far-fetched and investors would expect these and
many other risks to be monitored, evaluated and managed on an ongoing basis.

Some risks, once identified, can be avoided altogether and others may be accepted as
inherent to the particular business. Generally, however, management teams are expected to
lessen, control and/or transfer risks in accordance with the stated risk appetite of the
individual business.

As insurance is itself a risk transfer mechanism, it is not surprising that insurance companies
utilise reinsurance as a key means of transferring and controlling certain risks. Reinsurance is
especially vital to the operation of small and/or young insurance businesses where a run of
large claims over a short period of time or higher than anticipated total claims costs could
undermine the business. As previously mentioned, the purchase of reinsurance can reduce
the amount of capital required so, while potential investors consider the business
proposition, the start-up team has to turn their minds to the topic of reinsurance purchase.
F The reinsurers
How much reinsurance should the new business purchase? How much risk will reinsurers be
willing to accept in return for a reasonable premium?

Consider this…
The purchase of reinsurance can reduce the capital requirement for solvency but at what price does the cost of
increased levels of reinsurance outweigh the cost of additional capital?

Figure 2.2: Retention levels: reaching agreement

In respect of any excess of loss reinsurance, the lower the retention, the higher the cost will be
to the reinsured (insurer). Similar considerations would apply to proportional and other
forms of reinsurance protection.

A new start-up may decide to partner with a reinsurer on a proportional basis to smooth
potential losses and utilise the expertise of the reinsurer.

F1 Limits – how high?

What limits of liability and total sums insured per risk fit the business proposition? It may
impress brokers if underwriters can offer high limits but is the feel-good factor worth the
extra cost? What do the target customers typically require? Does the business want to cater
for the 5% of customers who need unusually high limits? Would the cost of the higher limits
be spread across all policyholders? How would that affect the competitiveness of the
company’s pricing? How are you going to control the use of higher limits (the reinsurers will
definitely want to know) and are the underwriters qualified to handle these limits? Will they
see enough cases with higher limits to develop/maintain their personal competence?

Together with acknowledging these questions, full consideration will need to be taken of the
market requirements for limits under the policies. During the development of the strategy, it
will need to be considered whether to target a particular niche, such as younger drivers, or to
be a balanced provider of insurance products. This understanding of the target market will
need to be clear to reinsurers so that they can price their covers.

Be aware
The reinsurers will want to steer a start-up insurer away from what they regard as higher-hazard or low-priced
areas of the market and agreeing the treaty exclusions will involve extensive negotiation.

The purchase of catastrophe reinsurance also needs careful consideration and significant
input is required from the company’s actuaries and the reinsurance brokers’ catastrophe
modellers. The development of an insurer’s reinsurance programme will be discussed in
chapter 8.

F2 Board approval
As reinsurance purchase is a critical area, which involves a great deal of money and is
fundamental to the survival of the business, decisions will be authorised at board level.
Finance, actuarial and underwriting will work together on recommendations for the board’s
approval and, as underwriting manager, you can expect to have many meetings with your
company’s reinsurance brokers and with many prospective reinsurers who may wish to
accept a share of one or more of the proposed reinsurance treaties.

As with any prospective reinsured, you want to paint a positive picture of the risk the start-up
company wishes to pass to the reinsurers by describing how you and your colleagues will
select and handle risks with expertise and discernment and why, in return, this business
deserves to attract the confidence of the reinsurers: this confidence reflected in their
willingness to offer broad covers, few exclusions, high limits and low prices!

F3 What will the reinsurers want to know?

The reinsurers need to understand the business proposition thoroughly: the details and the
big picture. As underwriting director, you will typically have very regular contact with the
reinsurers and will therefore need to demonstrate a broad understanding of the business
proposition: your professional expertise needs to extend beyond the technicalities of
underwriting to the whole insurance business. The reinsurers will also wish to understand
your own capabilities and level of understanding, as they will be particularly interested in the
underwriting standards which will be established under your direction.
Typical reinsurer questions:

Strategy How would you describe the company’s underwriting strategy?

Do you plan to delegate underwriting authority?
How do you see your product/service offering in comparison with those of your competitors?

Plans Describe the typical risks the company intends to write and provide a profile of the business you plan
to accept in the first year (for example, by property sum insured or limit of liability).
What is your estimated premium income for each of the four quarters of the year?
What is the seasonality of the business and its claims?
What do you think about the current level of pricing in the market (for the business you plan to
write)?
What is your target loss ratio? What allowance have you made for large claims, bad weather…?
What is your survey strategy?
What is your flood strategy?
What risks will you not accept?
What lines of business will you not write or accommodate for a particular customer or distribution
partner?
Will you accept exposures outside the UK?
What will be the maximum and average exposures (MD & BI)?
What is your definition of a risk?
Will your company become a member of Pool Re?
How will you establish your technical rates?
What discounts are you planning to use?
Are your policy wordings finalised and may we see them?

Control Who will write the underwriting guide? May we see it?
What authority limits do you, personally, have and how do you plan to control risk acceptance?
What proportion of risks do you expect to be referred to you?
How are you proposing to select (recruit) underwriters and measure their competence?
Who will manage claims?
What MI do you have access to or is planned?
What support/constraints does the system provide to underwriters?
Can individual underwriters amend policy wordings?
Who can sign-off endorsements?
How do you plan to measure aggregations?

This is, of course, not a comprehensive list.

F4 Building sustainable relationships

Although the reinsurance treaties finalised and subscribed at the end of this process of
discussion and negotiation are typically lengthy, detailed and contract certain, they should
not be regarded as the only end-product of the process, as all of the information provided and
discussed is valued and relied upon by the reinsurers. The quality of the information provided
will influence the relationship between reinsurers and new reinsured, as well as the cost of
the reinsurance cover.

Just as with potential investors, the start-up company’s objective is to secure the long-term
support of those reinsurers whose appetite for risk easily encompasses that of the new start-
up and whose terms, prices and credit ratings are most acceptable. It is important to establish
the relationship on a sound footing by providing as much quality information as possible,
being open with regard to any problems you face and paying attention to the reinsurers’
requirements and preferences.

When the new business matures and requires higher limits or different forms of reinsurance
in order to pursue further profitable growth, the company will want to have its choice of the
most advantageous reinsurance partners: building a good reputation and securing reinsurers’
interest and commitment begins at start-up.
G Risk appetite
By this stage, the senior members of the start-up team – board members of the new company
– have reached agreement with the investors regarding the funding of the business (the
capital requirements, required rates of return and reinsurance purchase), its financial and
business objectives and its approach: in other words, the corporate strategy.

The board is responsible for determining the nature and extent of the risks it is willing to take in achieving its
strategic objectives.
(UK Corporate Governance Code)

Key aspects of this agreement will be recorded in a statement of risk appetite, signed by the
board. From an underwriting perspective, this statement summarises:

the risks which are or are not acceptable;

maximum limits for individual risks and aggregate limits of exposure;
maximum income limits; and
maximum net retentions.

The statement of risk appetite will become, once the company is authorised to commence
business, the basis of your own underwriting authority as underwriting director.

Be aware
As a commercially sensitive document, you may not be able to distribute copies of the statement of risk appetite to
the underwriters within your control. However, you must ensure that the underwriting strategy, all guidance to
staff, levels of authority, licences and delegated authorities fit within the scope of the risk appetite statement.
H Go-live
By focusing on the interaction of the new company with its investors, reinsurers and
regulators, the impression may have been given that starting-up a general insurance
company primarily involves financial calculations, documentation of plans and meetings. It
does involve those activities but that’s not what it will look like to most of the people (staff
and professional advisers) involved. Most people will be working hard to recruit and train
other staff, furnish premises and install ICT, introduce accounting systems, and a mass of
other necessary tasks. Establishing a general insurance company requires a huge,
collaborative effort.

You also need to be aware of how your competitors view a new player forcing its way into the
market. They may feel threatened and resentful and could try to make business life difficult. It
is therefore important to stay focused on the business objectives.

Be aware
The necessary authority to conduct any of these tasks stems from the documented agreements described above:
between the board of the new company and its investors, reinsurers and regulators. Each person with authority
within the new company must be guided by corporate strategy including the statement of risk appetite which
summarises the key features relating to risk acceptance and management (not only insurance risk).

Of prime importance to everyone involved in the management of underwriting will be the

establishment of the underwriting strategy, along with underwriting guidance and
governance, as well as matters relating to products, financial plans/budgets, systems and
management information (MI).

H1 Underwriting strategy
The underwriting, product, distribution and marketing strategies of the new company must
support one another as closely as possible. If the distribution strategy focuses on groups of
brokers with little or no interest in the defined target customers, or if the product strategy
requires limits which the reinsurers are unwilling to provide, it is clear that the new company
will probably fail to achieve its objectives.

The underwriting strategy has to inform both underwriting and sales staff about the core
business the company is seeking to write and what limits apply. It should explain the agreed
approach towards both individual risks and features of the overall account. For example, the
capital funding of the business may only support a particular mix of business: possibly
general liability may not exceed a certain proportion of total premium income. Consistent
communication of the underwriting strategy to all concerned – with the necessary
explanations – is a particularly vital task when staff from other companies are being recruited
and brought into the company. When asked the question ‘What kind of business does your
company want to write?’, all underwriting and sales staff should be able to articulate a
consistent, accurate answer.
 Be aware
It will need to be clear to underwriting staff why the risk strategy has been set to target a particular market. Only
through discussion and appropriate explanation will it become apparent to the new underwriters that the company
has carefully balanced the cost of capital and reinsurance with the new business’s capability to attract targeted risks
at the price necessary to produce sufficient profit in the required time frame, and that the result of this complex set
of considerations is summarised in the underwriting strategy. Underwriters and sales staff need to understand this
background if they are to promote their new company and its underwriting strategy with confidence.

H2 Underwriting guidance
The underwriting director will have prime responsibility for ensuring that the following are
ready:

Underwriting guidance (on paper/intranet or incorporated into automated systems),

including acceptance criteria, reinsurance exclusions, base rates, loadings and discounts,
policy commentaries, standard endorsements and survey strategy.
Facilities for credit-checking and other databases relating to flood and subsidence
exposures.
Facultative reinsurance arrangements, if necessary.

Along with the company secretary/legal department, the underwriting director will have
checked that the new company has specific regulatory authorisation for all of the necessary
classes of business.

H3 Products
Whether under their direct control or not, the underwriting director’s agreement to the
following will be required:

Base rates and rating routines (with actuarial input).

Cost of extensions (with actuarial input).
Policy wordings (with legal and claims input).
Prospectuses (with compliance input).
Proposals/statements of fact (with compliance and claims input).
Third-party arrangements (with legal input).

H4 Plans and budgets

Although the underwriting director has access to the top-level plans and budgets which have
been agreed with the investors and the regulator, it is necessary to break these down to the
levels at which units (product/branch/region) and staff will be targeted. This work may be led
by operations with the input of underwriting, sales and finance.

H5 Systems and management information (MI)

The underwriting director will be anxious to confirm that underwriters have the necessary
functional support to accomplish their work. They will also want to ensure that the rating
routines accurately reflect the agreed approach; that base rates have been loaded correctly
and that the data warehousing facility is operational and will capture the necessary data in
the appropriate format. The format and content of many types of MI have to be specified in
order to monitor and manage products, underwriting, claims and financial results.

H6 Governance
The underwriting director will have agreed with the human resources function how the
recruitment of underwriters is to be approached. Role profiles, terms and conditions will have
been agreed and an interview and assessment process determined. As well as indicating
whether suitable for the role of underwriter in the new company, the recruitment process
should provide the information necessary to determine the new underwriter’s initial level of
underwriting authority, which will be documented in their underwriting licence. The
recruitment process may also indicate training needs which will have to be addressed.

Refer to 990, chapter 2, sections A and B

The operation of an insurance company as a whole will need to be monitored and UK

regulators are keen to ensure that methods are adequate. It is likely that the company will be
overseen by a board of directors and it is their job to monitor the activities carried out by
executive management. It is important to note that the structure and actual responsibilities
of boards vary slightly with the type of company and the jurisdictions in which they operate.
Integral to a board’s supervisory functions are two duties:

Shareholder interests.
Risk management.

In a plc, board meetings usually occur on a monthly basis. Meetings of sub-committees of the
board – audit, remuneration, risk and compliance committees, for example – are also held
from time to time.

H6A Corporate governance

Think back to M92, chapter 4, section A1

Corporate governance is defined as ‘the set of processes and organisational structures

through which the board and senior executives manage a company at the highest level’. This
may also be referred to as the system of governance.

All organisations need to put down in writing the key methods they use in carrying out and
managing their business. Corporate governance practices give structure and provide clarity
over the roles, responsibilities and authorities of senior management.
In the UK, the Financial Reporting Council publishes the UK Corporate Governance Code and
any firm listed on the London Stock Exchange is required to demonstrate in their annual
report how they have applied the Code. The UK Corporate Governance Code sets the
expectation that the board should maintain sound risk management and internal control
systems, which should be reviewed on a regular basis (at least annually). Key principles from
the Code have been incorporated into the FCA Handbook and must be applied by all regulated
firms.

Useful websites
www.frc.org.uk

www.bankofengland.co.uk/publications/Documents/praapproach/insuranceappr1406.pdf

H7 Underwriting audit
The underwriting audit process will, month by month, build up a picture of relative
competencies, training needs and general issues which require attention. In the early years of
trading, underwriting audit (and the specific discussions which flow from it) will provide an
excellent means of achieving the required commonality of approach between different
underwriters and units, as well as confirming to the board that underwriting strategy is being
observed correctly.

Be aware
If underwriting authority has been delegated outside the company (to scheme brokers or MGAs, for example)
appropriate audit procedures have to be devised and in place for go-live, also.

Along with operations, the underwriting director needs to monitor underwriters’ compliance
with contract certainty and other regulatory requirements, such as those concerning money
laundering, data protection and treating customers fairly. The establishment of a robust
complaints procedure is also essential from the outset.

Effective collaboration is key to the business’s success and the management team will
establish a schedule of regular meetings to review specific topics (such as ‘pricing’ with
representatives from underwriting, products and actuarial or ‘audit’ with representatives
from underwriting and operations) as well as more general monthly meetings involving all
areas.

Be aware
All areas will be required to support the company’s risk management processes.
I Start-ups versus established insurers
If your current company is long-established, you would be correct in assuming that it
probably did not follow the start-up process outlined above, which reflects current practice.

However, in order to comply with regulatory requirements, all companies are obliged to
develop clear structures of governance and sound risk management processes; new
companies, as described above, should have these from the outset. Sometimes it is more
difficult to adapt to new requirements than to start afresh: the challenge facing older, larger
general insurance companies to meet all regulatory requirements should not be
underestimated.

Given the regulators’ principles-based approach to regulation, implementation approaches

between even new companies will not be identical. There is also considerable variety in the
ways in which longer-established companies may choose to fulfil their regulatory obligations.
To understand the approach of any given company (or division of a company), you will have
to consider the relevant Principles and then evaluate the company’s practice in that light.

Underwriters can fail to appreciate how their own company operates when they work for a
large, established company with many different classes of business, products and distribution
channels and where everything appears to work like clockwork, year after year. These
arrangements, ways of working and understandings have been built up over many years and
are backed up by a wealth of historical data and analysis. It is for this reason that this unit has
commenced with a far more stark example of underwriting management in action: in order to
consider what is involved in developing a coherent, profitable approach to general insurance
underwriting when starting from scratch.

Your own first challenge in underwriting management is not likely to be the creation of the
underwriting strategy for a start-up insurer but almost all of the considerations in this
chapter would apply if you were responsible for developing a new area of business.

Be aware
In an industry where change is constant, this is not a remote possibility.
Summary
The main ideas covered by this chapter can be summarised as follows:

There are a number of questions that an underwriting director might ask the originators
of the business proposition, which fit within the following categories: products, target
customers, competition, environment and timing, delivery and service, projections,
people and regulation.
As well as providing start-up and ongoing capital investment, some investors may be
able to offer technical assistance which could prove invaluable, particularly in the early
days of a new company.
After claims costs, the largest business costs generally relate to staff, reinsurance,
commission and ICT.
In an uncertain business such as general insurance, potential investors, regulators and
reinsurers will require specific information about the start-up team’s assessment of risk
and how consideration of risk and its management has been built into the business plan
and the financial projections.
The statement of risk appetite summarises the risks which are not acceptable, maximum
limits for individual risks and aggregate limits of exposure, maximum income limits and
maximum net retentions.
The underwriting, product, distribution and marketing strategies of a new company
must support one another as closely as possible.
In order to comply with regulatory requirements, all companies are obliged to develop
clear structures of governance and sound risk management processes.

Bibliography
IRM. (2011) Risk appetite and tolerance. Executive summary. Available from
www.theirm.org/media/464806/IRMRiskAppetiteExecSummaryweb.pdf.

 Revision questions

1. Why might an insurance professional wish to be involved in a start-up operation?

2. What are the main business costs involved in running an insurance underwriting department?

3. What questions would you expect reinsurers to ask to assess whether they wished to offer cover for a start-up
underwriting operation?

4. What comprises a statement of risk appetite? What is its purpose?

5. What is the purpose of an underwriting audit?

 Revision answers

1. An insurance professional’s motivation might spring from a range of desires: to introduce a new product; to achieve
better results by avoiding the perceived errors of existing companies; to exploit new technology or distribution
channels; to utilise specialist knowledge to provide a more tailored service or to take advantage of a particular stage
of the underwriting cycle.

2. After claims costs, the largest business costs generally relate to staff, reinsurance, commission and ICT.

3. Reinsurers could ask any of the following questions:

How would you describe the company’s underwriting strategy?

Do you plan to delegate underwriting authority?
How do you see your product/service offering in comparison with those of your competitors?
Describe the typical risks the company intends to write and provide a profile of the business you plan to accept
in the first year (for example, by property sum insured or limit of liability).
What is your estimated premium income for each of the four quarters of the year?
What is the seasonality of the business and its claims?
What do you think about the current level of pricing in the market (for the business you plan to write)?
What is your target loss ratio? What allowance have you made for large claims, bad weather…?
What is your survey strategy?
What is your flood strategy?
What risks will you not accept?
What lines of business will you not write or accommodate for a particular customer or distribution partner?
Will you accept exposures outside the UK?
What will be the maximum and average exposures (MD & BI)?
What is your definition of a risk?
Will your company become a member of Pool Re?
How will you establish your technical rates?
What discounts are you planning to use?
Are your policy wordings finalised and may we see them?
Who will write the underwriting guide? May we see it?
What authority limits do you, personally, have and how do you plan to control risk acceptance?
What proportion of risks do you expect to be referred to you?
How are you proposing to select (recruit) underwriters and measure their competence?
Who will manage claims?
What MI do you have access to or is planned?
What support/constraints does the system provide to underwriters?
Can individual underwriters amend policy wordings?
Who can sign off endorsements?
How do you plan to measure aggregations?

4. A statement of risk appetite includes information relating to the funding of the business, its financial and business
objectives and its approach. The statement of risk appetite will become, once the company is authorised to
commence business, the basis of your own underwriting authority as underwriting director.

5. The underwriting audit process will, month by month, build up a picture of relative competencies, training needs and
general issues which require attention.
 3 Strategy

Contents Syllabus learning

outcomes

Learning objectives

Introduction

Key terms

A Corporate strategy 1.2, 2.1, 2.5, 5.1

B Multinational business 1.3

C Marketing 2.4, 2.8, 3.4

D Distribution 2.2, 2.3

E Operations 5.5

F Core elements of an underwriting strategy 2.1

Summary

Bibliography

Scenario questions and answers

Appendix 3.1: The Journal – ‘Hot topic: Focus on dual pricing’

Learning objectives
This chapter relates to syllabus sections 1, 2, 3 and 5.

On completion of this chapter and private research, you should be able to:

explain those corporate, functional and strategic business unit strategies which relate
most directly to underwriting;
examine the issues and implications of underwriting business internationally;
select appropriate criteria to evaluate options when considering the underwriting
response to other strategies;
explain the benefits and risks of using delegated authority arrangements; and
develop documented underwriting strategies which include the essential information.
Introduction
Although this chapter focuses on the creation and application of underwriting strategy, it is
important to understand how underwriting strategy at its highest level is derived from
corporate strategy and how it has to work alongside a number of other strategies in order to
be effective.

As underwriting director of a start-up insurer, you are responsible for expressing the will of
the board regarding risk acceptance and terms to all other underwriting managers and staff.
This will be driven primarily by the definition of risk appetite. There can be many levels of
underwriting strategy and within a single insurer there may be strategies applicable to
different divisions, product sets, schemes, distribution channels or countries of operation. As
underwriting manager for any of these areas, you may be responsible for updating the
relevant underwriting strategy and for negotiating changes with reinsurers and colleagues
(for example, those responsible for distribution and marketing). In order to do this effectively
and within your authority, you must understand how underwriting strategy has been derived
within your company and how the company’s other strategies impact on underwriting and
vice versa.

What can be stated with certainty is that all underwriting managers are responsible for
interpreting underwriting strategy when faced with the reality and complexity of customers’
risks and for ensuring that the full meaning and significance of the company’s underwriting
strategy is conveyed to staff reporting to them. Accurate interpretation and meaningful
explanation require an understanding of not only the company’s underwriting strategy, but
also its other strategies, particularly those relating to marketing, distribution and
operations. Indeed, in your own company, you may regard certain strategies relating to
marketing, distribution or operations as integral to your own strategy. Firstly, however, we
will look briefly at corporate strategy.

Key terms

This chapter features explanations of the following terms and concepts:

Aggregator Broker consolidation Commoditisation Company culture

Competitive advantage Corporate strategy Customer segmentation Differentiator

Hygiene factor Insurance (underwriting) Managing general agency Market dominance

cycle

Premium pricing Risk acceptance limits Risk appetite Strategic business unit (SBU)
Underwriting governance
A Corporate strategy
Corporate strategy states, at the highest level, which markets the company is focused on, the
value it intends to generate for shareholders, staff and customers, and how the company’s
approach will achieve this in the current environment. Further strategies at strategic
business unit (SBU) and functional levels will explain ‘what’, ‘why’ and ‘how’, in respect of
those units’ and functions’ contributions to the achievement of corporate strategy.

Research exercise
It is worth reading the corporate strategies of a number of companies with similar business interests, for example,
general insurance (www.zurich.com, www.aviva.com, www.axa.com, www.iag.com.au).

Is it possible to discern different priorities and approaches? Read the half-yearly and annual results statements
(particularly the summaries reported in the insurance press) for a number of different companies: what long- or
short-term issues do they focus on?

It is important to remember that published corporate strategies are primarily aimed at

market analysts and shareholders. For employees, corporate strategies are generally at too
high a level to provide guidance but for senior managers, in particular, the overall intent and
direction expressed in their company’s corporate strategy needs to be understood and
reflected in their own units’ or functions’ strategies and plans.

What guidance do insurers’ corporate strategies provide for underwriting

managers?
Most corporate strategies will include specific financial and non-financial targets that will
help to shape the underwriting strategy. For example, a return on capital (ROC) target is a
financial target that can apply across many different lines of business. The organisation may
wish to be in a top three position in a chosen market or be a niche player, building its
underwriting strategy around customer research.

In their published format, there is usually little of specific relevance regarding underwriting;
however, not every aspect of corporate strategy is made public. One of the most important
elements of corporate strategy, which is commercially sensitive and thus generally
confidential, is the company’s risk appetite.

Be aware
You should take care to note that the company’s risk appetite deals with more than insurance risk alone: it includes
investment risk (how should the company’s assets be invested?), counter-party or credit risk (how should the
company manage the risk of a reinsurer failing?), reputational risk (how should the company manage adverse
publicity to protect its share price?) and every other significant risk the company faces. When we discuss the
company’s risk appetite (insurance risk) in this unit, this is definitively the company’s maximum acceptance which
only the board can amend.

Below board level, all underwriting managers and underwriters operate within an
‘underwriting strategy’, a ‘gross acceptance policy’ or a ‘risk appetite’, which may at times be
exceeded by reference to someone with a higher level of underwriting authority. At no time
may this exceed the company’s risk appetite (insurance risk) as signed off by the board. All of
a company’s gross acceptance policies are derived from the company’s risk appetite
(insurance risk).

In the creation or development of an underwriting strategy, knowledge of the company’s risk

appetite is necessary but not sufficient. As stated in the introduction, it is also necessary to
refer to other functional strategies (such as marketing, distribution and operations) and to
those of distinct SBUs (which may be defined by product, customer and/or country). It is
likely that each SBU will require its own specific underwriting strategy, which must sit
comfortably within the company’s overall risk appetite.

Example 3.1
‘UK Commercial’ might be a SBU of a company with two other SBUs in the UK, ‘UK Personal’ and ‘UK Life’, or the
other SBUs might be commercial insurance operations in France and Japan.

A1 Competition for capital

Think back to M80, chapter 3, section A

While all functional and SBU strategies must comply with the requirements and intent of
corporate strategy, there will always be competition for resources within a company – the
fundamental (and limited) resource being capital. Just as each insurer must have adequate
capital resources in line with its size and the nature of the business it undertakes, insurers
must also evaluate the capital required by different SBUs and classes of business within the
company. This is a regulatory requirement, as well as an appropriate input to decisions about
how companies should conduct business.

Within an insurance company, at any given point in time, it is likely that a number of SBUs will
wish to grow their premium incomes. Each of these requests for capital investment has to be
evaluated separately and the capital required will be measured against the SBU’s profit
potential (and that of each class of business written) using projected combined operating
ratio (COR) and return on capital employed (ROCE). Different types of business have
varying capital requirements in order to write the business and this has an effect on the
ROCE.

Example 3.2
Let us assume that for every £100 of UK motor premium written, £50 of capital is required, and for every £100 of UK
casualty premium, £100 of capital is required. Let us also assume that both the motor and casualty books make a 5%
profit margin on the business written and that investment income on both books is nothing. ROCE on casualty will be
5% but on motor it will be 10%.

The evaluation will also consider the anticipated state of the market: are prices rising or
falling? A softer market (falling prices) implies that loss ratios will deteriorate, putting
pressure on profitability; while a hard market (rising prices) will improve profitability but put
pressure on capital (higher average premiums, even on a static book of business, will increase
the capital requirement). The Solvency II regulatory regime has led to an enhanced focus on
the allocation of capital between lines of business.

Be aware
As discussed in chapter 2, the purchase of reinsurance can reduce an insurer’s capital requirement. Decisions about
what to buy and how much will vary considerably from insurer to insurer based on the insurer’s size and maturity,
the spread and mix of business, and its performance (gross loss ratio). As well as evaluating the trade-off between
the cost of capital and the net cost of reinsurance, corporate risk appetite will shape the company’s approach to the
purchase of reinsurance. We shall consider reinsurance in more depth in chapter 8.

How can the company balance its short-, medium- and long-term objectives
with the need to meet its annual ROCE target?
A longer-term outlook may mean that a small but growing account, which generates a poor
short-term return on investment, will continue to be supported in anticipation of acceptable
returns in future. A large account, producing similarly poor returns, may be faced with a more
stark response from the board: capital investment in increased premium income is
unsupportable and immediate action is required to bring the COR to an acceptable level.
When a return to profitability cannot be anticipated in a reasonable timeframe, the company
must consider exiting the account.

Of course, an insurer has other opportunities for the investment of capital beyond the funding
of the underwriting function. Investments in infrastructure (such as buildings and ICT) and
projects (such as customer research) must also be considered and evaluated on a financial
basis. If a prolonged soft market is anticipated, insurers may choose to divert some of their
capital resource to new infrastructure and projects rather than allowing low-margin or
unprofitable accounts to expand.

The decisions made regarding the allocation of risk capital and the purchase of reinsurance
(in other words, the company’s ‘capacity’) are reflected in the underwriting strategies, plans
and budgets which state an individual account’s planned premium income for the
forthcoming year, as well as its target COR and ROCE. An insurer’s finance department will be
as concerned about an account which appears to be exceeding its planned premium income
as one which is failing to reach its target. Overall, minor variations may be absorbed within a
company as some accounts exceed target by a small amount while others fail to quite reach
their targets. However, no company wishes to be in the position of having to turn away
potentially profitable business due to lack of capital (see chapter 5 on planning).

Be aware
The requirements of Solvency II mean underwriting managers are increasingly involved in the assessment of capital
requirements, which must more closely reflect actual risk assessment under the regulations. The emphasis on more
accurate risk and capital assessments focuses insurers’ attention on the effective use of capital, as well as its overall
adequacy.

Underwriting management decision: capital requirements

If Account A grows by 20% (gross written premium (GWP)) next year, how will any change of mix affect its capital
requirement?

As noted above, the process of allocating risk capital within a company will include decisions
regarding entering new classes or markets or exiting existing ones.

A2 Entering and exiting

Entering a new class or market shares a number of features with a start-up situation,
described earlier. While the scale of the entry project can range from a household insurer
entering the market for pet insurance to the decision to establish a new operation in a
different country (see section B), there are a number of common considerations:

Costs versus anticipated returns.

Regulatory requirements.
Expertise.
Timing.
Capability.
Balance of a class of business on the overall risk mix of the portfolio.

The cost of capital (risk capital and investment in infrastructure) has been discussed above:
whatever the scale of the entry project, all of the costs must be evaluated against the
prospects for profitable returns. All new ventures in insurance are costly to establish, not
least due to the requirement to hold sufficient capital to cover the solvency capital
requirement (SCR), and it would be unusual for a new venture to produce a profit in less than
two or three years of operation.

Be aware
The SCR must be covered by an equivalent amount of capital (assets in excess of liabilities, subject to specific
eligibility, and valuation rules).

Think back to chapter 1, section B for a more detailed discussion of SCR.

In order to ensure that sufficient profit will be generated, the opportunity represented by the
new class or market must be evaluated carefully. How much demand exists? How much
competition is there for this new business and how effective is it? How volatile are the results
likely to be?

The regulation of insurance enterprises varies around the world and, in general, observance
of the requirements of regulation can be a costly and time-consuming process. Even when an
established UK insurer applies for authorisation in a new class of business, the regulator
takes time to evaluate its plans for the class and queries its expertise in the new area.

Capital and specific expertise can both be expensive to obtain but both are required to
establish the credibility of the new venture in the eyes of customers, intermediaries,
reinsurers and credit rating agencies (as well as regulators).

Timing can play a significant part in the success of a new venture: the ideal time is when a
hardening of the market is anticipated or is under way (see section C2). In these
circumstances, intermediaries and customers welcome increased competition and, as long as
prices continue to rise, other insurers may not react adversely. However, entry to a new
market or class when the market is softening could lead some existing insurers to indulge in a
bout of price discounting, compounding a deteriorating position. The new entrant could be
forced to lower prices below an economic rate (in order to gain a foothold in the market) and
thus push the prospects of profit beyond their planned time frame. The existing players hope
to encourage the new entrant to exit quickly before they also lose too much money: their
objective is to reduce competition and moderate the overall decline in prices.

Be aware
The decision to exit a class of business or market is not undertaken lightly. Irrespective of the circumstances, the
decision will leave customers and intermediaries inconvenienced and disappointed, and internal staff upset and
possibly redundant. The decision could represent a serious reputational risk to the insurer and its announcement
will need careful handling.

Useful article
PwC. (2014) Unlocking value in run-off. A survey of discontinued insurance business in Europe. Seventh edition.
September 2014. www.pwc.com/gx/en/insurance/reinsurance-rendezvous/assets/pwc-survey-of-discontinued-
insurance-business-in-europe.pdf

In some instances an insurer may exit at the optimal point before returns fall below an
acceptable level and losses are incurred. While exiting a class of business or market is a last
resort for an insurer, underwriters have an ongoing requirement to produce sustainable
positive returns on the capital deployed; therefore, in some circumstances, it is unavoidable
and the correct decision. It may be apparent that demand for a particular class of business is
diminishing rapidly or that the prospects of an economic sector or country are poor: insurers
can therefore anticipate the need to change their approach or exit. More commonly, losses
will have been incurred while attempts were made to bring the class or account back to
profitability. It may not be possible to redeploy the buildings, systems and other
infrastructure used for the administration of the business and their disposal will lead to
further losses, in addition to the cost of redundancies.

Even if the business is sold, the original insurer’s liability for the run-off must be considered.
Should the company handle the run-off itself (potentially for many years) or pay for the run-
off to be transferred to another insurer?

These costs and difficulties need to be measured against the damage done to the company by
continuing to engage in unprofitable or underperforming business – financial and
reputational damage – which could ultimately threaten the company’s survival.

Useful article
Jackson, L. (2010) ‘QBE personal lines motor account put into run-off’, Post Online, 6 January 2010.
Please contact knowledge@cii.co.uk if you wish to receive a copy of this article via email. (Please note, under UK Copyright Law the number
of copies we are able to email is restricted to one article per issue per CII member.)
B Multinational business
Even those general insurers with no strategic interest in writing foreign business have
existing customers who require cover for minor exposures abroad and wish to include these
exposures in their existing insurances. It is convenient and reassuring for the customer (and
their broker) and, hopefully, cost-effective, in that the additional premium should be less than
the cost of buying new, separate insurances for the foreign exposures.

Example 3.3
UK businesses with warehouses in continental Europe or the Republic of Ireland or the requirement of UK drivers
for motor insurance while driving in continental Europe on holiday.

Refer to M92, chapter 1, section B

Insurance and international trade and development are closely related and, as domestic
businesses of all types expand their operations abroad and/or acquire foreign businesses, the
insurance industry responds to serve these multinational companies. In the UK, the London
Market (see section B2) is the focus of this type of activity: devising and servicing global
insurance programmes. Although the impetus for this global business originated in the desire
of insurers to satisfy the requirements of domestic businesses as they grew and diversified,
the multinational businesses serviced by London Market and other UK-based international
insurers no longer need to have a connection with the UK.

Some insurance companies have themselves become multinationals, by acquisition and

expansion, offering insurance to the private citizens, businesses and governments of many
countries around the world. The motivations behind these insurers’ strategies relate to:

the search for a better return on capital and utilising excess capital (reflecting limited
scope for equally profitable growth in existing markets);
exploiting innovations more widely (product/system/approach/brand); and
spreading risk (through the location of exposures and timing of different economic
cycles).

Be aware
International business is when an insured is based outside the domicile of the insurer.

Multinational business is when insurance is required in more than one territory.

B1 Issues to overcome
There are several pitfalls and obstacles inherent in writing multinational business that the
underwriting strategy needs to address. The strategy should:

be very explicit regarding which foreign exposures are or are not acceptable;
provide clear guidance regarding from whom underwriters should obtain advice about:
 risk acceptance (including authorisation),
regulatory and taxation issues, and
specific local requirements;
explain the correct approach to processing such business and producing acceptable
documentation.

A number of immediate questions arise:

1. Is the insurer authorised to write the business in question? Has the insurer been granted
the necessary cross-border licence?
2. What are the regulatory issues of operating in the country/countries in question?
3. Is it clear (to the underwriter, broker and client) what servicing capabilities the insurer
has in the relevant location? Does the insurer rely upon third parties? Precisely what
happens in the event of a claim?
4. Who will survey the risk and provide local technical advice?
5. If the cover requested by the customer includes motor, worker’s compensation, general
and products liability or professional indemnity, is it acceptable for these covers to be
written from abroad? Many countries, especially in Europe, have minimum legal
requirements for these types of policy and any policy issued must comply with such
requirements.
6. Does the insurer’s reinsurance protection extend to foreign risks?
7. Are the covers requested normally available in the relevant foreign country? For
example, earthquake and flood covers are not readily available in many countries and
may not be covered by reinsurance.
8. Are there covers which can only be placed with local or state insurers?
9. Are there any local taxes and how do they operate?
10. How will the insurer treat currency fluctuations (affecting exposures, deductibles,
premiums and claims payments)?
11. Are there any political risks?
12. How will the portfolios be monitored? For example, from a distance or locally?

Be aware
It should, therefore, be apparent that for domestic insurers to accept occasional foreign exposures is typically a time-
consuming task which brings an additional degree of risk to the insurer through the lack of local knowledge of the
risk and potential challenges to service standards.

B2 Global insurance programmes

The creation of global insurance programmes is a key feature of the work of London Market.

Although London Market underwriters are well aware of the complexities outlined above and
have the expertise to deal with all of these issues, they too can be under tremendous pressure
due to the scale and diversity of the enterprises they are dealing with and the often tight
timescales in which they must respond: for example, in order to incept cover on a newly
acquired business for an existing client. Servicing businesses in many different locations,
whether directly or via third parties, remains a challenge.

Even multinational insurers will struggle to be authorised in every country where their
customers have exposures. (See section B3.) In the recent past, a multinational company
would have accepted that the insurer of their global programme is non-admitted in a
particular country. However, many organisations are now encountering an increased local
concern regarding the extent of protection offered by global non-admitted policies and their
regulatory and compliance implications.

Penalties for legal, regulatory and compliance breaches can be harsh and companies failing to
comply may be faced with fines, cancellation of cover, imposition of sanctions and – in
exceptional cases – imprisonment of personnel. As a result there is a growing demand for fully
compliant global programmes.

Definition of non-admitted cover

‘Non-admitted’ cover is a policy that is issued by an insurance company that is not licensed in the territory or
country in which the insured and/or the risk is domiciled.

Refer to M81, chapter 7, section B4 on DIC/DIL covers

Global programmes are increasingly popular with insureds as they provide certainty
regarding the extent of cover purchased, avoid duplication of cover and should provide good
value in return for the scale of their purchase. An alternative approach would focus on the
coordinated purchase of local covers with an additional difference in conditions/difference in
limits (DIC/DIL) cover arranged centrally, bringing all the local covers up to a common level.

Useful article
Guyatt, C. (2009) ‘Going Global’, Canadian Underwriter, December 2009.

B3 Multinational insurers
Multinational insurers may not wish to underwrite risks outside the country in which they are
based. Their corporate strategies may in fact require the businesses in different countries to
focus solely on their domestic markets. They may also have quite different insurance
operations in different countries: direct personal lines in one country, intermediated
commercial in a second, and marine and aviation only in a third, for example. However, those
multinational insurers dealing extensively with commercial insurance will often have
developed internal capabilities to assist large clients, even if they do not specialise in global
programmes.

Multinational insurers will utilise different entry strategies and structures in their businesses
around the world. In the early stages of development common approaches include joint
ventures with local companies and the acquisition of local insurers. Access to customers,
knowledge of risk features and familiarity with local regulatory/business regimes are
important potential advantages derived from these approaches.
In some countries foreign insurers will have no option other than to enter into a joint venture,
often with a state insurance company. From an underwriting perspective it is worth
remembering that the company’s degree of control and access to data may be diminished
under such an arrangement. Entry into a new country via acquisition of a local insurer poses
other potential issues, including establishing common understandings and practices in
underwriting and claims handling and extracting compatible management information.

Of course, establishing a completely new subsidiary company in a foreign country could be a

costly and high risk approach: hence the frequency with which the other approaches are
utilised. The scope to share expertise and specific innovations between group companies and
regions (and thereby derive enhanced profits and/or market share) often features
prominently in the corporate strategies of multinational insurers. For example, innovations
in distribution are often shared around the world:

Useful articles
Anker, G (2004) ‘Direct Line pulls plug on venture’, Post Online, 13 May 2004.

Post. (2009) ‘RBS mourns Direct Line Spain sale’, Post Online, 23 April 2009.
Please contact knowledge@cii.co.uk if you wish to receive a copy of either of the above articles via email. (Please note, under UK Copyright
Law the number of copies we are able to email is restricted to one article per issue per CII member.)

Attempts to introduce different approaches to insurance marketing and distribution may or

may not be successful but prime attention must be paid to the typical claims experience of
different markets and local regulatory attitudes.

Useful article
Denton, S. (2010) ‘Italian insurance regulator to act on high motor premiums’, Post Online, 30 July 2010.
Please contact knowledge@cii.co.uk if you wish to receive a copy of this article via email. (Please note, under UK Copyright Law the number
of copies we are able to email is restricted to one article per issue per CII member.)

Opportunities to share more general expertise and knowledge are possibly of most interest to
underwriters working for multinational insurers. While it would be unusual for a product
developed in one country to be entirely acceptable, unaltered, in another country, there will
be much to interest and inform underwriters in the general underwriting considerations and
long-term claims experience associated with a product or risk new to their domestic market.

As well as the wide range of insurance approaches and traditions prevalent around the world,
general consumer attitudes and the requirements of industry and commerce differ
considerably over time and location.

Example 3.4
Some years ago, the only insureds and insurers interested in large-scale viniculture, the cultivation of vines, were
located in continental Europe. Nowadays this industry is of major significance in many more locations around the
world (for example, South Africa, Australia, New Zealand and California) and underwriters in those countries wish to
learn from the experience of their colleagues in Europe: gaining, for example, a long-term perspective on the causes
and incidence of crop failure. Of course, European experience in the twentieth century is not necessarily applicable
to Australia in the twenty-first century but consideration of current challenges, such as climate change, to the
viniculture industry around the world can only benefit from the most comprehensive evaluation enabled through
the sharing of data, information and knowledge by underwriters.
C Marketing
In general terms, the objective of marketing is the creation of sustainable competitive
advantage. Many types of activity can contribute to this overall objective, including:

the identification of target market segments;

the development of products and their promotion;
pricing and distribution;
customer research;
branding;
competitor analysis;
environmental monitoring; and
the allocation of resources.

In the context of general insurance, it is apparent that a number of functional areas, including
underwriting, collaborate to accomplish marketing work and, therefore, this is not the
description of the typical responsibilities of a marketing department in a general insurance
company.

Competitive advantage is most effectively and sustainably achieved when a company’s

internal capabilities are tailored to address and continue to adapt to specific external
opportunities. Typically, a new insurer will build the capability to exploit identified external
opportunities; an existing insurer will look for further external opportunities in order to
utilise existing capabilities before investing in new internal capabilities. Before discussing
some of the capabilities which can contribute to competitive advantage, we need to turn our
attention to the opportunities presented by the external environment.

C1 The external environment and the demand for insurance

Some environments are more conducive to the successful growth and profitable operation of
general insurers than others. Those conducive attributes (such as stable political, legal and
judicial systems) will also support general economic growth and thus the demand for
insurance. General instability, by contrast, will undermine economic growth but may, in some
instances, increase the demand for insurance. Insurers have to evaluate the overall cost and
risk of doing business in each specific environment open to them against the expected
returns. Of course, the demand for general insurance is not a simple function of economic
development, prosperity or degree of risk: general insurance expenditure as a proportion of
GDP varies from 8.4% in the Netherlands, 2.4% in the UK and 3.2% in Taiwan to 0.7% in India
(source: sigma No 3/2016 ‘World insurance in 2015’, www.swissre.com/sigma). Particularly
in an international context, it is evident that history and cultural attitudes, as well as relative
affluence, are influential in determining attitudes towards the use of insurance.

Underwriting management decision: evaluating the opportunity

Is this a positive environment in which to offer insurance or, at least, one where the inherent risks are understood
and where there is a sufficient demand for insurance?
Other much more specific external influences affect demand for insurance, such as changes in
public perception (the requirement that polluters should pay for the remediation of polluted
land and waterways); technological innovation (the extensive use of communication
satellites); and public policy (the level of funding for health care). Of course, insurers do not
necessarily respond to every new demand or to the extent desired by potential customers.
Climate change might well increase the demand for insurance but insurers and reinsurers
may not be able to respond in every instance, just as flood and earthquake cover are already
not generally available in many countries. Insurance against acts of terrorism has in recent
years required the intervention of governments to support insurance and reinsurance
markets. Concern over the extensive use of asbestos and emerging claims costs have led to
restrictions in primary and reinsurance covers. The main constraint in these instances is the
combination of significant uncertainty and potential scale measured against insurers’
capital reserves.

Underwriting management decision: evaluating the opportunity

Are you satisfied that the cover required and/or the risks presented will not threaten the survival of the company? in
other words, is it within the risk appetite of the company? Do you have the expertise to handle new covers/risks or
can you develop or acquire it?

C2 The insurance (or underwriting) cycle

Think back to M80, chapter 2, section D and refer to 990, chapter 10, section F6

For many years the external environment has affected general insurance through the
operation of the insurance or underwriting cycle. While certain internal aspects of the
insurance market influence the precise path of the cycle (intense competition or the lack of it
can affect the amplitude of the cycle and significant claims events can influence timing), the
fundamental influence behind the cycle is the flow of capital seeking optimal returns.

Following a peak in 1994/95 and a trough of ‘dismal’ results between 1998 and 2001, prices
and profitability grew rapidly to another peak in 2003/04. The economic downturn that
followed the 2008 financial crisis also impacted the cycle, with consumers and businesses
affected in terms of their financial spending power. There are also clear signs of different
cycles between commercial and personal insurance, and with product lines within these
areas. Some insurers choose to exit a market rather than wait for an upturn in pricing levels,
while others develop alternative business models to create more non-risk income from their
customer bases.

Despite the fact that a ‘cycle’ by its nature repeats itself, insurers and underwriters can never
be sure where their business is on the cycle at any current point in time. This is only apparent
after the event, once the cycle has turned. The only predictable aspect of the
insurance/underwriting cycle is that it continues to impact the insurance market as
powerfully as ever.
Insurers continually strive to adopt and refine strategies to shield their businesses from the
full impact of the cycle. They may target areas of the market where there is less competition
due to the highly specialist nature of the risks or client requirements. Many will seek to
achieve a dominant position in their main markets, in the belief that they will have more
opportunity to influence prices and compete successfully on non-price-related issues.

Although most insurers would not choose to enter and exit markets in line with the cycle (due
to the costs and disruption caused), many will expand and contract the capital available to
support underwriting in line with the cycle. This strategy is most effective for insurers with
low fixed costs, as reduced volumes and income – while prices are low and loss ratios poor –
will not necessarily lead to unacceptable expense ratios. However, as most insurers have
relatively high fixed costs, their scope to reduce volumes and premium income while
maintaining acceptable expense ratios is limited.

For those insurers who might choose to follow the cycle (allowing their prices to rise and fall
in line with the general trend), it should be noted that there is no guarantee that ‘peak’ profits
will cover ‘trough’ losses.

Impact on underwriting strategy

An important part of any insurer’s underwriting strategy is how they intend to manage the
cycle. Different approaches may be adopted for different parts of an insurer’s portfolio. This
may relate to the:

relative market position of the insurer for different classes;

ratio of variable to fixed expenses for certain classes or units;
degree of competition in different parts of the market; and/or
scope for non-price-related competition.

Underwriting management decision: managing the insurance cycle

Where is the relevant insurance class or market on the cycle? Has the company the ability to survive the troughs and
exploit the peaks? Is there a point on the downswing when the company cannot afford to write more business (too
unprofitable)? Is there a point on the upswing when the company cannot write any more business (lack of capital)?
How well are competing insurers managing the cycle? What are our strategies for cycle management?

Research exercise
For a product or market you are familiar with, consider in what ways your own company and its main competitors
have sought to manage performance through the last insurance/underwriting cycle (peak-to-peak or trough-to-
trough). It may be worth discussing this question with colleagues in order to capture a range of views. Which
approaches appear to have been most or least successful?

While competition for capital is the ultimate driver of the insurance or underwriting cycle,
competition among insurers, reinsurers and intermediaries for business drives the
competition underwriters are most familiar with on a daily basis.

C3 Competition
The market for general insurance in the UK is highly competitive. Despite the fact that
insurers have consolidated and the market functions to provide significant competition and
choice for consumers and businesses, none of the large insurers alone can dictate terms
(attempts to do so result in an unpalatable loss of GWP and increased expense ratios) and
there appears to be no shortage of capital to support smaller companies and start-ups.

Be aware
Any evidence of monopolistic pricing or other form of anti-competitive behaviour would attract UK
governmentalEU intervention via competition legislation (see chapter 1).

Underwriting management decision: competitors

Who are the main competitors in each segment of the market in which your company operates? Are there any
emerging competitors worth watching? What are they doing?

Sometimes competition will not arise directly from other insurers but indirectly through:

changes in distribution (for example, through broker consolidation and the

rationalisation of insurer panels);
the use of technology in new ways (for example, the growth of aggregators); or
from non-insurers (for example, big consumer brands).

In response to competition, general insurers typically seek to differentiate themselves and

create competitive advantage through the effective management of the following features or
capabilities:

brand;
products;
distribution;
customer service; and
price.

Underwriting management decision: competitors

What are our competitors good at? How does our company choose to compete for customers?

C3A Brand
While every general insurer is concerned to create and maintain a good public image (not
least due to the intangible nature of insurance) and therefore positive associations with its
brand or brands, some companies invest far more heavily than others in brand management.
However, insurers generally enjoy low recognition, particularly amongst the public and the
owners of small businesses.

Useful article
Jackson, L. (2010) ‘Lloyd’s named UK’s strongest insurance brand’, Post Online, 24 February 2010.
Please contact knowledge@cii.co.uk if you wish to receive a copy of this article via email. (Please note, under UK Copyright Law the number
of copies we are able to email is restricted to one article per issue per CII member.)
In this way, big consumer brands, whether acting as intermediaries or insurers, can have a
significant competitive advantage in some sectors of the market.

Example 3.5
Part of this trend, Tesco has been able to leverage its significant customer base and reputation for providing good
value products and services.

C3B Products
Much effort is devoted to the differentiation of insurance products throughout the market.
Some insurers look to develop offerings that maximise cover and service; others look to
provide ‘lowest common denominator’ products. This is clearly an area of heavy involvement
by underwriting, which will be discussed later in this unit (see chapter 4, section C).
Regarding the creation of sustainable competitive advantage however, it is accepted that
products are usually easy to copy, and innovative covers, if they prove popular, can quickly
become the norm.

C3C Distribution
As distribution controls access to customers, the relative effectiveness of an insurer’s chosen
method or methods of distribution is a very important determinant of competitive advantage
(see section D). A key consideration for an insurer is channel mix and whether there is
channel conflict. This is particularly relevant where an insurer provides products directly to
consumers, as well as through intermediaries or strategic partners.

C3D Customer service

Many insurers pride themselves on their focus on customer service but customer service
which consistently excels and becomes a true source of competitive advantage is not the
norm. Good (but not consistently excellent) customer service is appreciated but it does not
necessarily influence future purchasing decisions. The nature and quality of a company’s
customer service depends upon the operational capabilities of the insurer as well as its
marketing strategy. Operations are discussed more fully in section E.

Insurers are under considerable pressure to find more cost-effective ways of operating and
this can create discrepancies between an insurer’s perception of good customer service and
an individual customer’s expectations (intermediary or end-customer). Taking decisions
around the nature of and level of investment in customer service initiatives is a particularly
difficult area in general insurance because reliable cost-benefit cases are difficult to
construct. For example, efforts to manage claims costs (by reducing claims leakage and
pursuing bulk purchasing initiatives) can severely irritate customers, despite the fact that
such initiatives are in the best interests of all honest policyholders.

The use of overseas call centres has been controversial and not universally welcomed but
have customers ‘voted with their feet’? Have competitors who advertise that none of their call
centres are overseas benefited? It is difficult to evaluate the true impact of any one factor in a
relatively complex purchasing decision and even more difficult to project what the impact
might be of proposed changes in customer service delivery.

Many professional intermediaries state that they favour those insurers who continue to
support branch networks and provide known contacts but the same intermediaries regularly
place business with other insurers (without expensive branch networks) because they are
cheaper!

Be aware
Only in respect of claims service might a broad generalisation be regarded as valid: namely, that a poor reputation
in respect of claims service will adversely affect an insurer’s reputation. However, a good reputation for claims
service does not guarantee insurers significant competitive advantage.

All of these features or capabilities – brand, products, distribution and customer service – can
be approached in many different ways. The features chosen need to work well together; in
other words, the marketing strategy must be coherent. This may seem obvious but there are
instances of insurers attempting to widen their product or customer base, having failed to
recognise that the existing brand or distribution method was not suitable for the new product
or did not provide sufficient access to the targeted customers. The marketing strategy
adopted must also be well-balanced: there is little point in investing heavily in innovative
products if there is insufficient brand awareness to support their sale.

Refer to discussion of what customers value in section C4C

To ensure that marketing expenditure is justified (i.e. will generate the expected return), it is
essential that each insurer understands which features or capabilities are true
‘differentiators’ or, in other words, have the potential to generate competitive advantage. It
could be argued that some of the aforementioned features are really ‘hygiene factors’ rather
than differentiators; that is, features which are expected as standard. A good claims handling
service might therefore be regarded as a hygiene factor: all insurers need one and while poor
service will drive customers away, an excellent service will not necessarily attract
significantly more customers or make higher premiums acceptable.

For every insurer, depending upon their chosen marketing strategy, there is a point at which
spending more money improving certain features or capabilities (which are already regarded
as ‘acceptable’ by customers) becomes ineffective. Increased expenditure will not result in a
more-than-equivalent increase in income. This can be a difficult conclusion for staff to
understand. Only by ensuring that front-line staff understand precisely the quality and style of
customer service to be delivered – and its rationale – can management hope to achieve the
intended level of customer satisfaction within planned budgets.

Useful website
The FCA’s then Director of Supervision, Clive Anderson, made a speech in November 2013 entitled ‘Trust and
confidence – ensuring firms’ ethics are built around their customers’. The transcript is available at:
www.fca.org.uk/news/trust-confidence.
C3E Price
So far in this discussion of marketing strategy, the focus has been on features (brand,
products, distribution and customer service) that take time and money to develop and refine
in the search for sustainable competitive advantage. In what ways might a focus on price
contribute to the creation of such an advantage?

In some parts of the general insurance market, it is recognised that features other than price
have relatively little influence on the purchasing decision. Such products, which have become
less and less differentiated, are described as commoditised. These products are not entirely
undifferentiated but, as price is the key feature, competition is fierce and profit margins are
low, reinforcing the undifferentiated nature of the competition. Motor insurance is a good
example of a highly commoditised market.

Refer back to the discussion of the insurance/underwriting cycle in section C2

In other areas of the market, where the opportunity to differentiate between insurers (using
brand, products, distribution and/or customer service) still exists, price remains a major
factor. An underwriting manager may have as much difficulty persuading underwriters to
focus on all the benefits a product offers, rather than simply its price, as convincing brokers or
end-customers of the product’s merits. Of course, competition based on price may be
appropriate if the lower price is based on reduced expenses, greater efficiency or lower risk
premiums.

Be aware
Any significant sustainable reduction in internal costs and/or commission could provide an advantage that may
be hard for other insurers to replicate in the short-term. An insurer whose risk selection process produces
consistently lower-than-average claims costs has a major advantage over competitors. Although rating structures
can be copied, access to internal databases and knowledge is restricted. Competition on the basis of risk selection has
the potential to create long-term advantage.

Underwriting management decision: competitors

Do we really understand our competitors’ marketing strategies? Can we evaluate each of the main features and
understand their overall approach to target customers?

Consider this…
Are the features your company intends to promote (compete on) true differentiators? Do they work well together?
For how long can any competitive advantage be sustained?

It is hard to predict which competitive features or innovations will generate lasting advantage
for the first insurer to adopt them or which will rapidly become ‘the way things are done’. In
the UK motor market in the 1980s, Direct Line generated a very significant ‘first mover’
advantage for themselves, which existing insurers found difficult and expensive to challenge.
By contrast, the collaboration of insurers with broker software houses (to improve brokers’
access to competitive products with easily updated rates), requires a sufficiency of insurers
to participate in order to secure brokers’ wholehearted support for these systems. Once
enough insurers agree to participate, such an arrangement may resemble a hygiene factor
rather than a differentiator.

Useful article
Ellis, A. (2010) ‘Aviva teams up with SSP’, Post Online, 25 February 2010.
Please contact knowledge@cii.co.uk if you wish to receive a copy of this article via email. (Please note, under UK Copyright Law the number
of copies we are able to email is restricted to one article per issue per CII member.)

C3F Sustainable competitive advantage

In the economy as a whole, ‘market dominance’ and the ability to command ‘premium
pricing’ are used as indicators of the achievement of a sustainable competitive advantage.

Be aware
‘Market dominance’ does not necessarily imply being the single largest company in the market: ‘dominance’ refers
more to the degree of influence a company exercises, rather than size alone. ‘Premium pricing’ is when one company
can successfully charge a higher price than others for a broadly similar product.

It may seem odd even to mention ‘premium pricing’ in the context of general insurance when
so much of the talk in the market is about commoditisation, which might appear to be its
antithesis. Although the search for ‘premium pricing’ can be obscured by the operation of the
insurance or underwriting cycle, whose swings can lead to extreme price movements,
successful insurers (those creating and exploiting sustainable competitive advantage)
optimise their overall premium against anticipated claims costs year after year by
determining clearly their risk acceptance/pricing matrix and flexing it appropriately. This
applies throughout the market, from the commoditised mass markets for motor and home
insurance through to the markets for specialist products and/or corporate clients at the other
end of the scale, where underwriting expertise is applied on an individual basis.

As insurers seek to achieve ‘premium pricing’ for portfolios or accounts, rather than for each
individual risk, the actual differentiator is risk acceptance rather than pricing. Thus two
insurers could use identical rating tables and apply them consistently but if each insurer had a
different risk acceptance policy, the end result could be two quite different books of business,
different mixes of business and different loss ratios.

The opportunity to take advantage of ‘premium pricing’ does not happen by accident.
Sufficient suitable customers, whether mass market consumers, SME businesses or corporate
customers, must be attracted to the insurer in the first place. An insurer wishing to take
advantage of ‘premium pricing’ for any particular group of customers must be in or
approaching a position of dominance for that group. This will only happen if the other key
features are also right: brand, products, distribution and customer service.

C4 Customer segmentation
In mass markets insurers have literally millions of opportunities to test different
permutations of competitive features on consumers and assess the outcome. In specialist
markets, insurers, intermediaries and corporate clients speak directly to one another and
insurers can shape their offerings accordingly. Whether consciously or not, the search for
greater understanding of customer needs and preferences is part of a customer
segmentation exercise.

The focus on customer segmentation has grown in recent decades as even the largest of
insurers has discovered how difficult it is to be ‘all things to all people’ (and operate
profitably), particularly in a world where customer expectations, distribution methods and
risks change rapidly. Understanding has grown that different parts of the market require not
just different marketing strategies but quite different operations, leadership and culture (see
section E on operations). Smaller companies, which cannot reasonably hope to dominate a
whole market, have discovered the benefits of narrowing their focus and achieving a
dominance (and thus good returns) in a more specific part of the market. Large insurers are
also following this path by being more selective in their choice of target markets and
developing a range of operating models and marketing strategies, as required.

C4A External research

Customer segmentation starts in the external environment where researchers look at
different ways of segmenting or categorising customers by their characteristics, needs,
preferences and behaviours. A range of specialists, including underwriters, using a wide
variety of sources, can contribute to such an exercise. Economists provide insights regarding
the anticipated growth or decline of different sectors in economies around the world, while
information on major external risks such as the anticipated geographical impact of climate
change may be provided by reinsurers. Marketing specialists can examine demographic and
lifestyle data purchased from firms such as CACI and the mass of government statistics now
readily accessible on the internet.

Useful websites
www.caci.co.uk

www.statistics.gov.uk, UK National Statistics, including business, economy, crime, population, price indices, earnings
etc.

With this background information, more detailed customer or sector research may be
commissioned in order to identify the characteristics which most influence behaviours
related to the purchase and use of insurance.

How are customer needs and preferences addressed by other insurers: do they consciously
target specific customer segments? How successful are they? Viewed from a customer’s
viewpoint, what are the competing products or alternatives? In the market for corporate
insurance it is obvious that self-insurance and captives form viable alternatives and thus
compete with conventional product/service offerings. The level of welfare, health and social
security provision in a country will clearly affect the willingness of its citizens to purchase
private insurance protection.
C4B Internal data and its limitations
Underwriters and actuaries can work together to review internal data relating to the claims
experiences of different groups and subgroups of customers, their projected exposures and
the cost and attractiveness of possible cover variations. Although many insurers have
implemented comprehensive data warehousing strategies for their current business, the use
of data mining software may enable insurers to explore internal databases in different,
revealing ways. Even though existing internal data may not have been fully exploited, it can
only take an insurer so far. In many insurance companies, current data and systems are based
on the assumptions and practices common 20 years (or more) ago. Although newer insurers
may have more up-to-date systems and better-organised data, they do not have internal data
covering a long period of time. For all insurers, therefore, a comprehensive and current
understanding of customer segmentation requires the use of as much relevant external data
as possible, as well as focused customer research.

C4C What does the customer value?

Efforts should be made to obtain customers’ views of their needs and preferences, not limited
by their conventional expectations of what insurers can or cannot offer. In the same vein,
insurers’ assumptions about what customers (former, current and potential) need or prefer
should be challenged rigorously and evidence sought to justify such assumptions. In
particular, researchers must pursue the issue of ‘value’: how highly do customers value the
various elements of insurers’ product and service offerings? Which elements are customers
willing to pay for or change insurer to obtain and which might be described as merely ‘nice to
have’? Any assessment of customer satisfaction has to be underpinned by a clear
understanding of the extent to which customers value the various elements of the
product/service offering. The aim must be to achieve high levels of customer satisfaction
with the elements which represent most value to customers (their perception, not that of
insurers).

Useful article
Aubert, N. (2014) ‘Aiming for happy customers’, Post Online, 19 June 2014.
Please contact knowledge@cii.co.uk if you wish to receive a copy of this article via email. (Please note, under UK Copyright Law the number
of copies we are able to email is restricted to one article per issue per CII member.)

C4D The insurer’s choice

Having identified groups of customers whose typical exposures and claims experiences are
within corporate risk appetite and sought out customers’ views, the segmentation exercise
proceeds to identify sectors and segments of customers whose needs and preferences may be
satisfied by the insurer’s internal capabilities and capacity in a cost-effective manner.

The exercise may reveal that customers in certain sectors are perfectly satisfied with existing
products but have certain service requirements that, if fulfilled, would give an insurer a
significant advantage. Other sectors/segments may be identified that are attractive but
require the development of new internal capabilities: this could relate to brand development
or new distribution channels. On the other hand, the conclusion may be reached that
customer requirements are currently well-satisfied by existing providers and the company
should look elsewhere for sectors in which to differentiate itself and gain competitive
advantage. This latter conclusion may be reached about a sector in which the insurer already
has a presence.

Consider this…
In the latter circumstances, is it better to maintain a presence without devoting significant resources (including
capital) to the sector or segment or to exit? Refer back to section A2.

C4E Success in customer segmentation

In order to turn a well-chosen target group and specifically tailored product/service offering
into a commercial success, a high proportion of all customers in the target group must feel
compelled to seek a quote from that insurer. Once an insurer is approaching or has achieved
this level of dominance – the opportunity to quote for a high proportion of the target group’s
insurances – the insurer’s underwriters have ongoing access to the best possible information
about the target group as a whole and, with this perspective, can exercise their powers of
discrimination in terms of acceptable risks and suitable terms, in order to build a book which
is balanced/optimised to achieve the desired underwriting result. Once achieved, this level of
advantage is far harder for other insurers to challenge because it is self-reinforcing: it can be
described as a sustainable competitive advantage.

Research exercise
Thinking about a familiar product or market, you identify the customer characteristics that influence:

the ways in which insurance is purchased (including distribution channel and method, typical retention
periods, pricing objectives and product feature preferences); and
typical claims experience.

How do these characteristics, preferences and behaviours influence your company’s approach to this particular
product or market?

C4F SME businesses

Although customer segmentation takes place in all parts of the market, in recent years
segmentation has been a particular focus among insurers of SME businesses in the UK. The
reasons behind this increased focus may include more intense competition in this part of the
market (among intermediaries as well as insurers), expectations of more sophisticated
analyses based on data captured in expensive computer systems and success stories
emanating from the USA. There are also some long-standing examples of sustainable
competitive advantage gained through successful customer segmentation in the UK, notably
NFU Mutual’s farmers and General Accident’s (now Aviva) motor traders.

A critical issue in customer segmentation, which impacts the market for SME insurance in the
UK, is that of scale. The difficulties which underwriters confront in attempting to build
reliable rating matrices for specific trades and small businesses due to small sample size, also
impact the broader picture of customer segmentation. The owners of SME businesses might
appreciate different types of product, service and distribution options but can they be
provided in a cost-effective manner if even a 100% share of the target group represents only
one or two thousand risks?

Be aware
At the start of 2015, there were 5.4 million enterprises in the UK and of these, 3.3 million were sole proprietorships
(no employees). Based on employee numbers, the remaining enterprises were defined as:

‘small’ (2 to 49 employees) – 1.3 million enterprises;

‘medium’ (50 to 249 employees) – 32,600 enterprises; and
‘large’ (250+ employees) – 7,000 enterprises.

‘Large’ enterprises account for 53% of total turnover and 40% of employment.
Source: Department for Business Innovation & Skills: Business population estimates for the UK and regions, 14 October 2015.
www.gov.uk/government/uploads/system/uploads/attachment_data/file/467443/bpe_2015_statistical_release.pdf

By way of comparison, there are approximately 36.5 million cars on UK roads whose drivers are required to be
insured, as of end 2015 (Department for Transport statistics).

C4G Fraud
New fraud continues to be a major issue for the industry and the value of fraud detected is at a
record level. ABI figures from 2015 show that insurers expose £3.6m worth of insurance fraud
each day.

As part of their underwriting strategy, insurers must make significant efforts to combat the
risk of insurance fraud. Insurers must develop sufficient screening tools to prevent the
introduction of fraudulent customers onto their portfolios. Such customers intend to make
false claims and ease the impact of opportunistic misrepresentation of risk to obtain cheaper
premiums. Underwriters must work closely with claims teams to understand the overall
counter-fraud activity that is undertaken.

Useful articles
Marriner, K. (2014) ‘Industry welcomes government fraud action’, Post Online, 7 June 2014.†

Association of British Insurers News release 13/7/2015. www.abi.org.uk/News/News-releases/2015/07/You-

could-not-make-up-savings-honest-customers-insurers-expose-3-6-million-worth-insurance-frauds
†
Please contact knowledge@cii.co.uk if you wish to receive a copy of this article via email. (Please note, under UK Copyright Law the
number of copies we are able to email is restricted to one article per issue per CII member.)
D Distribution
Think back to M80, chapter 3, sections E and F

Distribution has always been highly influential in shaping insurance markets and every
insurer’s distribution strategy is central to its business. As distribution methods and
customer preferences can be subject to considerable change, this is undoubtedly one of the
most challenging strategic areas in general insurance – one which presents both
opportunities and threats.

Some insurers focus on a single distribution channel, such as:

direct;
the use of agents; or
professional intermediaries.

Different methods can be used within a single channel, for example, a direct insurer could
transact business by telephone and/or the internet through contact centres or could adopt a
purely internet-based service. There is also considerable scope for direct insurers to utilise
different media for advertising purposes, as well as the possibility of white-labelling their
products on behalf of well-known consumer brands.

On price comparison/aggregator websites participating insurers can include direct insurers,

despite the fact that the aggregator takes a commission. Some direct insurers choose not to
participate on such sites.

Similarly, insurers using the professional intermediary channel use a variety of distribution
methods which are also subject to change. While most professional intermediaries in the UK
are now keen to use internet-based quotation facilities for small commercial business, some
years ago the same business was often being dealt with by on-site underwriters in brokers’
offices.

Many large insurers favour a multi-channel distribution strategy, utilising many different
distribution methods.

D1 Delegated authority arrangements

Refer back to M80, chapter 3, section F

You can refer to unit P66 for in-depth information on technicalities of delegated authority
beyond the scope of unit 960.

One important aspect of an insurer’s strategic mindset is the possibility of using delegated
authority arrangements to attract business. These arrangements take several forms, namely
binding authorities, lineslips, consortia, group/affinity programmes and master covers.
Detailed coverage of the technicalities of delegated authority is beyond the scope of this
syllabus. We will consider binding authority arrangements in this study text, which are
contracts whereby an insurer/underwriter authorises a third party – such as a broker or
managing general agent (MGA) – to act on their behalf.

Binding authority arrangements offer a number of advantages to the insurer, including:

access to businesses in local markets that would not normally come into their sphere;
cost-effectiveness of writing high volume/low value business that would be too
expensive to write individually in the open market;
lower operating costs;
access to knowledge, experience and reputation of the coverholder;
a more cost-effective way of trying out a new class of business without employing a new
set of underwriters, on a follow basis; and
localised and efficient claims handling which enhances the insurer’s reputation.

There are, however, various disadvantages, which include:

loss of control;
failure of coverholder to report adequately;
premiums not adequately accounted for or paid;
local legislative/regulatory rules which may not be complied with;
impact of poor claims service on the insurer’s reputation;
mismanagement of funds;
accepting a lead share on risks for a class of business in which the insurer has little or no
expertise;
anti-selection where the coverholder has several binding arrangements in place with
different insurers for similar risks; and
unauthorised sub-delegation.

Binding authorities can be a cost-effective way of writing risk which an insurer may not have
access otherwise to write. In light of the potential disadvantages, it is apparent that an insurer
should take great care in choosing a coverholder and they should ensure that a detailed due
diligence exercise is completed before authority is granted. Some of the questions they
should be asking include:

Does the coverholder have the necessary knowledge and experience? Does the
individual(s) named in the binding authority agreement have suitable experience to
make decisions?
Does the coverholder hold binders with other insurers? Does it have a reputation for
correct management of these binders?
Are the necessary controls in place?
Is the coverholder aware of the local regulatory environment and does it have processes
in place to pay local taxes etc.?
What is the coverholder’s ICT capability? Will it be able to produce bordereau in a timely
and accurate manner with the information required by the insurer?
As well as exercising due diligence, the insurer should have a stringent audit system to ensure
the coverholder is adhering to the rules and regulations set out in the binding authority
agreement.

Research activity
Have a look at some of the binding authority contracts that you have access to. See if they have specific guidelines
relating to underwriting within them. What level of detail is provided? How is compliance with the guidelines
checked?

Be aware
In addition to the UK-specific regulatory requirements imposed on insurers and coverholders based in the UK, there
are also Lloyd’s-specific requirements for those operating in the Lloyd’s market. These are outlined here:
www.lloyds.com/the-market/i-am-a/delegated-authority.

Lloyd’s publishes a Code of Practice, which serves as an introduction to delegated authority in the Lloyd’s market.

The FCA conducted a thematic review of delegated authority in the general insurance market. The review, published
in July 2015, highlighted that improvements are needed in the due diligence undertaken and the consideration of
their regulatory obligations.

www.fca.org.uk/news/fca-says-firms-not-treating-delegated-authority-arrangements-as-outsourcing-in-general-
insurance-market-

D2 Access to customers
Within an overall marketing strategy which has identified key products and target customers,
those responsible for distribution must identify the channel and methods of distribution
which will provide best access to the target customers. By focusing on access to customers,
well-aligned distribution strategies will help the insurer achieve its sales targets in the most
effective manner, namely achieving the highest volume of sales for the lowest acquisition cost
per policy or per premium.

In the past, there was a tendency for specific customer groups to be strongly aligned with
particular distribution channels and methods. In the UK it is evident that this tendency is now
less marked, with even the role of professional intermediaries in the market for SME
commercial business under apparent threat.

Useful article
Swift, J. (2010) ‘QBE: shock findings show a third of SMEs would go direct’, Post Online, 1 February 2010.
Please contact knowledge@cii.co.uk if you wish to receive a copy of this article via email. (Please note, under UK Copyright Law the number
of copies we are able to email is restricted to one article per issue per CII member.)

The use of line slips and the coinsurance of large commercial risks remains a very effective
way for insurers to access these particular customers and still achieve a spread of risk.
Intermediaries who can offer both access to the most appropriate insurers and other forms of
advice and support (for example, broader risk management or the management of captives)
will clearly represent the most effective channel accessing this significant customer group.
For some customer groups, the distribution method may be highly influential in the choice of
insurer. For example, direct-only companies and those using tied agents seek out customers
who wish to deal in these ways and those who might be persuaded to do so.

D3 Knowledge of risks
As well as providing access to customers, insurers’ distribution strategies and methods
provide underwriters with knowledge of customers and their risks.

Be aware
Different distribution strategies and methods affect the volume and quality of risk information available to
underwriters and the opportunities they may have to differentiate acceptance criteria and terms. Distribution
therefore has a very significant impact upon underwriting and upon the approaches, or strategies, underwriting
areas can adopt.

To assess the impact a distribution strategy (and/or method) has on the understanding and
selection of risks and the application of appropriate terms, in the following example please
consider the extent to which each option offers:

quality knowledge of target customers and risks (characteristics, behaviours,

preferences, claims experience);
opportunities for underwriters to develop and apply detailed acceptance criteria and
differentiated terms (including risk premiums); and
direct decision-making for the insurer’s underwriters, with the ability to consider
unusual risks and adjust standard terms.

Example 3.6
An insurer currently has a relatively small book of personal lines motor business. Market research suggests that the
following three approaches would be equally effective in acquiring the desired volume of new business:

Option 1 Option 2 Option 3

Provision of a dedicated contact centre An advertising campaign in a number of Exclusive marketing to the members of an
for selected brokers, all based in daily newspapers, supported by direct over-50s organisation, with the
provincial towns. internet fulfilment. membership organisation holding
delegated underwriting authority.

Evaluation of options

Option 1 Option 2 Option 3

The brokers are already known to the
insurer and the underwriters may
assume that new business from these
sources will fit a particular
socioeconomic and geographic profile.
(They need to check to what extent the
brokers deal out-of-area.)
Brokers generally pride themselves on
their ability to attract and retain clients
who will be profitable for both broker
and insurer. They are less likely to wish
to deal with a client who has a poor
Based on the newspapers selected (local,
provincial or national), the broad profile
of the readership will be known.
However, mass advertising is a fairly
indiscriminate approach to the
acquisition of potential customers. It
might be assumed that the overall claims
experience of those responding to the
advertisements may be poorer than that
of customers acquired under Option 1.
However, in view of the general
decrease in customer loyalty/inertia, it
As the membership of the organisation is
known and the historical claims
experience may also be available, the
opportunity exists to shape the product
offering, acceptance criteria and terms to
best mutual advantage. The fact that the
customer segment is very specific
(drivers aged over 50) may, from an
underwriting perspective, provide
welcome balance to the insurer’s existing
motor book or it may confirm an existing
bias. The important point is that the
 claims experience as such a client will
cost the broker more in handling
charges and could undermine the
broker’s relationship with the insurer.
‘Local knowledge’ may enhance the
broker’s client selection. It may
therefore be assumed that the new
business will generally be of average or
above-average quality.
This option could provide the insurer
with a reasonably diverse book of
personal motor business. As the
brokers were specifically targeted by
the insurer, the underwriters can
compare the new business
(quoted/incepted) with the assumed
profile.
As the business will be processed on the
insurer’s system, the underwriters will
have full access to all relevant
management information. In due course,
this data could provide the basis for
refinement of acceptance criteria and
risk premiums.
The contact centre will need to be
staffed by underwriters who can satisfy
the requirements of professional
intermediaries and they will expect the
staff to have some degree of authority to
amend terms and premiums. All risks
will be underwritten by the insurer’s
own staff, operating under licence.
would be wrong to assume that the only
readers responding to such
advertisements would be those with a
higher-than-average propensity to
claim.
Nonetheless, the typical underwriting
response to such a broad potential
customer base would be to draw up
tight acceptance criteria in the first
instance. The underwriters will have the
opportunity to review all quote data on
the system and amend general criteria
and terms as they wish. They will have
to be alert to the impact of other rival
offers from competitors which at any
point could distort response levels. As
the profile of the business develops, the
option to target other socioeconomic or
geographic groups, by advertising in
different newspapers can be considered.
As contact with customers is internet-
only, there will be very limited
opportunities, if any, for underwriters
to consider waiving acceptance criteria
or amending terms on individual risks.
The success of this approach will largely
depend upon the quality of the
acceptance criteria and rating
structures built into the system and the
degree of refinement which can be
applied over time.
profile of the new business is known
before even a single quote is issued.
With appropriate limits applied to the
delegated underwriting authority and
referral and audit processes
implemented, this option could produce
the most predictable result (sales and
loss ratios) of the three examined. The
downside to this arrangement is that
much of the knowledge of the target
customers and specific expertise in
underwriting is retained by the delegated
authority holder. Although there will be
some interaction with referral
underwriters, the nature of the
arrangement precludes overly-frequent
referral. The management information
obtained by the insurer’s underwriters
may be quite limited, especially if
bordereaux are used. This option may
therefore provide limited development
opportunities for the insurer.

Summary of evaluation
Based on the three criteria outlined earlier, each option has advantages and disadvantages, depending upon the objectives of the insurer and the insurer’s
current capabilities. There isn’t a ‘best’ option but rather a ‘best-fit’ option depending upon the individual insurer’s circumstances and ambitions.

Option 1 Option 2 Option 3

Provides the most scope to build an Makes sense for an insurer wishing to Potentially provides the best knowledge
understanding of a diverse selection of build a direct business while of a specific segment of target customers.
customer requirements and risk highlighting the precision with which Offers an insurer with the desire to work
experience and the best opportunities to the advertising media need to be in niche areas the opportunity to build a
respond by amending general selected and the time it may take to build book at relatively low fixed cost.
acceptance and rating structures, as well the desired profile of business.
as on an individual basis.
Through direct communication with the
brokers, it would be possible to
influence the profile of new proposers
quite quickly (for example, the insurer
wants more or fewer young drivers).

Be aware
The ‘knowledge and scope-for-action’ criteria described in this chapter are not designed to encourage underwriters
to veto distribution options which do not maximise these features: they are intended to help underwriters respond
to such options by evaluating potential opportunities and limitations and, on that basis, devise appropriate responses
which enable insurers to achieve their targets.

Additional points
Costs – would any of the three options outlined above be costlier than another?

The following are general observations on the relative costs of systems, intermediary
remuneration (commission), advertising and underwriting staff:

Systems. Always costly to build, amend and operate; the actual cost would depend upon
what systems capabilities the insurer already had. Options 1 and 2 could be costly;
Option 3 could be cheaper depending upon the actual division of work between the
 insurer and the delegated authority holder.
Commission. Option 3 (enhanced commission) more costly than Option 1; Option 2, nil
commission.
Advertising. Option 2 very costly.
Underwriting staff. Option 1 most costly; Options 2 and 3 less costly.

As the cost of advertising could equal the cost of standard intermediary commission, there is
possibly little overall difference in the cost of the three options. The cost of systems (new
build or adaptation) could represent the most significant difference between the options.

Consider this…
Quotation success rates – if the amount of new business obtained by each of these three options is the same, do
you think that the rate at which quotes are converted into new business would be the same or differ? What does this
imply about the volumes of quotes which must be generated?

Renewal retention – another important element in the cost equation. Which options would
typically retain most and least business at renewal, in your opinion?

The example above involved a personal motor product. In considering the relationship
between distribution and underwriting strategies, the scale of the potential customer base is
a critical feature. Due to the size of the personal motor market, not only can substantial
expenditure on advertising be justified but the scale of the customer and claims databases
associated with personal motor enables sophisticated rating structures to be developed
which cannot be emulated in other areas of the market. Thus in the personal motor market
there are sufficient potential customers and reliable data for many insurers to pursue
subgroups, such as drivers aged over 50, with good prospects of success.

By contrast, the challenge represented by SME commercial business in the UK is becoming

increasingly apparent as insurers and intermediaries experiment with different distribution
channels and methods with the objective of securing worthwhile market shares at reasonable
cost. Although professional intermediaries continue to handle a considerable amount of SME
business, innovative approaches including direct sales, white-labelling, the use of price
comparison sites and a range of different MGA approaches are increasingly prevalent.
However, many of these approaches present a far greater challenge to underwriters in the
SME market than in a mass market such as personal motor.

As mentioned in section C4F of this chapter, the SME market lacks the scale of the personal
motor market and this is further compounded by the lack of homogeneity in SME business
and its lower claim frequency. It is therefore more difficult to build up data and knowledge on
which reliable, highly differentiated rating structures can be based.

The pressure on insurers and intermediaries to find cheaper ways to handle SME business is
understandable: SME premiums are relatively low and underwriters’ and brokers’ salaries are
relatively expensive. There have therefore been a number of different initiatives involving the
use of electronic communication to speed up routine administration and eliminate
duplication between brokers and insurers. Many of these initiatives have also sought to
standardise and reduce insurers’ question sets.

D3A The cost of (not) asking questions

Underwriters naturally want to know as much as possible about the risks proposed to them,
but in today’s insurance markets they might be constrained from asking all the questions they
would like to ask.

In mass markets, such as UK personal home and motor, the number of questions asked of new
proposers has been reduced and the questions themselves have become increasingly
standardised. Limited numbers of standardised questions are cheaper to process on
computer systems and make the work of price comparison sites simpler. Insurers have
adapted policy covers to avoid having to ask questions which could be perceived as difficult
to answer accurately or which might put the insured at a disadvantage when they make a
claim.

Example 3.7
Bedroom-rated household policies avoid the need for specific valuations, as does the trend for maximum valuations
(such as ‘Buildings Sum Insured £1m maximum’).

This approach supports those customers who wish to ‘shop around’ and serves to reinforce
the predominant focus on price in UK personal lines insurance. This has had an inevitable
impact on product design, with fewer significantly differentiated product and service
offerings widely available.

Commoditisation
The process by which products become less differentiated and buyers care less about which company they buy
from: price is the main deciding factor.

Fewer questions and fewer options also support cheaper, non-advised sales – another
feature of the UK personal lines market. It could be said that a certain equilibrium now exists
within this market as proposal questions, acceptance criteria, rating structures and products
have adjusted to the new distribution methods introduced over the last 30 years.

This process is still at an early stage in the SME market. Underwriters realise that reduced
question sets (and/or poorly phrased questions) can lead to the insurer being selected
against and there is a tension between those who favour simpler rating structures (cheaper
and faster to use) and those favouring more complex rating structures (which can
discriminate to a greater extent between high-, low- and average-hazard risks). It remains to
be seen whether the increasingly common use of statements of fact rather than proposal
forms will affect the general quality of information available to underwriters and their ability
to manage loss ratios.

Any trend towards the lowest common denominator in SME product design is hindered by the
continued, substantial involvement of professional intermediaries in this class of business.
Brokers want to be able to differentiate their offerings (and gain competitive advantage) but
they also feel the pressure of mounting costs and are narrowing down the range of contracts
they are prepared to offer, particularly for smaller business clients. Insurers too are
considering carefully the cost of additional benefits and value-added services against
customer requirements and the need to be price-competitive.

In non-advised sales to SME businesses, the drive for price-competitiveness could benefit
those insurers whose products offer lower limits of indemnity (for example, £1m rather than
£2m for public liability cover) which may or may not be appropriate for individual
businesses. As a matter of underwriting strategy and the requirement to treat customers
fairly (TCF), insurers involved in non-advised sales must address the suitability of their
products in respect of their essential features.

Insurance Act 2015

Under the Insurance Act 2015, effective since August 2016, the burden is on the insurer to ensure it has sufficient
information to underwrite a risk. See chapter 1, section D2B for more information on the Insurance Act 2015 and
its effect.

D4 Differential pricing
As noted above, different distribution channels and methods will have different costs
attaching to them: different up-front costs (for example, expenditure on systems) and
ongoing costs (commission, advertising, underwriter support etc.). Later in this unit we will
discuss the assessment of risk premiums and the other elements which make up the final
premium to the customer.

In an ideal world the calculation of general insurance premiums would be on a ‘risk premium
plus’ basis (that is, risk premium plus all other attributable costs). Often, particularly in the
most competitive areas of the business, a more complex approach is required in order to
achieve a specific target premium through the optimal selection of:

product/service benefits;
target customers and acceptance criteria;
distribution channel and methods; and
insurer administration.

One of the biggest challenges in general insurance is not necessarily the identification of
attractive market segments but rather identifying the best means of accessing particular
segments cost-effectively and understanding the implications of that choice. As previously
mentioned, some low-cost methods of distribution can over time reduce the insurer’s
knowledge of customers and risks and thus reduce their own capability.

Many distribution arrangements are based on a different allocation of administrative

responsibilities and costs between insurers and intermediaries. For example, some
intermediaries undertake to issue policy documents on behalf of the insurer and this may
reduce the overall premium. For the same risk, some direct insurers will be able to charge less
than insurers using intermediaries, if advertising costs are lower than commission costs. As
well as acquisition costs, insurers might also consider how different retention rates or ability
to cross sell affect the costs attributable to different distribution options.

Example 3.8
Retention rates on business acquired through online aggregator sites are likely to be lower than average, increasing
the cost of simply maintaining a static level of total premium income.

Consider this…
Would underwriters developing a rating structure for a particular group of risks be justified in adjusting the risk
premium based on the distribution method or channel?

Most intermediaries, particularly those focusing on clients in a geographical area or involved

in a particular type of business, will claim that they bring superior discernment to the
selection and management of clients, to the benefit of the insurer’s claims experience.
Typically, such intermediaries will still be offered the insurer’s standard open-market
premiums, however, some have started to offer better screen rates to certain intermediaries
or enhanced commission. Intermediaries may be given access to underwriters with the
ability to offer higher than standard discounts and they may also participate in some form of
profit-share scheme, reflecting the overall profitability of their book of business.

Some intermediaries who have specialised in serving the needs of particular groups of
customers will argue that they not only select clients well but that their long experience
enables them to underwrite these risks more effectively than the insurer. This is the basis for
many delegated authority arrangements, for example, schemes and MGAs. An insurer wishing
to target an unfamiliar group of customers or a group which they have difficulty in gaining
adequate access to, may consider such an arrangement.

The insurer may amend the standard base premiums and discounts available to the delegated
authority holder: the intermediary may have long-established expertise backed-up by
excellent claims data which justifies such amendment. Even if the base rates and discounts
are issued unaltered, there is every chance that their application in the hands of the delegated
authority intermediary will vary to some degree.

A challenge often arises fairly soon after differential pricing has been agreed: when internal
underwriters and/or other intermediaries realise that a scheme broker or MGA has more
advantageous rates for the same risk-types and the differential cannot be wholly attributed to
administration/commission. Technically, there may be a justifiable argument for differential
risk pricing.

Be aware
Appropriate justification for differential risk pricing depends upon scale and knowledge, namely the size of the
sample of risks, the degree of understanding and thus the predictability of the claims experience. Any set of risk
premiums assumes a certain mix of risks: if the mix is significantly different, the risk premiums should reflect this.
This is an issue which will be dealt with later in the unit but it is fundamental when considering risk pricing across
different distribution options.
Differential risk premiums required?
Until now the discussion has focused on insurers either starting up or, as in the example
above, wishing to grow a small existing book. Insurers with substantial existing books of
business, when asked to consider the appropriate risk premiums for a new distribution
arrangement, might fail to consider biases inherent in their current book of business. These
biases, if long-standing, will be catered for within the existing rating structure (through cross-
subsidies to a greater or lesser extent) but if the mix of business derived from the new
arrangement does not mirror the existing account, the use of the existing risk premiums may
not produce the predicted result. This problem is more likely to arise in areas such as SME
than in personal motor, due once again to the issues relating to lack of scale and homogeneity;
this restricts insurers’ ability to develop reliable, multi-factorial risk premiums.

D5 When things change

Change affects all insurers, even those who want to continue to do the same things in the
same way: the environment and markets in which insurers operate make change inevitable.
As an underwriting manager, you have to be alert to changes in distribution channels and
methods which may impact your company’s underwriting strategy and results. Insurers using
the intermediary channel in the UK will be very aware of the changes associated with broker
consolidation over the last decade, most noticeably the prevalence of higher commission
levels in commercial insurance. (The consolidators have built large businesses from the
acquisition of many smaller intermediary firms.) Consolidation may also have disrupted
relationships between underwriters and intermediaries and changed the type and quality of
business offered by particular intermediary offices. The assumptions which underpinned the
underwriters’ approach to business generated by the intermediary have to be re-validated.

The advance of technology, specifically the ability of some insurers to amend rates every day
if they wish, and to set automatic acceptance quotas for certain types of risk, provides
significant opportunities in respect of underwriting strategy for these companies. These
developments create immense challenges for other insurers without similarly sophisticated
systems.

Critical reflection
How can insurers without sophisticated systems amend their underwriting strategies and procedures to ensure that
they do not acquire by default a disproportionate share of less-desirable business?

Currently, there is also a debate surrounding dual pricing by motor insurers. This is either in
the form of charging different rates for the same risk depending on whether it is new business
or a renewal or charging differing rates for the same risk depending on the distribution
channel. In July 2013, the FCA announced it would investigate the practice of dual pricing.

Useful website
In July 2014, the FCA published its review of price comparison websites in the general insurance sector. The report
(TR14/11) is available from the FCA website: www.fca.org.uk/your-fca/documents/thematic-reviews/tr14-11.
Useful articles
The Journal, ‘Hot Topic: Focus on dual pricing’, Oct/Nov 2009, reproduced in appendix 3.1 for an example of the
interaction of marketing and underwriting.

O’Brien, S. (2013) ‘Dual pricing, priced out’. Post Online. 4 June 2013.†
†
Please contact knowledge@cii.co.uk if you wish to receive a copy of this article via email. (Please note, under UK Copyright Law the
number of copies we are able to email is restricted to one article per issue per CII member.)
E Operations
An insurer’s operational strategy will be largely determined by the company’s marketing and
distribution strategies. This is not to imply that only one operational strategy best fits any
particular combination of products, target customers and distribution channel but that, in
order to be effective, an insurer’s operational strategy must be well-aligned to these
strategies in particular. For insurers wishing to deal effectively and profitably with a range of
customer groups, different operational structures, technologies and styles of operation may
be appropriate for different units within a single company.

Customers and intermediaries may prefer to interact with insurers:

face-to-face;
by mail or email;
by telephone; and/or
via internet sites.

Underwriters require data in order to manage risk acceptance: the costs and relative
advantages of different types of operational structure and technology will influence how
insurers respond to these preferences and requirements.

The advance of computer technology, communications and the internet has encouraged a
centralising trend in general insurance in the UK. Large networks of branch offices have
become far less common and the centralisation of certain functions, such as document
production and dispatch, has changed the work that once went on in those branch offices. As
well as managing costs, insurers are also looking to achieve greater consistency in the service
provided and improved risk management by operating out of a smaller number of larger
offices.

While for some insurers this trend may have resulted in a smaller number of larger regional
offices, with separate claims centres in two or three locations and a central document
production and dispatch unit, for others the majority of staff now operate out of very much
larger offices, split by function (such as underwriting, claims and accounts) rather than
geographical area, with their own dedicated call-centres. Some insurers make extensive use
of home-based workers and overseas back-office and call-centre units.

Managing change
In the last few decades there has been a great deal of experimentation with different
operational structures and technologies, and this continues. It is apparent that, as operations
are generally centralising, those customers and intermediaries who have a strong preference
for individual, relationship-based service may be disappointed by the options offered by
many insurers.

Consider this…
What impact have the changes in operational structures and technologies had on insurance company staff?
While the impact on customer service tends to be the main focus in any discussion of changes
in operational structure, process or technology, how those delivering the customer service
are themselves served is a particularly relevant topic for those involved in underwriting
management.

Thirty years ago insurers published detailed books of personal motor rates (which were
typically updated every six months or annually) for use by branch staff and intermediaries,
whereas for the same business today the rates are held in computer databases and may be
updated daily. Customer service staff in call centres have online scripts and access to answers
for frequently asked questions, as well as the ability to request assistance from supervisors
and underwriters. Some insurers dealing with commercial business falling within the
micro/small category may operate in a similar way to the typical personal lines call centre.
For business conducted in this way, underwriters typically work behind the scenes
supporting the customer service staff and their supervisors and/or they work with actuaries
monitoring claims experience, take-up and retention rates, and developing rating structures
and products.

In many ways less has changed for underwriters dealing with commercial (other than those
noted above) and more specialist business. Underwriters may access rates and underwriting
guides online and they have the ability to refer to more senior colleagues by email, as well as
by telephone. They are often now required to process business in its entirety, which in the
past underwriters may have handed over to more junior members of the team. Whether in a
local, regional or head office, underwriters have access to the internet and often to their own
company’s intranet. The availability of detailed, monthly information about the performance
of specific accounts and greater access to management information might be regarded as the
most welcome innovation for these underwriters.

Underwriters continue to work in a range of roles requiring varying levels of underwriting

skill and knowledge, along with customer service, project management and supervisory skills.
From an underwriting management perspective, while the basic requirements have not
changed, each aspect of the management of the underwriting function has to be considered
with care.

Underwriting management decision: assessing operational underwriting capability

Does the number of underwriters, their skills, authority levels, supervision, referral capability and supporting
technology meet the requirements of:

the relevant marketing and distribution strategies?

the relevant underwriting strategy?
Can risk acceptance be managed within agreed limits?
Are the approaches to monitoring and auditing appropriate and effective?
the regulator’s training and competence policy?
Underwriters are, of course, costly to employ. Increasing costs have encouraged insurers to
look to new technology to handle increasing volumes of business with less and less human
intervention. Clearly the optimal balance between automation and human interaction (from
both the customer’s and company’s perspectives) will vary between customer groups and
products and will vary over time.

One of the costs arising out of increased automation is, ironically, the cost of skilled
underwriters due to their relative scarcity. Older operational structures (typically branch
networks handling both personal and commercial business) provided a broad training for
staff wishing to pursue a career in underwriting (whether branch, specialist division or head
office). Newer structures tend to be more specialist and the opportunities to pursue a career
in underwriting are less apparent to many staff. This is an industry issue and one which, as an
underwriting manager, you will face. Does the industry:

attract skilled underwriters by paying higher salaries?

invest heavily in training those with lower skill levels?
understand where the senior underwriters of tomorrow are coming from?
invest in more technology support?

Be aware
This latter option is not necessarily the easy answer. The adoption of new technology in commercial insurance has
been complex and costly, and few commercial underwriters express total satisfaction with their own company’s
current systems. This dissatisfaction reflects a fundamental dilemma which remains to be resolved in many
companies: to the extent that commercial underwriting requires a degree of individual judgment, the
implementation of highly automated systems could be counter-productive as well as very costly (to cater for all or a
high proportion of necessary variations). At the same time insurers are looking for cost savings, better information,
consistency and risk management which improved systems can provide. Each insurer has to determine the extent to
which the development and use of computer systems represents a hygiene factor or source of competitive
advantage and they then need to decide how to achieve the necessary trade-off between cost, timeliness and
functionality in the development of their systems.

Company culture and leadership styles

For the purposes of this brief discussion of operational strategy we have considered
operational structures and technologies, how they are changing and how the delivery of
customer service and staff roles have been impacted. The focus now shifts from physical
structures and supporting technologies to company culture and styles of leadership.

Company culture reflects ‘the ways things are done’ and influences the development of
important organisational capabilities, such as communication, decision-making and
performance management (all critical in underwriting and customer service). Culture also
influences how a company’s management and staff approach issues such as change
management and, in this and many other ways, these organisational capabilities can become
significant sources of competitive advantage.

Many companies try to articulate key aspects of their desired culture within corporate
strategy and will make links to issues such as remuneration (pay and benefits), staff retention
and development opportunities. In reality, much of what makes up a company culture is
commonly understood but not explicit and therefore difficult for the company to influence
directly.

The most effective way of influencing culture is through leadership. Many roles include
leadership accountabilities and no one style of leadership is uniquely suited to underwriting
management. As different customer and internal functional groups have different service
requirements, the units which service those groups require different styles of leader who can
appropriately influence staff actions and behaviours.

Most large companies, with a diversity of customer groups and internal functions, will seek to
develop a common underlying culture with the necessary, appropriate variations at unit level.
The appropriate ‘tuning’ of culture requires an awareness and sensitivity which individual
unit leaders are best placed to provide. How leaders spend their time indicates most clearly to
staff what is valued in the organisation.
F Core elements of an underwriting strategy
You may have heard the truism about asking a number of underwriters to evaluate the same
risk – yes, they all come up with different answers. The same holds true when describing the
content of underwriting strategies. We have therefore spent a significant amount of this
chapter discussing those elements of corporate strategy (particularly risk appetite and
marketing, distribution and operational strategies) which not only impact upon underwriting
strategy but are often regarded as integral to it.

In order to address this variation in approach, we have dealt with each area in turn and will
now focus on what might be regarded as the core elements of underwriting strategy, common
to all. These core elements will be examined in greater detail in subsequent chapters of this
unit.

Be aware
What appears in a written underwriting strategy and which responsibilities are allocated to an underwriting
department, its staff and managers vary considerably between insurers.

Rather than underwriting strategy, it might be more accurate to refer to underwriting

strategies, in the plural. As noted earlier, each SBU within an insurance company is likely to
have its own underwriting strategy and it may apply differently to different distribution
channels or deals. Documented strategies will be designed for particular audiences: they may
be for the board, reinsurers, internal staff or brokers. They may be written in rather terse
technical terms or more descriptively, aiming to educate and inform. Subsets of underwriting
strategy, describing ‘target markets’, will be produced for internal and external use.

If a documented underwriting strategy is used as the key point of reference for an

underwriter’s licence, it must be as explicit as possible. That said, it is impossible to
anticipate every eventuality and the effectiveness of any underwriting team will be greatly
influenced by its ability to share implicit understandings regarding risk acceptance (the
means by which underwriters identify unattractive risks that fall within the company’s stated
underwriting strategy, for example). However, as compliance can only be assessed against the
explicit requirements of underwriting strategy or policy, you may find that the auditors
(internal/external) object to an approach which relies heavily upon implicit understandings
(see chapter 9).

Research exercise
Based upon the underwriting strategy which currently operates within your unit and/or the documentary basis of
your personal underwriting authority, list which aspects are explicit (fully documented/referenced) and which are
implicit (understood but not documented). Would you recommend any changes?

F1 Risk acceptance
The one topic which every underwriting strategy must deal with is the management of risk
acceptance. In its simplest form this comprises:
 the risk acceptance limits which apply; and
how risk acceptance is controlled (known as underwriting governance).

The risk acceptance limits are derived from, but do not necessarily match, the limits specified
in the statement of corporate risk appetite: an underwriting strategy for personal or
commercial lines, for distinct SBUs or for a specific scheme or MGA will only contain the limits
appropriate to that business. In some underwriting strategies, the limits applying in relevant
reinsurance treaties may be referenced (see chapter 8).

As well as individual limits (for example, sums insured and limits of indemnity), the risk
acceptance limits will include:

the definition of a single risk;

exposure accumulation limits;
maximum income limits;
acceptable classes of business; and
geographic limits.

Information regarding the availability of additional reinsurance facilities, such as facultative

arrangements, and advice relating to significant categories of unacceptable business should
be included. Other subsidiary strategies, such as those relating to flood or subsidence as well
as survey strategies, should be included or referenced. As well as describing which risks may
be accepted, the source or means of determining appropriate premiums for acceptable risks
should be indicated.

An insurer’s system of underwriting governance usually relies on a number of different

controls. Insurers using highly automated systems depend on the accuracy of rating routines,
tables and the personal profiles of customer service staff and underwriters. At the other
extreme, the legitimate scope of underwriters with limited or no systems support is defined
by their personal underwriting authorities or licences. Irrespective of the nature of the
insurance operation, all underwriting activity must be monitored and audited in such a way
as to ensure that the relevant underwriting strategy is being applied and corporate risk
appetite has not been exceeded (see chapter 9).

With the implementation of Solvency II, greater emphasis is placed on the ability of
underwriting managers to project and work within specified risk profiles and this
requirement has to be translated into day-to-day risk acceptance processes as well as
underwriting governance.

F2 Additional underwriting targets

While risk acceptance is clearly the key responsibility of the underwriting function, most of
what follows is shared to some extent with other functional areas, such as, sales, distribution,
marketing, claims and operations but will typically be included in underwriting strategy.
 Targets relating to loss ratios/COR: these may be expressed as the desire to achieve a
COR of X% ‘over the cycle’ or may reflect the targets for the current period only.
Other financial measures, such as GWP and commission ratio.
Guidance relating to the state of the market (the insurance/underwriting cycle) and how
the company wishes to tackle the challenges this presents.
Business development focus:
which accounts are targeted for growth;
particular types of customer or product;
particular types of distribution channel or deal; and
desired mix of business (relevant to risk profile, also).

F3 Service
As underwriting strategy includes the management of risk acceptance, a documented
underwriting strategy may be used to share important operational information about the
underwriting function, such as the following:

The service standards that apply:

responses to internal referrals or external business propositions; and
the handling of complaints and indemnity issues.
How authorities/licences are granted, reviewed and updated.
Auditing: how frequently branches/units will be audited and in what ways.
Internal communication issues: where to go for information (intranet, circulars etc.),
head office and branch contacts, specialist referral points. Links to survey and claims
departments.
Other services: seminars, training, development opportunities.

F4 For restricted circulation

Aspects of underwriting strategy that are commercially sensitive and thus confidential will
not be widely available. These could be, for example, considerations relating to:

entering/exiting markets;
reinsurance purchase and retention levels; and
cycle management: timing of rate rises, tolerance of losses within risk appetite, etc.

F5 From strategy to practice

As we have illustrated, there are many inputs to any underwriting strategy. Having examined
the influence of corporate and other functional strategies, subsequent sections of this unit
will examine how underwriting strategy is translated into policy and practice, and how
practice might, in turn, suggest changes in strategy.
All underwriting strategies are subject to change: to respond to changes in corporate or other
functional strategies; to rectify underperformance; in anticipation of changes in exposure to
risk or to manage the cycle more effectively. All such changes must be communicated
effectively.

Underwriting management decision: communication of strategy

Has the communication been effective? Are reminders required? Have the target audience fully understood the
strategy and what they need to do in order to comply with it? Have they had a chance to ask questions? Are they
following the strategy?

Have other interested parties received and understood the strategy (surveyors, reinsurers, intermediaries, for
example)? Have you checked?

How do you plan to monitor whether the new strategy is achieving its intended aims?

Part of our examination of underwriting policy and practice in the next chapter will include
thinking about how to monitor performance long before the final results (such as fully
developed loss ratios and customer satisfaction scores) are available. Similarly, when
underwriting strategies are in the process of development or change, you need to establish
how their application and effectiveness will be monitored from the day of their
implementation, in order to ensure that the intended objectives are fully met, benefits
achieved and nasty surprises avoided.
Summary
The main ideas covered by this chapter can be summarised as follows:

Corporate strategy states, at the highest level, which markets the company is focused on,
the value it intends to generate for shareholders, staff and customers, and how the
company’s approach will achieve this in the current environment.
Most corporate strategies will include specific financial and non-financial targets that
will help to shape the underwriting strategy.
The underwriting strategy for domestic insurers should be explicit regarding which
foreign exposures are/are not acceptable.
Multinational insurers will utilise different entry strategies and structures in their
businesses around the world.
The objective of marketing is the creation of a sustainable competitive advantage.
For many years the external environment has affected general insurance through the
operation of the insurance or underwriting cycle. While certain aspects of the insurance
market influence the precise path of the cycle, the fundamental influence behind the cycle
is the flow of capital seeking optimum returns.
Distribution is highly influential in shaping insurance markets and every insurer’s
distribution strategy is central to its business. As distribution methods and customer
preferences can be subject to considerable change, this is undoubtedly one of the most
challenging strategic areas in general insurance: one which presents both opportunities
and threats.
An insurer’s operational strategy will be largely determined by the company’s marketing
and distribution strategies.
Every underwriting strategy must deal with the management of risk acceptance, i.e. the
limits and how it is controlled.

Bibliography
Airmic. (2014) ‘Understand clients’ business models to stay relevant, Airmic tells underwriters’, 28 October 2014.
www.airmic.com/news-story/understand-clients-business-models-stay-relevant-airmic-tells-underwriters-0

Chorn, N. and Hunter, T. (2004) Strategic Alignment. Richmond Ventures Pty Limited.

CII and Ernst & Young. (2007) The future of distribution in SME commercial general insurance. 1 May 2007.*

Hughes, J. (2010) ‘Performance – shareholder returns: cut to the core’, Post Online, 19 May 2010.†

Lafley, A.G. and Martin, R.L. (2013) Playing to win: how strategy really works. Boston, Massachusetts: Harvard
Business Review Press.

Marriner, K. (2014) ‘MGAs hear Lloyd’s plans for delegated authority business’, Post Online, 11 February 2014.†

Nurala, R. (2014) ‘Big data analytics – the solution to insurance fraud?’, Post Online, 13 June 2014.†

PricewaterhouseCoopers. (2011) The spirit of the global footprint: how insurers can build a profitable growth
strategy through international expansion. November 2011.

Rumelt, R.P. (2012) Good strategy/bad strategy: the difference and why it matters. London: Profile.

Thuring, F. (2012) ‘A credibility method for profitable cross-selling of insurance products’, Annals of Actuarial
 Science, March 2012, volume 6 (issue 1), pp. 65–75.
* Available to CII members only via the Knowledge Services website (www.cii.co.uk/knowledge).
†
Please contact knowledge@cii.co.uk if you wish to receive a copy of any of these articles via email. (Please note, under UK Copyright Law
the number of copies we are able to email is restricted to one article per issue per CII member.)

Scenario 1 – Question

As underwriting manager, you are about to introduce a new senior underwriter (previously employed by another
company) to your department. Your new colleague has already had an opportunity to read the relevant
underwriting strategy and an initial underwriting licence level has been agreed.

In order to ensure that the new underwriter fully understands the underwriting strategy (as well as how it supports
and is supported by the company’s other key strategies), what information would you plan to include in this
discussion and what questions might you ask?

You may choose to illustrate your points using either a personal or commercial point of view but not a more
specialised/narrow focus. Please remember that this is not intended as a test of product knowledge.

Scenario 2 – Question

Your competitor, Insurer A, has launched a new product set specifically designed to meet the needs of Customer
Group X. There has been a great deal of favourable comment in the insurance press and there has even been some
discussion of the products and its approach in the national press.

This certainly looks like a good idea and most of the elements of Insurer A’s approach could be replicated quite
easily. A project team has been asked to consider the merits, implications and costs of your company adopting a
similar approach and launching a rival set of products for Customer Group X.

As underwriting manager and one of the eventual decision-makers, what issues would you expect the project team
to consider?

See overleaf for suggestions on how to approach your answers

Scenario 1 – How to approach your answer

Aim
This scenario tests your understanding of the source of underwriting authority in a general insurance company, the
other strategies that relate most directly to underwriting and the essential elements of an underwriting strategy.

Key points of content

You should aim to include the following key points of content in your answer:

Brief personal introductions: your role and background/experience; ask about new underwriter’s
background/experience, unless already well-acquainted through recruitment process.
Wider company perspective: objectives, strategies, plans and, particularly, risk appetite. Relevant marketing
and distribution perspectives, plus operational strategy (including ICT/systems) and general implications for
underwriting.
Walk through the department’s underwriting strategy, make the links to what you have already discussed (for
example, your own department’s risk acceptance limits in relation to the company’s risk appetite) and
encourage new underwriter to ask questions (effectively comparing and contrasting with previous company).
Acknowledge what is similar but emphasise aspects which are distinctive.
Illustrate key points by going into more detail regarding underwriting policy. Advise new underwriter where
 information on detailed underwriting policy and practice can be found and who should be consulted, if in
doubt detailed information regarding acceptable risks under reinsurance treaties, for example). Identify
current issues such as state of market/position on underwriting cycle and department’s approach.
Review agreed underwriting licence and link to issues already discussed. Reflect on any important implicit
understandings not documented. Confirm referral procedures. Describe company’s approach to underwriting
governance and customer service expectations (whether customer- or colleague-facing role). Explain how
underwriters communicate with claims and risk control functions.
Ensure new underwriter has ample opportunity to ask questions.

Scenario 2 – How to approach your answer

Aim
This scenario reflects a typical marketing dilemma which requires you to consider and respond to the issues raised
from an underwriting point of view.

Key points of content

You should aim to include the following key points of content in your answer:

More information about Insurer A’s initiative:

Evidence of sales of new product set to Customer Group X.
Size and potential value of Customer Group X.
Other insurers already active (or thought to be preparing to be active) in this segment – their existing market
share (and this company’s share).
Details about Insurer A’s product offering.

Internal information on Customer Group X:

If already underwritten by this company – general claims experience of our Customer Group X risks; if
subdivided, are there more/less attractive subsets?
How different is our product offering for Customer Group X, compared with Insurer A’s?
What would be required to match or better the cover provided by Insurer A? If we did so, would it fit within
current strategy (including reinsurance coverage)? What else could we do to differentiate our offering for
Customer Group X?

Prioritisation:
What’s in our current product development plan already? What evidence do we have that any of the options
discussed re Customer Group X could prove more rewarding than the product development work already
planned?
For the options under consideration, what would the product development work cost and how long would it
take to complete? Do we have the resources? Do we understand all of the issues and risks involved in pursuing
any of these options?

External perception/reaction:
How will customers (and brokers) react? Would it look like a ‘me too’ approach that could undermine our
brand image or such a good idea that our company’s entry will be welcomed? Might our Customer Group X
initiative drive prices down?
Appendix 3.1: The Journal, ‘Hot Topic: Focus on dual pricing’,
Oct/Nov 2009
 4 Underwriting policy and practice

Contents Syllabus learning

outcomes

Learning objectives

Introduction

Key terms

A Managing change 5.1

B Evaluating risk 2.9

C Establishing cover and terms 1.1, 2.4, 2.8

D Portfolio management 2.1, 2.7

E Scheme underwriting 2.3, 2.8

Summary

Bibliography

Scenario question and answer

Appendix 4.1: New Statesman

Learning objectives
This chapter relates to syllabus sections 1, 2 and 5.
On completion of this chapter and private research, you should be able to:

evaluate current underwriting policy and practice by assessing their appropriateness

and effectiveness;
identify options for the amendment of underwriting policy and practice;
assess the implications of proposed changes to underwriting policy and practice; and
consider how best to apply the agreed changes to underwriting policy and practice.
Introduction
Whether an insurer’s underwriting strategy is documented in brief, technical terms or in
great detail, it is underwriting policy which defines the full implications of the strategy and
underpins the day-to-day practice of underwriters. While certain aspects of underwriting
policy are derived directly from underwriting strategy (for example, authorised classes of
business and maximum exposures), other aspects of policy have to be tested, selected and
refined to meet both corporate and customer requirements.

In this chapter we examine how this is achieved by considering:

risk evaluation through classification and categorisation of risks;

acceptance and renewal criteria;
risk improvement and control;
establishing cover and terms;
portfolio management; and
scheme underwriting.

We shall start, however, by discussing your role in monitoring and amending underwriting
policy and practice.

Key terms

This chapter features explanations of the following terms and concepts:

Ballpark price Business mix Categorisation Cherry-picking

Classification Cover comparisons Cross-subsidisation Expense allocation

Historical internal claims data Market claims data Portfolio management Product design

Product mix Risk acceptance Risk control Risk improvement

Scheme underwriting Survey strategy

A Managing change
Be aware
Anticipating, determining and handling change through the amendment of underwriting policy is a major
responsibility of all underwriting managers and this capability is at the core of their professional expertise.

As the requirements of insurers and their customers change, so must underwriting policy.
Change in underwriting policy may be necessary because:

policyholders and/or brokers may have requested other cover options;

the market may have to react to new reinsurer requirements or newly implemented
legislation;
an insurer’s claims experience may be consistently worse than expected; and/or
opportunities may arise to exploit new technology in the sales process or a new source of
business may emerge.

The manager responsible for dealing with the underwriting aspects of such issues and
proposing changes in underwriting policy has to evaluate carefully the issues involved,
potential solutions and impacts. Any new policy must fit within current underwriting strategy
and avoid conflicting with other relevant strategies, such as marketing or distribution.

Claims staff, risk control surveyors and actuaries will often be key collaborators in evaluating
policy options; they have access to important, relevant information and their work may also
be directly affected by any change implemented.

As well as investigation, reflection, liaison with colleagues and a degree of creativity, the
evaluation of different options will generally require a financial assessment in the form of
projected monetary sums, such as total premium, claims cost and exposure, as well as an
assessment of the business risks attached to each option. Finding data relevant to the issue
under consideration and using it appropriately can represent a considerable challenge.

In many instances, the appropriate data with which to project the impact of a change in
underwriting policy may not be readily available or may be less than ideal (they may be scant
or corrupt). Historical data may be unavailable or of poor quality due to the failure to collect
relevant data, poor data-entry standards, the use of bordereaux in delegated authority
arrangements and/or the limitations imposed by multiple legacy systems. Notwithstanding
the efforts made by insurance companies in recent years to improve the quality of their data
and access to management information (MI) (increasingly necessary in order to satisfy the
requirements of Solvency II), finding the necessary data with which to project the impact of
future changes will still often present a challenge.

Assessing the potential impact of change is necessary, however, even when everyone is
convinced that it is ‘the right thing to do’. Actuarial or statistical colleagues will be able to help
model the potential impact of changes to assist decision-making, determine how the impact
of the chosen option should be represented in financial plans or budgets and agree a means of
monitoring those impacts after implementation (see chapters 5 and 9).

Need for effective implementation

Each underwriting policy change must be supported by MI and portfolio management data to
allow underwriting and pricing teams to assess the impact of the change against
expectations.

Underwriting strategy may be clear and underwriting policy well-considered but if

underwriting practice fails to follow the required policy, an insurer’s business is
fundamentally undermined as executive management is no longer in control. Underwriting
governance has already been mentioned in chapter 3 and monitoring and operational
controls will be discussed later in chapter 9, but it is worth mentioning here that it is
pointless to devise a change in underwriting policy without considering carefully how it
should be implemented and subsequently monitored.

Underwriting management decision: implementing policy changes

Have all operational impacts been assessed and discussed with those areas affected?

Policyholders (new and existing), brokers, underwriters and customer service staff, as well as
claims staff and risk control surveyors, may all be affected in different ways. What might be
done to explain the change in advance?

An insurer’s underwriting policy should be made as explicit as possible in order to support

good governance and efficient operations and thus a successful, sustainable business. Every
effort should also be made to document changes in underwriting policy, as this information
will greatly enhance the insurer’s ability to make best use of its historical premium, claims
and exposure data.

Example 4.1
The full impact of revising an aspect of policy cover or of changing risk categories may only be apparent five or
more years after the change is implemented, once everyone involved in the change has moved jobs or forgotten the
details. Potentially important knowledge may be lost about:

internal processes (Was the impact of the change correctly assessed? How might such assessments be
improved?);
competitive advantage (If the change was beneficial, should we go further? Or, if the change proved far less
beneficial than anticipated, why was that so?); and
the use of historical data (What part did the change under consideration play in changing claims experience or
business mix?).

Look before you leap

As a new underwriting manager, you require as much information about underwriting policy
as possible and should be careful not to dispense with information about what was done in
the past. As you learn about the company’s strategies, you will be consciously relating what
you know about underwriting policy to underwriting strategy, as well as developing an
understanding of other relevant strategies. Is there a good fit between underwriting policy
and strategy or are there apparent conflicts? Keep asking questions and, when you identify
gaps in your understanding, do not be surprised if they turn out to be gaps in everyone else’s
understanding (which require filling). The different perspectives of colleagues in other areas
of the business and of intermediaries and end-customers will greatly enhance your own
understanding and ability to devise and implement successful underwriting policy initiatives.

You will inevitably be comparing your current company and its underwriting strategy and
policies with other insurers you have worked for or know of. It is important to understand not
only what is done in your current company but also why. Although many common
approaches and practices underpin the operation of general insurers, no two insurance
companies are the same. Underwriters and their managers must understand and observe the
specific requirements of their own company.

Research exercise
In your current company, investigate how effectively new customer service staff and underwriters are advised
about the company’s policy and practices. How are existing staff kept up to date? How is this monitored?
B Evaluating risk
Whether an insurer’s target markets are narrowly – or broadly – defined, it is the
responsibility of underwriting managers to:

establish and maintain suitable classification systems;

classify and categorise the risks which fall within the insurer’s target markets;
establish which classes/categories are acceptable, acceptable with modification or
special terms, or unacceptable;
explain the principles which underpin the classification and categorisation;
explain the company’s approach to risk acceptance (including relevant gross acceptance
limits and reinsurance arrangements);
set branch referral limits and establish the framework for personal underwriting
authorities or licences; and
ensure effective audit procedures are in place to monitor compliance with the
underwriting policy.

B1 Classification and categorisation

The work of classification and categorisation is intended to identify and group risks based on
the degree of hazard they typically present. Historical internal claims data, as well as any
market claims data available, will form the basis of classification and categorisation
exercises with the addition of any relevant external data that can be obtained. For example,
forward-looking socioeconomic or meteorological information can indicate that the claims
experience of particular groups of risks may improve or deteriorate.

Definitions:
Classification: the systematic identification of common features in insurable risks (such as
vehicles, drivers, trade activities or types of premises) relevant to specific classes of
business (for example, different classifications are required for motor, property and
liability).

Think back to M80, chapter 3, section D

Categorisation: the allocation of a category (such as below average, average or above

average) to classified insurable risks according to their assumed degree of hazard.

Example 4.2
Two small businesses: a plumber’s business and an electrician’s.

The vans each use for their businesses present a similar, average degree of risk; they have small purpose-built
business premises, both used purely for storage (both located in areas with an average crime rate and no flood risk);
however, depending upon the type of contracts undertaken, the degree of hazard they present for public liability
purposes could be very different. Does the plumber use heat? If so, to what extent? Do they undertake heating and
 ventilation contracts? Does the electrician work on purely domestic contracts or a mixture of domestic and
commercial contracts?

In this simple example, the classification criteria are as follows:

Class of business Classification criteria

Motor Nature, size and use of the vehicle.

Property Standard of construction, use and location.

Public liability Nature of the processes undertaken and potential third-party values at risk.

In this instance, both businesses can be categorised similarly for motor and property but they may be categorised
differently in respect of public liability.

Designing and amending systems of classification and categorisation for insurance risks is a
complex task and you will need to make a number of decisions as illustrated by the following
diagrams:

Figure 4.1: Classification system development

You will need to consider the following questions:

Have you access to data to support this level of classification (historical/current data)?
Are the claims costs at individual classification level statistically significant?
Is this level of classification meaningful and useful to underwriters?
Are they motivated to use and maintain the classification?
How many classifications will they search through, to find the correct one, before they
use the default code?
Figure 4.2: Categorisation system development

B1A Re-categorisation
Although an insurer’s classification and categorisation of risks needs to be reviewed
regularly, underwriters will be wary of amending categorisations too quickly in case an
apparent trend proves to be short-lived. Insurers are also concerned not to damage their
competitive position by being markedly out-of-step with the rest of the market. Of course, an
individual insurer may make the right call and identify the need to re-categorise a particular
group of risks before the rest of the market and thereby secure the success of their business.
The potential impact of re-categorisation must be considered carefully.

Underwriting management decision: re-categorisation

Risks in a specified range of postcodes are moved from Risk Category 2 to Risk Category 1 – their risk category has
improved and the associated property rating has been reduced. This is good news for new business but should all
existing business within these postcodes also benefit from the reduction?

In reaching your decision, a number of issues will need to be considered:

What impact will this have on revenues?

 To what extent will the retention rate on existing business improve?
If the reduction in base rating is very substantial, should existing business cases benefit
fully at next renewal or should their rates be reduced gradually over two or three years
(in those cases where no claims are incurred)?

B1B New risks

As well as monitoring the appropriateness of existing classifications and categorisations,
underwriters must assess new risks as they appear. The emergence of radically new risks,
such as nanotechnology, presents real challenges to specialist underwriters in the first
instance but all underwriters must keep up to date with the many influences that impact the
risks for which they are responsible. The ongoing impact of globalisation, 24/7 working and
new arrangements with suppliers (such as just-in-time delivery) are most clearly influential
in commercial lines business. How should insurers respond?

Useful article
Zurich. (2014) ‘The unknown risks of nanotechnology’, March 2014. insider.zurich.co.uk/industry-talking-
point/unknown-risks-nanotechnology/

The renewable energy sector presents many opportunities and challenges for insurers. The
London Market is taking a lead in investigating the risks associated with this new sector.

Useful articles
Lloyd’s. (2014) ‘Wind Turbine certification sets the standard to harness wind power’, 1 December 2014.
www.lr.org/en/energy/news/wind-turbine-certification-the-sets-standard-to-harness-wind-power.aspx

Murray, E. (2014) ‘Renewable energy: an ill wind?’, Post Online, 14 October 2014.†
†
Please contact knowledge@cii.co.uk if you wish to receive a copy of this article via email. (Please note, under UK Copyright Law the
number of copies we are able to email is restricted to one article per issue per CII member.)

Other developments have an impact across the market, such as the current concern
surrounding modern methods of construction, particularly timber-frame buildings.

Useful article
The following article makes clear the difficulty in isolating the impact of the different factors behind the upsurge in
claims and the insurers’ dilemmas in deciding how to react to the situation:

Post. (2010) ‘Fire risks – timber frame: the burning issue’, Post Online, 10 March 2010.
Please contact knowledge@cii.co.uk if you wish to receive a copy of this article via email. (Please note, under UK Copyright Law the number
of copies we are able to email is restricted to one article per issue per CII member.)

Input from other areas of the business

Some categorisation work may be reviewed in conjunction with colleagues from marketing
and distribution. They may have ideas about targeting particular customers or risks and
underwriting staff may have identified areas which appear to perform better than expected
(see chapter 3, section C4). Sales staff may also be keen to alert underwriters to apparent
discrepancies in an insurer’s categorisation of household and SME risks, in particular.

B1C Classification and categorisation across the market

Not surprisingly, the classification and broad categorisation of risks can be very similar
between insurers operating in mature markets. While recognising similarities, underwriters
must focus on what makes their company’s approach distinctive.

For those insurers operating in high volume markets, typically personal lines, complex
multi-dimensional rating tables are built and maintained using these classifications and
categorisations. This type of very significant investment enables insurers to respond quickly
to changes in the market or in product performance by amending their categorisations
and/or associated rates or terms. By this means, significant competitive advantage may be
derived by maintaining an appropriate balance of risk (and revenue) within their respective
accounts. Due to the high volumes involved, errors in classification, categorisation or the
associated premium rates could have a significantly adverse impact on volumes, the mix of
business written and/or profitability.

For those underwriting large commercial risks, a failure to understand the insurer’s
approach to risk acceptance could undermine the company’s success, or indeed survival,
through the inappropriate acceptance of a relatively small number of risks. At this end of the
market, the main focus is on the in-depth assessment and evaluation of individual risks rather
than fitting the risk into a particular classification and categorisation system for the purposes
of acceptance and rating. However, if accepted, the risk must be fully classified to ensure that
its exposure, in particular, is correctly represented in the insurer’s MI systems.

An individual insurer’s approach to risk acceptance, whether supported by complex tables or

the exercise of individual judgment, must match the company’s particular formulation of
strategic and financial objectives, and recognition of this intentional differentiation between
insurers is critical. Taking time to discuss and explain your company’s principles of risk
acceptance and reviewing individual risks or risk categories which appear to fall on the
borderline of acceptability/unacceptability is therefore time well spent by underwriting
managers. As well as supporting staff through discussions and referrals, underwriting
managers are also responsible for ensuring that underwriting guides and computer programs
accurately reflect the company’s acceptance criteria.

Explaining the company’s approach to risk acceptance is particularly important where

individual underwriters are expected to evaluate risks which cannot be easily categorised.
This can be as relevant to the supervisor of customer service staff in a call centre dealing with
motor or household insurance as to underwriters evaluating large industrial risks.

B2 Acceptance and renewal criteria

Although insurers’ risk classification systems utilise numerous risk features and
characteristics, acceptance procedures that are not wholly automated provide underwriters
with the opportunity to review other information, either supplied by the customer or broker
or easily accessible via the internet, in their assessment and evaluation of individual risks.

While underwriting management must endeavour to provide as many relevant guidelines as

possible to cover issues that may arise in new business presentations, proposals or at
renewal, underwriters must take care to assess all information available to them (whether
specifically requested or not). They should also document what they consider to be the key
features of the risk, how these have been assessed and on what basis they have arrived at
their final decision regarding the risk’s overall acceptability.

It is often the case that a risk presents a mixture of positive and adverse features that need to
be evaluated individually as well as collectively. Recording the features and their assessment
is an essential part of the process that will enable the efficient handling of the risk, if accepted,
at subsequent renewals or when changes are notified. This record may also be used, along
with others, when changes to risk acceptance criteria are being considered. The documented
rationale for the acceptance (or declinature) of individual risks also supports typical audit
procedures (see chapter 9).

Underwriting management decision: establishing acceptance criteria

Although committed to a particular target group of customers, some risks within the group may present identifiable
adverse features that you would rather limit or exclude. In these circumstances, how would you evaluate each of the
following options?

Decline all risks with that feature.

Decline all such risks once a quota level has been reached.
Decline those with a high degree of the feature.
Exclude or limit cover for claims arising from that feature.
Continue to accept all risks from the target group.

In the above circumstances, if you decided to decline all risks with a particular feature while
looking to target the group more generally, this could provoke an adverse reaction from
brokers who are looking for an insurance partnership with a balanced portfolio. However,
improved data analytics and portfolio management, coupled with pricing sophistication, is
allowing insurers to segment and sub-segment their portfolios with brokers. While this focus
on superior risk solution may leave a broker with reduced options for higher risk customers,
it is in this niche that specialist insurers with specialist products can find an opportunity, for
example, targeting younger drivers.

Be aware
‘Cherry picking’ may be used as a pejorative term but it is a rational approach to the business of general insurance:
underwriters must be selective because they know that even the most carefully selected business can produce very
substantial claims costs. At the same time, insurers must underwrite appropriate volumes of business in order to
cover their expenses and each insurer therefore has to balance their view of insurance risk against their need for
volume and revenue. An insurer’s underwriting policy should explain to staff how to determine where that
balance lies.

B3 Risk improvement and control

Some types of risk improvement form part of standard acceptance criteria, particularly those
relating to physical security: for example, types of lock, the installation and operation of
alarms, acceptable safes and money-handling arrangements. In establishing and reviewing
these and similar acceptance criteria, underwriting managers need to balance the interests of
the insurer with the perception of their customers (and their brokers) and market practice.
Although certain risk standards will be fairly common throughout a given market, some
insurers may differentiate their offerings by requiring markedly higher standards, often in
return for another benefit (premium reduction or enhanced cover) or possibly as an absolute
criterion for acceptance.

B3A Risk control surveys

Risk control surveys (whether in-house or outsourced) are a significant investment and cost
to an insurer, and the underwriting manager needs to target this resource at the right parts of
the portfolio, for example by:

targeting – either by risk hazard or by size of exposure – those risks that would benefit
from additional risk management in order to achieve the desired loss ratio; and
supporting the customer proposition, particularly in larger commercial risks where the
broker and client would value the risk management expertise that an insurer could
provide.

Survey strategies must be designed to fit the risk profiles of target business, as well as to
satisfy the requirements of the reinsurers and the insurer’s own internal risk management
procedures.

Underwriting management decision: survey strategy

Which risks should be surveyed (type of risk, location, values at risk, number of employees etc.)? When (pre- or
post-inception) and how frequently should risks be re-surveyed? Should only risks generating premiums over a
certain threshold be surveyed?

Value of surveys
Risk control surveys are commonly regarded as a means of validating information provided
by the proposer or broker (possibly of growing importance with the increased use of
statements of fact rather than proposals). They can also be used to validate the approach
adopted by underwriters: is the risk within strategy, has the estimated maximum loss been
assessed correctly and/or is the level of discount for sprinklers appropriate?

Surveys also provide insurers with an opportunity to require or suggest risk

improvements appropriate to the particular circumstances of individual risks, thus avoiding
potential claims, as well as distress and disruption to insureds. As risk improvements
generally cost money to implement, it can be difficult to sell the benefit of a survey to some
insureds, although many small businesses and high net worth customers appreciate the
support provided.

Larger corporate businesses are more likely to regard risk control surveys as a worthwhile
part of the insurance package, as they provide a professional external opinion to
complement the company’s own risk management procedures.

Be aware
From the insurer’s viewpoint, the value of conducting surveys is entirely undermined if underwriters, on receipt of
the surveyor’s report, file it without reading it or fail to follow-up the risk improvements required or suggested.

Whether in respect of an individual risk or over the course of many surveys, the surveyor may
well notice:

risk features about which questions are not normally asked;

proposal questions which have failed to elicit relevant information;
changes in what might be understood as the ‘normal’ activities of particular types of
business; and/or
changes in typical employees, for example, more casual workers.

Although surveyors typically visit only a sample of risks, have any changes been noticed in the
type of risks accepted by the insurer? This may be one way for underwriting management to
check that a desired change is taking place or that nothing unintended is happening. In-house
surveyors should be assisted to develop a good understanding of the underwriting strategy
and policy. This is more difficult to achieve with an outsourced risk control service.

Having established a survey strategy (at an acceptable, proportionate cost), it should not be
left to the discretion of local underwriters or managers whether they follow the strategy or
not. The strategy defines a minimum level of activity which the reinsurers and internal risk
management have been advised will be undertaken. A small additional budget for ad-hoc
survey requests may be provided to local managers, as well as allowing for post-loss surveys
in the overall budget.

Making use of additional information

The internet has provided underwriters and underwriting systems with the ability to access
third-party databases (for example, vehicle licensing) and a vast amount of additional
information, particularly related to location (for example, mapping sites, area crime statistics
and the Environment Agency), which can be used to good effect. However, surveyors’ visits
provide an unrivalled source of cohesive information and digital photographs, as well as
surveyors’ views of the management of individual risks, which can support individual
underwriting decisions as well as validating and helping to refine underwriting policy.
C Establishing cover and terms

C1 Policies, contracts and products

Be aware
It is not the purpose of this unit to consider the construction of policy wordings (contracts).

Think back to M80, chapter 2, section B

An insurer’s underwriting policy should indicate the range of policies/products available and
the extent to which it is acceptable to consider amending policy wordings. At one extreme no
changes may be permitted other than the application of standard endorsements; at the other,
large commercial contracts may be subject to lengthy, detailed negotiation making each one
unique. However, the requirements of contract certainty make the use of standardised
clauses and wordings increasingly useful even for the largest risks.

Research exercise
In your current company, who is authorised, on a day-to-day basis, to apply non-standard endorsements and who
may sign-off wording changes? Find out how claims staff are alerted to the use of a non-standard wording in an
individual policy.

Refer back to chapter 1

Underwriting management is required to ensure that current and proposed wordings (and
endorsements) do not conflict with corporate risk appetite, including the scope of the
insurer’s reinsurance protection. Proposed changes to wordings must be evaluated from
financial, legal and regulatory perspectives and formal change-control should be applied to all
wordings. It is the role of the underwriting manager to explain and communicate the changes
to the claims team as well as the underwriting community.

C2 Product design/policy terms

What is described as ‘product design’ in personal lines and SME insurances might be
considered the equivalent of determining policy terms on large commercial risks. A similar
process of evaluation has to be undertaken, balancing what is regarded as necessary and/or
attractive to policyholders with what is acceptable and cost-effective to insurers. The main
criteria used in determining terms are therefore suitability and cost.

While the core covers appropriate to most types of general insurance are fairly standardised,
many insurers use the extension of these covers (on a mandatory or optional basis) and the
inclusion of added-value services as a means of differentiation in the marketplace. Brokers,
particularly scheme brokers, will often inspire/encourage the enhancement of cover as a
means of differentiating one insurer’s offering from another’s. Other insurers, whose focus is
predominantly on price as a differentiator, will focus more closely on what is regarded as core
cover in order to achieve as high a position as possible on price comparison (aggregator)
website lists. Thereafter, once the customer has been attracted to a competitive base
premium, the insurer can offer a range of additional covers and benefits to meet precise
customer requirements. Certain insureds, notably large companies, may choose to avoid
purchasing anything other than core cover and may choose to limit even that through a
measure of self-insurance.

C3 Limits
Apart from those policy limits defined by legislation (for example, employers’ liability in the
UK), underwriting management must decide what limits they wish to provide for different
types of risk or product.

Be aware
The limits underwritten will affect the cost of an insurer’s reinsurance cover, as well as reinsurers’ willingness to
support that insurer.

Limits tend to increase throughout the market either as a competitive move amongst
insurers or when claims settlements/inflation can be seen to have eroded the value of the
current limit. As with the extent of cover more generally, some insurers will deliberately
moderate limits in order to offer more (apparently) competitive premiums, as well as to fit
their overall risk appetite. The standard limits offered in certain products need to be
considered carefully in the light of treating customers fairly (TCF) requirements, particularly
in respect of non-advised sales to SME businesses.

Underwriting management decision: establishing policy limits

Given the prevalence of private homes worth in excess of £1m in the south-east of England, what public liability
limit of indemnity should be offered as standard to small tradesmen (for example, plumbers and electricians)
operating in this area?

Having stated that limits tend to increase over time, insurers have always used inner limits to
reduce the impact of a large number of insureds being hit by the same event and these limits
have been under increasing scrutiny of late. Reinsurers have become particularly interested
in the limits applied to contingent business interruption extensions in primary property
damage policies, due to increasing claims costs and the unpredictable aggregation of claims
from many insurers (re-insureds), impacted by the disruption of a single supplier to their
many insureds, for example.

Useful articles
AIR Worldwide. (2012) ‘The 2011 Thai Floods: Changing the Perception of Risk in Thailand’, April 2012. www.air-
worldwide.com/Publications/AIR-Currents/2012/The-2011-Thai-Floods--Changing-the-Perception-of-Risk-in-
Thailand/

Crawford UK Technical Committee. (2009) ‘CBI – an increasing global claims risk’, 1 May 2009, available to CII
members only. www.cii.co.uk/knowledge/claims/articles/cbi-an-increasing-global-claims-risk/14925
Different classes of insurance have cover/limit arrangements peculiar to those classes, such
as first loss insurance for property risks.

C4 Cover comparisons
The potential complexity of a product comparison requires some consideration: How deep
should the comparison be? Should full policy wordings be compared or simply prospectuses?

Three ways in which product comparisons generate challenging questions:

Although most core covers are fairly standardised, this still leaves lots of scope for
variations. Extensions and add-ons can be very varied. How significant are they for the
purpose of the comparison?
The request for a product comparison may arise in response to a particular situation
which highlights differences in cover which may not have been considered as significant
by most end-customers, intermediaries or, indeed, insurers. Consider, for example, the
public controversy which arose regarding the disruption caused by the volcano eruption
in Iceland in April 2010.

Travel insurance policies will differ in this situation; there is no standard set of conditions which applies to a
situation of this kind.
Nick Starling, Director ABI: ‘Ash shows travel cover limits’, Insurance Times, 16 April 2010.

Useful article
Dunkley, D. (2010) ‘Business interruption policies need 21st century update: Aon’, Post Online, 21 April 2010.
Please contact knowledge@cii.co.uk if you wish to receive a copy of this article via email. (Please note, under UK Copyright Law the number
of copies we are able to email is restricted to one article per issue per CII member.)

Critical reflection
Is the situation a one-off incident or one that will influence customers’ purchasing decisions in the future?

Marketing and underwriting areas are likely to have quite different perspectives on
certain aspects of cover that can only be rationalised acceptably through a collaborative
approach in which each relevant aspect is costed and evaluated. Before considerable
expense is incurred, how can the potential demand for a new or amended cover be
assessed?

C5 Inclusions/exclusions
Underwriters have every reason to be wary about extending cover. If cover is to be extended
to include subject matter or contingencies not currently insured, the underwriters are not
likely to have claims data on which to assess suitable base rates and they will have great
difficulty in predicting how customers and claimants will react to the extension. Some
customers may ignore or forget about the new cover and simply not claim; others may use the
cover as intended; some may recognise an opportunity to claim that the underwriters had not
anticipated: how many claims might be expected and at what cost?

It is worth noting that even though there may be exclusions in policy wordings, when an
unexpected or rare situation arises some insurers may choose to pay claims which are
excluded, for example, after the 2011 UK riots or the Iceland volcano mentioned in section C4.

Both in respect of standard, long-established covers and novel cover extensions, many years
or decades may pass without a particular aspect of cover attracting attention until a
circumstance arises, either affecting a great many individuals or companies in a short period
of time or involving a prominent, exceptionally costly case that attracts everyone’s attention.
While insureds question if they are covered (whether directly affected or not), insurers’
executive management query whether anyone realised this particular source of claims was
covered and had such significant potential. Has an equitable premium been charged for this
exposure in the past? Should that premium be increased? In the light of recent experience,
should the cover be restricted or withdrawn? What are the potential financial and
reputational impacts of continuing to offer the cover versus withdrawing the cover?

Limiting or withdrawing cover is usually motivated either by the recognition that the
potential exposure is higher than acceptable or that the exposure is higher than acceptable
and insurers have already incurred heavy losses from this source. Insurers would rather be in
the former position than in the latter but if in the latter, is the most clean-cut solution to
withdraw cover? Particularly where heavy losses have already been incurred (and thus
insureds and their governments are well aware of the issue), this can be the hardest solution
to adopt if the move to withdraw is widespread throughout the market.

Government intervention
Although requiring direct governmental intervention in issues such as terrorism, there are a
number of very significant issues where parts of the insurance industry (primary insurers
and reinsurers) have worked together to continue to offer cover, even if in a restricted form.
Offshore employers’ liability exposures (in the aftermath of the Piper Alpha disaster), sudden
and accidental pollution and contamination cover, and cover for claims arising from the
production and use of asbestos are examples of such instances. There have been recent
developments relating to the compensation available to those who develop asbestos-induced
cancer, mesothelioma. Following the Mesothelioma Act 2014, victims and their families are
able to apply to the government for compensation worth on average £123,000. Although
some insurers have withdrawn from offering cover in these areas (as is their prerogative),
others have continued to offer limited cover, generally in association with enhanced risk
management measures, closer scrutiny, reporting and, crucially, the support of their
reinsurers.

Irrespective of any government influence, insurers have to be alive to the fact that if they
withdraw cover for some of the most significant risks run by insureds, they will find it
increasingly difficult to sell their products and will encourage large insureds, in particular, to
self-insure.

Useful website
www.gov.uk/government/news/asbestos-victims-to-get-123000-in-compensation

Research exercise
Investigate what restrictions regarding asbestos apply in your company’s public liability covers. Does the level of
cover offered vary between different products or different groups? How does this cover compare with that of
competing insurers? If you have access to this information, what protection is provided by your company’s
reinsurance programme in respect of asbestos?

Be aware
Total undiscounted cost of UK asbestos-related claims to the insurance market is expected to be around £11bn for
the period 2009 to 2050, according to a research by Actuarial Profession’s UK Asbestos Working Party.
New Statesman, 29 January 2010. Full article is reproduced in appendix 4.1.

Useful article
‘Asbestos claims to cost insurers £11bn by 2050’, Post Online, 27 January 2010.
Please contact knowledge@cii.co.uk if you wish to receive a copy of this article via email. (Please note, under UK Copyright Law the number
of copies we are able to email is restricted to one article per issue per CII member.)

Another example of a cover dilemma for insurers relates to the ways in which policy wordings
are interpreted in different jurisdictions, notably in the USA.

Not only is it impossible to avoid this particular issue if your company deals with
multinational customers, but every small business with a typical products liability cover
(even if they do not ‘knowingly export’ goods outside the UK) can become involved in
defending actions abroad, with unpredictable results. Insurers and reinsurers do what they
can to identify and manage exposures and limit the scope of cover (for example, by excluding
punitive and exemplary damages) but it is an issue that cannot be avoided.

Assessing the potential impact of limiting or withdrawing cover (in respect of claims costs
and business retention) can be very difficult, particularly if the motivation to limit cover
springs from a sudden upsurge in claims (implying that the historical, developed claims
experience does not reflect the more recent experience). For some classes of business,
particularly liability covers, even the total withdrawal of cover may not halt new claims
intimations for years or even decades. The cost of these claims will have to be absorbed
despite the cessation of premium income.

C6 Excesses, deductibles and incentives

C6A Excesses
A common method of modifying cover is through the application of excesses. When the
excess is mandatory, such as those applying to windscreen damage (motor) or subsidence
(household), as well as reducing the total cost of common claims, the excess is also designed
to modify the insured’s behaviour. In both these instances, the excess is intended to
discourage claims for minor, cosmetic damage.

C6B Deductibles
Refer to chapter 7, section C1

Insureds willing to accept a voluntary excess (often in addition to the standard excess) in
return for a premium discount will often prove to be more risk-aware, careful customers. Is
their behaviour inherent or solely motivated by the voluntary excess? This question needs to
be considered when calculating the appropriate premium discount. Accepting a voluntary
excess could be regarded as a form of selection against the insurer!

Many large commercial enterprises choose to self-insure much of the attritional risks
associated with the business. For example, a business with a large fleet of vehicles may wish
to self-insure minor own damage day-to-day ‘knocks’ by way of a significant deductible. By
doing this they can avoid the insurer’s ‘turn’ on these minor claims.

For large commercial risks, a careful examination of the risk’s historical claims costs (and
that of other similar risks) will be undertaken to determine what level of deductible is
appropriate, whether an aggregate deductible should be used to limit the total cost to the
insured and how the remainder of the insured risk should be rated. The insurer may
essentially be providing a claims handling service to the insured for 95% of all claims
occurring in a year but the insurer has to ensure that an equitable premium is charged for the
5% of claims that may exceed the deductible (in addition to the cost of providing the claims
handling service). For underwriters unfamiliar with this type of business, there is a danger
that the 95% of claims (that tend to occur year-in and year-out and that should be highly
visible in the historical claims experience) disguise the potential cost of the 5% of claims
(which although few, will be highly variable and costly).

Although primarily focused on matters relating to underwriting (such as risk, policy limits
and claims experience), some product features are more heavily influenced by marketing
concerns than others: one such example is no claims discount (NCD). With the introduction of
protected NCD and levels up to 90% NCD in motor insurance, it should be apparent to those
studying this unit that base pricing has been adjusted upwards to enable such large discounts
to be offered. The success and prevalence of NCD arrangements in motor insurance is largely
due to the very high volume of policyholders in this class of business, which provides an
excellent rating base for the calculation of premiums and the opportunity to adjust base rates
gradually over time in order to accommodate increasing NCD scales.

C6C Incentives and discounts

With all forms of renewal incentive and premium discount, it is important to distinguish
between characteristics or aspects of risks that truly merit distinctive treatment due to the
reduced level of risk they bring to the ‘pool’ and those aspects that are or have become
predominantly marketing features. All parties (underwriting, marketing and actuarial) are
responsible for evaluating and monitoring what a feature is actually worth in monetary terms
(reduced acquisition or claims costs or improved rates of retention, for example), utilising
that information in the planning process and providing underwriters with clear criteria
regarding the value and application of such incentives and discounts.

Whereas in automated systems base rates can be adjusted by a series of loadings and
discounts based on characteristics of the risk and the cover requested, for business where the
evaluation of the risk and its pricing is either partly or entirely manual, the choice of base rate
and all subsequent loadings and discounts may be in the hands of an individual underwriter. It
is particularly important therefore that underwriters exercising such discretion fully
understand how base rates have been calculated, what has already been accounted for in their
calculation and what has not (see chapter 7 on pricing).

Underwriting management decision: establishing discount policy

If discounts are available for ‘superior’ features, what constitutes ‘superior’? For an average selection of new
business, what proportion of risks would you expect to exhibit ‘superior’ characteristics – 5% or 50%?

In an industry not usually noted by outsiders for its optimism, a frequent answer to this
question seems to be 90% to 95%, judging by the typical application of discretionary
discounts (independent of any supplementary commercial discounts designed to assist
matching a target price).
D Portfolio management
Be aware
In its broadest sense, the term ‘portfolio management’ refers to the balancing of distinct elements within an area of
responsibility in order to achieve overall objectives. To provide more detail in an insurance underwriting context, it
refers to the management of a portfolio of risks rather than individual risks, through the development of consistent
and predictive MI to provide insight to current and future performance.

The process necessarily involves monitoring how the distinct elements within the portfolio
perform and change over time as well as determining how best to manage the portfolio,
primarily via acceptance/renewal criteria and pricing.

The distinct elements could be:

different products within a personal lines account (home, motor and travel);
customer segments within a construction account (tradesmen, demolition contractors
and general builders);
classes within a commercial combined account (property and liability);
a range of exposures or degrees of hazard present within an account; or
many other ways of segmenting a general insurance portfolio: large general insurers may
have many portfolios initially broken down by class of business and then by distribution
channel.

D1 Importance of business mix

In addition to monitoring the performance of these distinct elements (their growth or decline
and relative profitability), it is necessary to monitor the overall mix of business closely.

An insurer’s underwriting strategy should set out, in broad terms at least, the type of business
the company wishes to accept. The underwriting policy needs to provide the detail of the
desired mix of business to ensure that the risk profile and performance of the business match
the expectations of the shareholders and optimise the use of the capital allocated and
reinsurance purchased.

The expression of strategic intent may focus on rate of growth, market position or the nature
of the returns expected (their scale and volatility). Underwriting management’s role is to
select and maintain the mix of business which can be best relied upon to deliver the strategic
requirement. For example, an insurer required to produce steady returns with low volatility
might consider limiting the proportion of liability business in the account and exposures in
regions prone to extreme weather events (e.g. hurricanes).

Refer back to chapter 1, section B3 for capital modelling and Solvency II

Alternatively, if the strategic decision has been taken to raise the necessary capital, purchase
appropriate reinsurance, recruit highly experienced underwriters and claims officials in order
to write a high hazard (high returns) book of business, there is little point in writing lots of
standard motor or SME business as that will not generate the necessary returns. An
appropriate balance is still required, even within a high hazard portfolio, to help the business
survive the inevitable volatility in results. The methods by which underwriting managers
previously determined their optimal mix of business are being supplemented by the more
intensive use of capital modelling required under Solvency II.

Having established what mix of business is required, underwriting management’s next

challenge is to achieve that mix and maintain it. Although individual underwriters can be
advised about the desired mix of business and referral processes established to review large
or unusual individual risks, only underwriting management can monitor the overall balance of
the portfolio and make appropriate adjustments.

Be aware
Monitoring the mix of business is a very important area of work because a relatively small change can have a
disproportionately large effect on the profitability of an account or portfolio.

Monitoring the mix of business can be a more difficult task than it first appears because
important changes of mix are often well-disguised in aggregated figures. Establishing a
monitoring approach that identifies changes of mix before the profitability of an account is
affected requires knowledge, imagination and persistence.

D1A A good mix of business?

As well as satisfying strategic requirements, what other characteristics do portfolios
described as containing a ‘good’ mix of business share?

Enough of it: whatever segments, categories or classes of business comprise the

portfolio, there should be sufficient business of each type to enable underwriters to gain
an understanding of the business and to produce sufficient data on which rates may be
reliably based.
But not too much: the portfolio should not be over-exposed with more than its ‘share’ of
a particular type of business unless that represents a specific strategy (for example, most
insurers would not wish to have a disproportionately large share of business in known
flood zones).
Countervailing tendencies: in other words, when some parts of the portfolio are
experiencing poor returns, other parts are performing well; the portfolio is not
concentrated on areas in which all customers/products suffer low growth/poor
experience simultaneously. But any ‘support’ offered from one part of the portfolio to the
other should not always move in the same direction.
Fit: does the portfolio make proper use of the company’s resources, not just capital and
reinsurance but also its human resources and ICT capability? Or does it include ‘odd’
pieces of business for which the company is not appropriately resourced or equipped?

D1B Change of mix (cover) and interpreting claims experience

Just as it is impossible to evaluate an individual motor claims experience without first
establishing whether the cover is comprehensive, third party fire and theft, or third party
only, the same is true of the claims experience of a motor account as a whole.

Example 4.3
How has this small fleet performed?

Year Vehicle/years (v/y) Total claims cost Claims cost per v/y

1 10 £9,600 £960

2 10 £9,000 £900

3 10 £8,400 £840

Without specific information about the cover mix of an account, there is a tendency to assume that the cover has
been constant and therefore the above summary seems to indicate an improving claims experience against a
constant exposure of ten vehicle/years per annum.

In fact, the fleet has vehicles insured on comprehensive and third party only bases.

Year Vehicle/years (v/y) Comp exposure and claims cost TPO exposure and claims cost

1 10 8 v/y £8,000 2 v/y £1,600

2 10 5 v/y £5,000 5 v/y £4,000

3 10 2 v/y £2,000 8 v/y £6,400

While the cover mix has changed from predominantly comprehensive cover to predominantly third party only
cover, the claims cost per vehicle year has been static over the three years, at £1,000 for comprehensive vehicles and
£800 for third party only vehicles. What appeared as an improvement in claims experience was solely attributable to
a change of mix.

This highly simplified example demonstrates that the use of aggregated figures, without checking for change of cover
mix, may result in significant misinterpretation of results.

In the above example, on what basis should the premium for Year 4 be calculated? We have been advised that the
fleet’s exposure will increase, at renewal, to 15 vehicles.

One approach may be to take the Year 3 claims cost of £840 per vehicle/year, gross it up for expenses, commission
and profit and multiply by 15. (Let us assume, for the sake of the example, that no adjustment is required for
inflation, change in claims frequency or late-reported claims.) Or, maybe, take an average over the three years of
£900 per vehicle/year?

The correct answer is, of course, to project forward into Year 4 the likely claims costs for comprehensive and TPO
vehicles separately (£1,000 and £800), based on the actual split of vehicles in Year 4. How many of the 15 vehicles
will be comprehensive; how many TPO?

The insured is not sure: the split may be 9 Comp/6 TPO or 2 Comp/13 TPO, but they would like to agree one overall
rate per vehicle, for simplicity’s sake.

Projected claims costs for Year 4:

 Comp TPO Total claims cost
exp & claims cost exp & claims cost

Option 1 9 v/y £9,000 6 v/y £4,800 £13,800

Option 2 2 v/y £2,000 13 v/y £10,400 £12,400

Comp TPO Total claims cost

exp & claims cost exp & claims cost

Depending upon the mix of business (Options 1 or 2), the projected claims cost per vehicle for the whole risk could
be £920 or £826.67 per vehicle (a difference of almost £100 per vehicle). If the underwriter had used either £840 or
£900 per vehicle as the basis of their Year 4 premium projection, the fleet with 9 Comp and 6 TPO vehicles would
have been significantly underpriced, while the insured would have found a cheaper quote elsewhere for the fleet
with 2 Comp and 13 TPO vehicles.

Should the insured be offered one overall rate per vehicle for the renewal of their small fleet?

No! The insured needs to advise the split for renewal: the premiums for the Comp and TPO vehicles should be
calculated separately, then the renewal premium and any mid-term adjustments will be correct.

Cross-subsidisation
The consequences of ignoring cover mix can be significant and that principle holds true for
other forms of mix encountered in insurance portfolios. As in the cover mix example, a
feature or characteristic of some risks within a portfolio, which generates a significant
difference in the claims experience of those risks, should be recognised in the rating of those
risks. If the additional claims cost is not attributed to the risks that generate it but is
accommodated within the overall pricing of the portfolio, those risks are being cross-
subsidised. The premiums for some risks are cheaper than they should be, while other risks
are paying a higher premium than necessary.

Underwriting management decision: cross-subsidisation policy

Should a young driver or a tradesman using heat pay the same premiums as other drivers or tradesmen,
respectively?

For a static portfolio in a market with little competition, cross-subsidisation might not
destabilise the portfolio. More commonly, customers and brokers will notice which of the
insurer’s premiums are relatively high or relatively low compared with the rest of the market
and the insurer will experience an inflow of the cheaper (cross-subsidised) risks and an
outflow of the more expensive risks. Having lost a proportion of the business that provided
the subsidy and gained more business requiring a subsidy, a portfolio could quickly move to a
loss-making position.

Although cross-subsidies are undesirable, they cannot be wholly eliminated from insurance:
they are part of the ‘pooling’ process. Although each risk should make an equitable
contribution to the pool, the individual contribution at any point in time will rarely, if ever, be
absolutely correct. The aim should be to avoid prevalent cross-subsidies and to monitor
closely those that are known to exist.

Critical reflection
A form of cross-subsidy?
An internal debate may surround how best to charge for those risks which rely particularly heavily on the highest
levels of reinsurance cover purchased (treaty and/or facultative). Should the reinsurance cost be absorbed by the
whole account or should a charge be allocated on a pro-rata basis based on exposure? Internal administrative costs
have to be considered and probably only a straightforward charging mechanism will be acceptable. Alternatively, it
may be argued that the purchase of reinsurance is to be regarded as means of protecting the account as a whole and
it is therefore appropriate for the cost to be treated as a central charge.

D1C Product mix and operational expenses

The product mix of a portfolio may be influenced by the insurer’s desire to satisfy the
insurance requirements of particular end-customers, a strategic focus on particular areas of
insurance business or a desire to diversify. The relative diversity of an insurance portfolio can
influence the amount of capital required to support it (in general, greater diversity may
reduce the capital requirement). As noted in section D1A, many factors contribute to the
achievement of a well-balanced portfolio or account, which satisfies the company’s strategic
requirements.

A portfolio’s mix of business will significantly influence the servicing of the business: how and
at what cost? Operational considerations and the need to maintain efficient, cost-effective
solutions will, in themselves, influence the mix of portfolios.

Adding Product Z to a portfolio already containing Products W, X and Y may seem attractive
from the end-customer and intermediaries’ points of view but if Product Z requires specialist
handling, how much needs to be sold in order to justify the cost of establishing the new
handling arrangements? By contrast, if Product Z can be serviced in exactly the same way as
the existing products, there is a good chance that sales of Product Z (even at a relatively
modest level) will improve the overall productivity of the existing operation (in other words,
the handling of Product Z may be absorbed at little or no additional cost).

Understanding the cost of handling different products is very important when determining
underwriting policy, as well as in budgeting and pricing. As establishing accurate costs for
individual products is a notoriously difficult exercise, most insurers establish their own
conventions about how costs are to be assessed and allocated to products as part of the
budgeting process. Whatever convention is chosen, the nature of the allocation of expenses
between products, how the allocation impacts pricing and sales and how change of mix may
undermine the usefulness of the allocation need to be concerns of underwriting management.

The expense allocation may be based on:

a percentage of premium, derived from the experience of a number of years; or

a flat sum plus a percentage of premium.

Both methods are designed to recover the total cost of expenses. Although these methods
appear equitable, they do not reflect the actual cost of handling different products and can
lead to difficulties when the mix of business changes.

Example 4.4
Company X
Total premium £5m; Total costs £1m = 20% of premium

Year One Premium Allocated expenses Expenses recovered

per policy

Product A £1m 1,000 policies @ £1,000 £200 £200,000

Product B £2m 1,000 policies @ £2,000 £400 £400,000

Product C £2m 5,000 policies @ £400    £80 £400,000

Totals £5m 7,000 policies £1m

The underwriting manager of Company X is aware that the £80 recovered from each Product C sold is less than it
actually costs to handle each policy. However to remain competitive in the market for Product C, price is all-
important and it has been demonstrated that Products A and B can provide the balance of expenses.

Year Two Premium Allocated expenses Expenses recovered

per policy

Product A £1m   1,000 policies @ £1,000 £200 £200,000

Product B £1.6m  800 policies @ £2,000 £400 £320,000

Product C £2.4m 6,000 policies @ £400    £80 £480,000

Totals £5m   7,800 policies £1m

In Year Two, the insurer’s total premium income has remained static at £5m and the existing expense allocation of
20% has recovered £1m from the three products, as before. However the total number of policies has increased to
7,800 (from 7,000). An additional 800 policies (11%) apparently had to be handled within the existing £1m budget.
How did operations manage the productivity challenge?

Although we have been told that it costs more than £80 to handle Product C, we do not know the actual cost and we
have not evaluated the savings generated by the loss of 200 Product B cases (which we understand generated
particularly high claims handling costs). Without further information we cannot evaluate the impact of this change
in mix on expense budgets and the balance between numbers of new business handlers and claims staff required.

This example demonstrates the impossibility of making sound decisions without monitoring
product mix, as assumptions about overall claims costs, operational requirements and
expense allocations can be undermined by a change in mix. Although most portfolios do not
experience radical change year-on-year, more gradual change over a few years could result in
similarly adverse results, if the implications of change in mix have not been considered and
managed.

Minimum policy premiums

The application of minimum policy premiums can be another means of dealing with expense allocation and/or it can
reflect the desire to exclude smaller risks from a portfolio. A small business might accept a minimum premium of
£300 but look elsewhere if the minimum premium was £500. What starts as an attempt to manage expenses, can
result in an unexpected change of mix with implications for claims experience. For this reason, the ongoing impact of
the application of a minimum policy premium should be monitored.

Having discussed how influential mix of business is and how potentially damaging an
unrecognised change of mix can be, some of the implications for planning (see chapter 5) are
apparent. Key assumptions regarding claims costs and expenses (as well as capital,
reinsurance and solvency) are necessarily based on a specific, assumed mix of business.

Be aware
Specifying how much of what business is to be written in the forthcoming period (and monitoring achievement) is
essential: a simple premium income target is not sufficient.

D1D Mix of business and pricing

Although underwriters talk about ‘the price for a risk’, seeming to imply that there is a single
correct price for every individual risk, this is a theoretical concept based on assumed perfect
knowledge in an unchanging world. In reality, where a range of prices for a single risk are
calculated by individual underwriters, there is tendency, through competition, for the typical
market price to move to a narrower range or ‘ballpark’ pricing. Underwriters know that if
their price is above the ‘ballpark’ range they are unlikely to compete effectively for the risk,
unless there are other strong reasons for the insured to choose a more expensive insurer.

Even where very similar processes are adopted, the historical claims experience of a
particular portfolio, its mix, expense allocation and the assumptions used in its projection will
ensure that no two insurers’ base rates are identical. The technically correct premium for an
individual risk is determined by the context of the portfolio to which the risk belongs.
This ‘context’ includes the relevant reinsurance arrangements: the level of protection
purchased and its cost (see chapters 7 and 8).

Underwriting managers are therefore responsible for not only approving the correct
premiums or rates – technical rates – to be used but also the degree to which these may be
amended (loaded or discounted) to meet market expectations of ‘ballpark’ pricing. The
overall level of amendment needs to be tracked, as do any particularly extreme amendments.

In some instances, technical rates that are significantly different from the market norm may
reflect the historical experience of a small or unbalanced portfolio but they should not be
dismissed as simply ‘wrong’ unless further investigation confirms an unwarranted bias. A
technical rate which appears out of step with market expectations may reflect an important
underlying feature of the relevant portfolio which should not be ignored. A significant
discrepancy may also reflect the movement of market rates away from the level of pricing
necessary to generate profit and, as such, indicate that continued participation in this market
should be on a highly selective basis.

When examining the historical and current experience of any portfolio of business, the
underwriting manager must:

understand the mix of business and how it has changed in the past and is changing now;
understand how technical rates have been arrived at and whether there are any
significant cross-subsidies;
monitor how technical rates are amended by underwriters on a day-to-day basis;
watch for distorting trends either in the mix of business written or the amendment of
technical rates;
create specific targets regarding business mix; and
be prepared to take steps to rebalance the portfolio.

D1E Broker portfolios

Throughout this section the discussion on portfolio management has focused on insurers’
portfolios of business and how they might be managed to achieve agreed objectives.
However, the term ‘portfolio management’ can also refer to the approach taken by insurers to
brokers’ portfolios of business.

Rather than approaching an insurer with a succession of individual risks prior to their
renewal dates, an intermediary may approach one or more insurers, requesting terms based
on their overall evaluation of a portfolio of risks. The broker is, of course, looking for
advantageous terms based on the potential profitability of the portfolio and any
administrative savings that might accrue through the arrangement as enhanced commission.
The broker is not (cannot be) obliged to place eligible business with any particular insurer, as
each customer must be offered the best options to meet their specific requirements.
However, if the arrangement has been considered with care and the insurer’s underwriters
have completed a portfolio review in advance of the agreement, there is every chance that the
majority of eligible insureds will find that it is to their advantage to renew under the portfolio
arrangement. As a result of the portfolio review, the insurer should be able to specify the type
of business they are unable to accept and which business they regard as eligible.

An intermediary can agree to more than one such arrangement and insurers will often
continue to find themselves in competition for the best business. Brokers may also look for
this kind of arrangement at short notice when another insurer withdraws suddenly from the
market and many of their customers require cover immediately or from first renewal.

The assessment and management of this type of portfolio arrangement follows the same
principles outlined above, with some of the additional considerations discussed in the next
section on scheme underwriting.

Does the portfolio, as currently constituted, fit with the insurer’s underwriting strategy
and policy?
How do you assess the mix of business the portfolio contains – very diverse or relatively
homogeneous? The more diverse, the more difficult it will be to agree general terms.
What is the history of the portfolio (previous insurers; how has it been handled; volume,
recent growth, claims experience; quality of data)?
What approach to administration, commission levels and pricing are you willing to offer
and what is the broker looking to achieve? If the broker requests a profit share
agreement, this requires the input and support of actuarial and finance colleagues in
order to model the impact on pricing and ensure that internal budgets correctly reflect
the potential cost of such an agreement in future years.
E Scheme underwriting
Schemes are a common means of intermediaries exploiting their knowledge of and access to
particular end-customer groups. In return for this improved access, insurers provide tailored
covers, differentiated service and/or keener pricing. At least, this is what is generally
understood as a valid basis for scheme underwriting.

The intermediary’s superior access to specific end-customers is a necessary element of any

scheme arrangement. The end-customers could be:

members of an affinity group (National Trust members or classic car owners, for
example);
customers of banks or building societies; or
end-customers whose risk profile makes them, to some extent, less attractive to the
general market (e.g. scaffolders, solicitors, oil distribution firms).

The underlying proposition may be that the affinity group is in a sense self-selecting and has a
lower-than-average exposure to risk or, for some commercial schemes, membership of the
affinity group is directly linked to qualifications/registration, again ensuring a lower-than-
average exposure to risk and superior claims experience. Regular access to large numbers of
customers through banks or supermarket loyalty card arrangements may imply little about
typical exposure to risk or claims experience but simply provide the benefit of regular access
(opportunities to market/sell) and scale.

Some schemes are created to enable individual risks with common risk-related issues to be
presented to insurers as a group. This approach may, if successful, provide the insurer with a
better appreciation of the group’s true claims experience, which justifies a more moderate
application of terms than would be appropriate if single risks of the type were presented.
Such customer groups may also wish a modification of standard product cover to fit their
particular needs (see chapter 3).

Given the wide range of motivations and opportunities which may underpin scheme
proposals, what is required of insurers is similarly varied. This can include:

the provision of re-branded documentation for an entirely standard product;

minor amendment of products and wordings;
bespoke claims handling and processes; or
the creation of a radically different product.

Having first established that the proposed scheme arrangement is within underwriting
strategy and its volumes/values and mix of business fit within corporate risk appetite, the
scheme proposal must be fully assessed. The main differentiator may be the marketing
approach rather than the product cover or it may be the administration of the scheme which
is believed to generate a competitive advantage. Price will usually be a very important
differentiator.
Underwriting managers should determine, in advance, the type, quantity and quality of
information required in order that propositions may be considered on an equitable,
appropriate basis within a reasonable time frame.

Underwriting management decision: evaluation of scheme propositions

What evidence exists and what assumptions can be made regarding:

future claims costs;

expenses; and/or
level of sales?

Some intermediaries are not well-acquainted with the ways in which insurers evaluate
scheme proposals and an early response from the insurer, detailing the information required,
may save time for both parties. While intermediaries will always understand the insurer’s
focus on a target maximum claims ratio, the issues around expenses and sales may be less
apparent. The insurer needs to assess the expense involved in evaluating the proposal and
setting up the scheme, as well as additional recurring expenses.

Example 4.5
For a scheme requiring an amended policy wording, underwriters will have to consider the broker’s requirements to
confirm whether the proposed changes would be acceptable in principle. If so, underwriters then have to make the
changes and have them validated, and the new policy wording has to be formatted professionally and printed. The
new wording is allocated a new system code and every computer program using policy wording codes has to be
updated to recognise the new one and associate it uniquely with the scheme intermediary. All relevant internal staff,
including claims staff, must be advised about the use of the new wording and the changes it introduces.

From then on, the new policy wording code generates additional work each time a program referencing such codes
is maintained or updated and a new line has to be included in each relevant MI report. When general changes are
made to policy wordings, for example reflecting new legislation or regulatory details, the new wording has to be
updated. Whether the new scheme sells 1, 100 or 1 million policies, the type of expense described here is incurred
regardless.

Hence the focus on the scheme’s realistic sales potential. What is the ‘whole market’ potential:
how many solicitors operate in the UK, how many National Trust members are there? What
special degree of access does the intermediary have to these potential customers? What
evidence demonstrates that this access can be translated into actual sales?

Additional considerations
Refer back to chapter 3, section D1

Delegated authority – the scheme proposition may involve aspects of delegated authority. Is
this appropriate? Does this delegation of authority improve customer service, improve the
quality of underwriting, de-duplicate administrative procedures and/or reduce expenses? Are
there any downsides to this arrangement? How will the exercise of delegated authority be
monitored? What will this cost? Is the insurer satisfied that the intermediary company is a
suitable potential partner in this venture? Remember that although work can be delegated,
responsibility cannot: the insurer remains accountable.
Administration – whether the administration of the scheme (the means of administration
and the allocation of work between the intermediary and insurer) is an innovative or
conventional feature of the proposed arrangement, all of the details and costs must be
established before the scheme arrangement can be agreed. This includes agreement
regarding the collection and exchange of data and MI, the payment of premiums and
commission, scheme performance review dates, referral and audit arrangements and,
possibly, the sharing of ICT facilities.

Competition – does the scheme proposition have any direct competitors? If so, what are this
scheme’s unique selling points? Does the insurer already participate in other similar
schemes? Might the new scheme draw business from existing schemes (underwritten by this
insurer) and thereby antagonise other intermediary partners? Might the scheme draw
business from the insurer’s general account? As well as annoying other intermediaries (and
internal staff from branches without access to the new scheme), the insurer may face
recycling its own business: incurring the cost of new business policy set-up, at a lower
premium and higher commission than previously charged. This possibility does not
necessarily rule out the new scheme proposal: the likelihood, scale and cost have to be
assessed and included in the overall evaluation.

All of the above serves to explain why, for every successful scheme (generating profit for both
intermediary and insurer from a satisfied customer base), there are innumerable other
unsuccessful schemes.

Be aware
Schemes underwriting is a specialist business requiring professional focus.
Summary
The main ideas covered by this chapter can be summarised as follows:

As the requirements of insurers and their customers change, so must underwriting

policy. Any new policies must fit within the current underwriting strategy and not
conflict with other relevant strategies.
Each underwriting policy change must be supported by management information and
portfolio management data to allow underwriting and pricing teams to assess the impact
of the change against expectations.
As well as monitoring the appropriateness of existing classifications and categorisations,
underwriters must assess new risks as they appear.
An insurer’s underwriting policy should indicate the range of policies/products available
and the extent to which it is acceptable to consider amending policy wordings.
Underwriting management is required to ensure that current and proposed wordings do
not conflict with corporate risk appetite, including the scope of the insurer’s reinsurance
protection. Proposed changes to wordings must be considered from financial, legal and
regulatory perspectives.
Portfolio management involves monitoring how the distinct elements within the
portfolio perform and change over time. It is also necessary to monitor the overall mix of
business as this will significantly influence the servicing of the business.
Schemes are a common means of intermediaries exploiting their knowledge and access
to particular customer-end groups.

Bibliography
Swiss Re and Bloomberg New Energy Finance. (2013) Profiling the risks in solar and wind. Swiss Re Ltd.

Scenario 3 – Question

Your company’s relationship with a substantial broker has broken down badly and the broker’s account will be run-
off over the next 15 months. The account is proportionately significant for your company; it has run profitably until
now and comprises a book of fairly homogeneous business.

The marketing, sales and distribution managers have been tasked with devising ways of replacing this business. The
budget approved by the general manager, to whom the whole management team reports, requires total income to
grow in line with general inflation, at least, and an underwriting profit to be made. There is a recognition that
expense levels (including commission) will probably increase and allowance has been made for this.

As underwriting manager, you can anticipate that many different types of proposal will be put to you, particularly in
the next few months as the run-off gets under way. This is a serious situation for the company and the general
manager expects each member of the management team to focus on this issue for the next year or so, until the lost
business is replaced.

Describe the underwriting issues which you can envisage arising from attempts to replace this business.

In anticipation of these types of issue, outline the ground rules you would propose to your marketing, sales and
distribution colleagues and any other actions you would take.
See overleaf for suggestions on how to approach your answer

Scenario 3 – How to approach your answer

Aim
This scenario is concerned with the adaptation of underwriting policy and practice to a change in company
circumstances: namely, the need to write a substantial volume of business quickly. It tests your ability to understand
the potential implications of a range of business options and to identify necessary underwriting actions.

Key points of content

You should aim to include the following key points of content in your answer:

Issues:

Poor quality and/or under-priced business may be acquired to plug the gap. This could lead to general price
rises in later years, resulting in a loss of further good business.
It may be difficult to evaluate accurately the quality of business available from potential new sources or
arrangements.
New business pricing levels may come under immediate pressure, undermining ability to achieve
underwriting profit. Remaining, supporting brokers may not appreciate a marked distinction between new
and existing business pricing.
Reinsurers may react adversely to any uncertainty around risk profile and to general market comment
regarding loss of original broker’s support and new business drive.
Service levels (underwriting/sales) for remaining business could suffer, with focus on filling the gap. If new
business quality is poor, claims service levels may also be put under pressure in due course.
Although the immediate business requirement/target is short-term, the potential implications are long-term.

Ground rules/actions:

Remind all concerned of underwriting strategy and key aspects of policy; with clarity on no-go areas, confirm
which areas are worth considering.
Identify which aspects of existing accounts (known relationships) should be targeted and what support you,
as underwriting manager, will provide to encourage those intermediaries to offer the company more good
business. You must consider how any such options support the underwriting profit target. (Example: an
existing broker may want a slightly modified product offering, possibly broker-branded. If achievable within
short time-frame, this may increase expense levels modestly but need not affect underwriting profit, if
product modification is considered appropriately.)
For entirely new accounts or propositions from less familiar brokers, you must confirm what
information/data will be required. Guidelines should be provided to help quickly eliminate any proposals not
worth pursuing and highlight those with the best chance of success.
Confirm your approach to scheme underwriting and how requests for delegated authority and/or profit share
will be handled. Outline typical arrangements for portfolio reviews. Confirm underwriting department service
standards (how long to review an initial scheme/portfolio proposition and how long to initiate, if successful).
Confirm approach to risk acceptance to your own staff: if any amendment is to be made, explain changes and
confirm in writing. Advise risk control staff. Make necessary arrangements to enhance monitoring of mix of
business and exposure control. Consider management information requirements. Advise reinsurers of issues
and plans and keep them updated.
Potential pricing issues (pressure to discount; response to increased commission levels) need to be discussed
with underwriters and sales staff, before they approach the market.
Consider creating teams within underwriting to focus exclusively on new versus existing business; also,
consider overall staffing and skill levels.
Appendix 4.1: New Statesman, ‘UK asbestos-related claims to
be around £11bn for 2009 to 2050’, 29 January 2010
© New Statesman 2010. All rights reserved.
 5 The planning process in underwriting

Contents Syllabus learning

outcomes

Learning objectives

Introduction

Key terms

A Plans and budgets 5.1

B The role of the underwriting manager 2.8, 5.1

C Assumptions and forecasts 2.8, 5.1

D Expenses 5.1

E Cash flow and investment income 5.1

F Liaison 5.1

G An ongoing task – monthly monitoring 5.1, 5.2

H Management and financial accounts 5.1

I Your plan and budget 5.1

Summary

Bibliography
 Scenario question and answer

Learning objectives
This chapter relates to syllabus sections 2 and 5.

On completion of this chapter and private research, you should be able to:

explain the central role of planning in underwriting;

distinguish the contribution of underwriters and others to the planning process; and
identify the key inputs and outputs of planning and budgeting.
Introduction
The development of underwriting strategy has already been described, as has its translation
into the day-to-day practice of underwriters through the creation and application of
underwriting policy. Use of the planning process turns these strategic intentions and
practical approaches into coordinated and prioritised actions, with measurable outcomes.
Planning poses questions about: which actions should be undertaken, when, how and with
whom; how much actions will cost; how much business can be accepted; what level of
profitability needs to be achieved; and how we will know we have achieved our plan.

Thus planning and budgeting processes underpin many aspects of underwriting policy
involving the assessment of profitability, the determination of pricing requirements, the
management of exposures and other forms of monitoring, all of which will be discussed in
later chapters.

In this chapter we shall be discussing:

typical planning and budgeting approaches;

your involvement, as an underwriting manager;
important components of plans and budgets;
the need for monitoring; and
distinctions between management and financial accounts.

Key terms

This chapter features explanations of the following terms and concepts:

Assumptions Budgets Cash flow Combined operating ratio

(COR)

Critical success factor Deliverables Expenses Financial accounts

Forecasts Investment income Management accounts Measurable targets

Monitoring Planning process Plans Return on capital employed

(ROCE)

Timing
A Plans and budgets
Refer to 990, chapter 5, sections A and B, and chapter 6, sections A and B

Plans articulate and guide the implementation of strategies, projects and policies. Budgets
translate plans into financial measures which specify inputs and outputs and are used to
manage performance. Planning, budgeting, monitoring results and explaining exceptions or
variances are significant, time-consuming tasks for most managers.

Be aware
Each company approaches planning and budgeting in its own way.

From an underwriting perspective, ‘plan’ and ‘budget’ may appear to mean the same thing. If
next year your unit is required to increase its premium income by 10% and achieve an earned
loss ratio of 55% or less, that might be referred to by staff as ‘the plan’ and those are the
measures which would appear in the related budget.

In fact, the plan should explain by what means:

income is to be increased (for example, by selling more of the same products via
different intermediaries; by launching new products; by focusing on larger cases); and
the loss ratio contained at 55% (for example, by focusing on better performing products
or customer groups; increased excesses).

A1 Return on capital employed (ROCE)

Refer back to chapter 3, section A1 for more detail on ROCE

The plan will be a mixture of top line and bottom line targets, and should include clear actions
and owners against each item. Ultimately, the targets are typically linked to capital allocation
and return on capital measures, as well as metrics such as loss ratio and combined ratio.

Your budget should tie in the underwriting initiatives and actions to the overall plan so that
all stakeholders (including actuarial) can help to predict and project the potential impact of
actions on profitability.

A2 Which of the possible options are to be used: what’s the

plan?
The actions proposed in your draft plan must reflect corporate plans and strategies. If the
company’s strategy is to limit the number of intermediaries it deals with, your plan needs to
reflect this approach. The plan also needs to detail the implications of your proposed actions
which may include the need to recruit staff or retrain others, open new branches or improve
current ICT systems. Typically, the agreed plan will be the result of discussions between you,
your staff, your immediate superiors and more senior management: a mixture of top-down
and bottom-up planning.

A3 Measurable targets
The plan should include measurable targets/deliverables (such as launch dates for new
products or timescales for the recruitment of staff/recruited staff). It is important to identify
those deliverables which represent critical success factors (namely, things which need to be
in place in order to achieve an objective; things which are vital for success). The specific
highlighting of these deliverables is intended to provide a shared focus which assists
prioritisation across the organisation. For example, if without the timely launch of a new
suite of products this year’s plan and budget are not achievable, the product launch is critical
to the success of this year’s plan. All relevant parts of the company need to be aware of this
and act accordingly.

A4 Financial measures
Refer to 990, chapter 6, section A

Financial measures (representing income, claims and expenses) are compiled into the
budget which relates to your plan. Your budget should be much more than a passive
prediction of how your area of responsibility will perform in the next twelve months, all
things being equal. It should reflect the impact of the actions you plan to take to ensure that
the result meets corporate requirements in all respects.

The budget approval process should present all budget holders with real challenges: are their
proposed budgets sufficiently ambitious (in terms of profit and growth) and, at the same
time, achievable? No individual budget can be approved in isolation as each must be viewed
in the context of the company’s major divisions, as well as at an aggregate level, in order to
ensure that the overall capital allocation (based on business volumes and underwriting
results) is acceptable. Once approved, the plan and budget become the source of your unit’s
financial and non-financial targets for the year.
B The role of the underwriting manager
Your involvement, as an underwriting manager, in planning and budgeting will depend upon
your role, the size and nature of the insurance company you work for and the company’s
approach to these processes. As we will see later in this unit, approaches to monitoring are
closely related to how companies approach planning and budgeting.

B1 High-level planning
As an underwriting manager, you are likely to be involved in agreeing high-level planning
guidelines in conjunction with your company’s central planning function (or finance and
actuarial teams).

Underwriting management decisions: high-level planning

How much capital is likely to be available?
What ROCE is required and how does that relate to next year’s anticipated mix of business?
Which rates of inflation should be used for the next twelve months for projecting claims costs or for
rebuilding costs?
What allowances should be made for reinsurance costs in the course of next year?
What increase in head-count is permissible?
What overall increase in salary costs should be anticipated?
What is the regulatory context?
What are the current and expected future market conditions?
What amounts will be used for fees and levies?

B2 Product planning
If you are the manager responsible for a group of products, you will use the centrally-set
guidelines to develop your unit’s plan and budget in detail for the forthcoming year.

Underwriting management decisions: product planning

For a given set of products, what scope for growth exists (given likely competition and the position of the
underwriting cycle)?
Which products will grow faster than others?
Which will produce most/least profit?
If you plan to exit a product next year, what impact will that have on the budget? Will it impact on other
products? If commission costs are rising, what implications are there for your products’ projected rating
increases?
Will there be cross-subsidy between products or will each product be expected to achieve a positive return?

With the increased use of risk-based capital modelling, you will be required to relate planned
changes in exposure to your products’ allocation of capital and their relative performance
(ROCE).

B3 Regional planning
As an underwriting manager at a regional operational unit, you will have significant input to
the development of the unit’s plan and budget, particularly in explaining the use of any
assumptions which vary from those set centrally.

Underwriting management decisions: regional planning

If the company has recently amended local postcode ratings for household business, what impact will this
have on your region’s household business next year? Will increased new business from lower-rated postcodes
compensate for lapses from higher-rated postcodes?
Two new schemes should go live next year in your region: how much income will they generate and how do
you anticipate the volume of claims to build up in the course of the year? What are staffing/expenses
considerations?
C Assumptions and forecasts
None of the questions posed in section B are necessarily easy to answer: in fact, most cannot
be answered with certainty. Just because some postcodes will attract lower rates next year,
will this automatically generate increased sales in those areas? Clearly not.

It is necessary to examine each issue in turn and create forecasts, based on assumptions, of
what may happen. Assumptions and forecasts must be based on the best-available research
and data and this information should be documented, so that the assumptions and agreed
forecasts can be reviewed, validated and subsequently monitored. In this way valid
assumptions and forecasts can be distinguished from mere assertions, in which senior
management can place little confidence.

Example 5.1
Regarding the questions raised in section B3 about the lower-rated postcodes, if at the end of the year sales have
increased by only 2% compared with a forecast of 10%, what went wrong? If the rationale behind the 10% forecast
was recorded, it should be possible to determine whether something truly unexpected happened or whether the
approach to determining the forecast or any underlying assumptions was poor.

Will higher sales be generated in those postcodes where rating has been lowered and, if so, what increase in
sales might be anticipated?
What is the extent of the reduction in rating?
Have you evidence of the impact of other similar reductions in the recent past?
How many broadly acceptable households are in these postcodes and what is your company’s current share?
How do your rates compare with those of competitors?
Does your company have any particular (non-price) advantages in these postcodes: a supportive local broker
or a willingness to accept risks which other insurers tend to avoid?

What other questions would you consider?

Depending upon the answers to these questions, it might have been agreed that sales could increase between 5 and
10% in the plan period.

With the benefit of hindsight, the choice of the figure at the top end of the range (10%) may not have been wise but
the main factor undermining this aspect of the plan was the entry of a new competitor to the market offering an
economy product.

If the failure to achieve the anticipated growth was of significance to the account as a whole, the conclusion may be
that far more effort should have gone into the research behind the forecast and the actions of new and existing
competitors monitored more closely.

It is important to understand the status of planning assumptions and forecasts. For example,
insurers with property exposures will include assumptions about the cost of severe weather
events in their budgets: they may allocate a specific claims cost or a percentage load on
claims cost, say 5%. This is an assumption based on the projected cost of severe weather
events over a period of years, not a forecast of what will actually happen in the specific
planning period in question. If, in the year in question, severe weather claims costs amount to
1% or 10%, this does not necessarily invalidate the planning assumption, which was intended
to reflect a likely average cost for a highly variable element of the budget. Other aspects of the
plan will, however, demand a forecast that must relate specifically to the period in question.
Sales volumes, as above, are one such example.
C1 Importance of timing
As well as considering how you and your colleagues wish to develop the account, the timing of
changes and new initiatives must be considered. Unless implemented in the early part of the
year, most of the impact of a rating change will only be evident in the subsequent year.
Similarly, a recruitment exercise to obtain more underwriters (and thus support increased
sales) could easily absorb six months, or more, before the new underwriters are in place.

When creating a plan and budget for your area of responsibility, you have to identify the
issues and risks (internal and external) which are likely to affect the achievement of your plan
and consider how best to manage or mitigate these issues and risks while meeting the
requirements of executive management. These requirements will usually be expressed in
terms of:

income growth;
profit; and, increasingly,
ROCE.
D Expenses
As well as those components of the budget that relate directly to underwriting (premiums and
claims, primarily), there are many other items for which you may be deemed to have
responsibility. If this is the case, you are likely to be involved in determining the budget for
those items.

For example, although your role may involve responsibility for the effective performance of
staff employed in your unit – and you may be involved in decisions regarding headcount – it is
likely that projected staff costs (pay, benefits and other related costs) will be provided to you,
possibly using a simplified formula calculation. Similarly, within most large companies there
is likely to be a specific budget-holder for ICT costs with whom your plans for the forthcoming
period (for systems-support for a new product or upgraded data capture) must be discussed
and agreed.

D1 Fixed expenses
The calculation of these ICT costs (projected and actual) and their allocation to your unit’s
budget may be on a specific basis or they may be included in an overall management services
charge borne by all units, which covers an allocation of fixed expenses (those expenses that
do not alter with the level of business written, such as the costs of a building).

Even in respect of some items which are very closely related to underwriting, such as
reinsurance costs, you may be required to include specifically projected costs within your
budget or you may be provided with a figure representing a general cost allocation.

D2 Variable expenses
Allocation of variable expenses is typically at product or business level, with adjustments
being made to reflect delegated underwriting or claims handling.

Those responsible for the planning and budgeting processes within your company will
determine the approach to expenses (such as staff costs, ICT and reinsurance) by balancing
the need for proper focus on costs and responsibility for expenditure with the need to focus
on what individual underwriting managers can most effectively influence and the need to
avoid unproductive complexity in allocating detailed costs to individual units or products.
E Cash flow and investment income
But what about cash flow and investment income, both of which are important elements of
the ROCE calculation? You will be expected to consult your finance and actuarial colleagues
who will provide you with either figures developed specifically for your account or a COR
target, adjusted to allow for cash flow and investment income assumptions, as well as return
on capital and profit requirements.

Example 5.2
As advised, your account’s income is required to grow by 10% next year, while achieving an earned loss ratio of 55%
or less. The earned loss ratio target (incurred claims as a percentage of earned premium) has been derived using
assumptions regarding commission costs and other expenses based on a COR (incurred claims plus expenses divided
by earned premium) of 98%. Actuarial and finance have confirmed that a COR of 98% will support the required
return on capital and profit on your account, on the assumption that the account’s mix of business and cash flow
remain stable and the account does not grow by more than 20%. Although fictitious, these figures are intended to be
broadly realistic; however, different classes of business will have differing earned loss ratio targets to produce profit
depending on how much capital is required to support the business.

Refer to section H for financial accounts

By these means, underwriting managers are encouraged to focus on what they can effectively
influence (risk exposures, premium, claims and certain expenses) and leave others to manage
ICT costs and investment income returns. This is not to suggest that you should not take
every opportunity to review all relevant aspects of the budget (ideally before the period of
peak budgeting effort within the company), in order to appreciate the validity and impact of
the assumptions used and how you might improve the performance of the business. Cash flow
may not be one of your prime responsibilities but if your underwriters answer accounts
queries more promptly, will overall performance be improved?

Actuarial, finance and/or the central planning function supply important base data and
targets for your plan and budget but you also need to consult with other colleagues.

Underwriting management decisions: planning and the need for liaison

How do your product plans fit with marketing and sales plans?
At a regional level, are those responsible for distribution recommending any changes which may impact the
balance of the account?
Will a proposed new product require the recruitment of specialist claims handlers?
Have your plans for new or amended products or growth initiatives been shared with the company’s
reinsurers?
F Liaison
As an underwriting manager you will be constantly liaising with other staff with an interest in
how your account performs, either on a regular, formal basis (e.g. monthly meetings) or as
and when their advice is required.

F1 Actuaries
Actuaries and their staff deal with the financial impact of risk. They provide assessments of
financial security systems with a focus on their complexity, their mathematics and their
mechanisms. Actuaries evaluate the probability of events and quantify the contingent
outcomes in order to minimise the impacts of financial losses associated with uncertain,
undesirable events. They use various capital modelling tools to assist them in their
deliberations.

Actuarial input to all classes of insurance and reinsurance business is vital. It can be
particularly important in classes of business where there are a large number of claims
expected as a normal consequence of underwriting that particular class.

Example 5.3
Motor insurance (private hire or commercial vehicle/fleet) will generate a large number of attritional, day-to-day
high-volume, low-value claims as well as the occasional high-value, low-frequency third-party bodily injury claims.
Using historical claims data and anticipated changes in the claims environment, actuarial input into expected loss
ratios can be extremely useful for the underwriting manager in suggesting future strategy.

F2 Compliance
Refer back to chapter 1

The compliance officer and their staff are charged with ensuring the legislation and
regulations for the class of business in the territory written are adhered to.

If your unit holds monthly meetings to monitor progress towards targets (see section G), it is
very likely that the compliance department would have a representative at the meeting to
deal with any compliance issues that may arise.

Example 5.4
For a UK motor unit there is a requirement to populate the Motor Insurance Database in an accurate and timely
matter. The compliance department will want to be assured that this requirement is met on a regular basis and that
any potential problems are spotted as early as possible so that measures can be introduced to ensure adherence.

F3 Sales/marketing
Although this function is concerned with premium generation and good relationships with
third-party insureds/brokers etc., they should be aware of your need to generate target ROCE
and that sometimes there are conflicting pressures of turnover and profit. Where there are
conflicting pressures, the need to make sufficient returns predominates.

F4 Other underwriting staff

As the underwriting manager of the unit, you are responsible for ensuring that each member
of your underwriting and administration team is aware of their role and responsibilities
within the unit. They should each have mutually-agreed targets to measure performance and
these targets should be regularly monitored. Communication channels to you should be as
open as realistically possible.

F5 Senior management
Senior management obviously have a keen interest in how your unit’s business is run. It is
usual for a monthly meeting to be held with all underwriting managers to record how each
unit is meeting its pre-agreed targets. Results are discussed, actuarial projections are made
based on historical claims data, and other issues are aired. If necessary, individual meetings
are arranged outside of this forum.

As with your own staff, it is important to maintain clear and open lines of communication
with the senior management team.

F6 Claims
For catastrophe classes of business, liaison with claims staff may be limited to occasions
when a catastrophe claim does occur. For classes such as UK motor, where there is a high
frequency of low value claims (as well as the odd catastrophe one), it is likely that liaison
between claims and underwriting staff is very frequent. Underwriters will want to know about
changes affecting the frequency and severity of claims; the claims department will want to
know how any changes in underwriting policy will affect their workload. It is not uncommon
for a claims representative to be involved in the monthly unit meeting for these classes.
G An ongoing task – monthly monitoring
This may sound like a formidable task: to pull relevant data and information together, discuss
plans with colleagues in other functions and units (and with intermediary partners and
reinsurers), agree priorities, all within a relatively tight period of time.

It would be a very difficult exercise to accomplish if the issues were only reviewed once a
year: in reality, work goes on throughout the year in support of planning and budgeting,
although finalising next year’s plans and budgets can still be a testing experience.

Example 5.5
A typical planning process
Throughout the year:

Executive and senior management participate in conferences and reviews intended to check the overall
direction of the business, assess progress on strategic objectives, scan the environment for opportunities and
threats and, generally, review and update high-level objectives. Other levels of management may also
participate in similar, formal planning conferences.
Formal and informal discussions with intermediary partners and reinsurers will contribute to the assumptions
made in your plans and provide a view of general market trends for current and forthcoming periods.
Refer to M92, chapter 3, section B6
At all levels of management, monthly management and financial accounts will be reviewed against current
budgets and the previous year’s actual figures. Within every unit and project team, monthly performance
(financial and non-financial) will be reviewed against targets. Variances from plan will be queried (see also
chapter 9 on monitoring). Although these monthly reviews examine what has already happened, they should
contain elements which are directly relevant to planning for the future, for example:
When variances are examined, why did the current plan fail to anticipate events or trends which have
proved to be significant? If certain assumptions or forecasts were poor, how can they be better
validated in the future? Seasonality impacts need to be considered; for example, in a motor portfolio
one can expect claim frequency to increase in winter months when the weather is bad. The main way
better plans and budgets are created is by reflection on how the current versions could have been
improved.
As you advance, month by month, through an annual plan and budget, you will be obliged to state how
you view the outcome of the remainder of the year: what is your forecast? If sales have been below
plan in the first three months of the year, will this deficit continue through to the end of the year or may
some of the deficit be eliminated by better than planned sales in later months? If a higher than expected
number of large claims has been intimated in the first half of the year, what is the likelihood of this
higher level continuing? Depending upon the nature and scale of the variance, a decision will be taken
whether to stick with the existing budget or to reforecast the budget for the remainder of the period. In
addition, as you reflect on the plan and budget for the remainder of the current year, you are inevitably
thinking ahead to the next planning period.
Throughout the year profitability reviews will be conducted for individual products and classes of business
(see also chapter 7). By the time of the annual budgeting exercise, many of the rating amendments required in
the next year will already have been agreed in principle and, on the basis of regular reviews, reasonable
assumptions can be made about those not yet agreed: these assumptions can be fed directly into the relevant
budgets.
Monthly meetings allow for regular review of various aspects of the business. Are the planned premium
income targets being met? If not, why not? Are the required ROCE figures being met? Are staffing levels
adequate? Are service standards being met? What is the state of the market – are rates rising or falling? All
these issues and more can be addressed on a regular basis rather than let issues of concern drag on and
potentially become more serious.

Of course, for those companies who use twelve-month rolling plans, the above work supports
an updated plan every month as opposed to a new plan once a year.
H Management and financial accounts
The budget you prepare or contribute to for your own area of responsibility should directly
reflect those measures you can influence and/or are tasked to monitor. The budget form
should mirror the management account you receive every month. Typically, this will involve
a relatively small number of measures, which may be available at many sub-levels (for
example, at product, scheme, class, intermediary and/or branch level).

A basic monthly management account (and thus budget) would include:

written premium;
earned premium;
incurred claims cost (payments plus change in outstanding estimates); and
earned loss ratio.

This is usually presented on a gross basis (gross of reinsurance premiums and recoveries).

As management accounts are purely for internal use, they will reflect the needs of individual
units. Expenses may or may not appear, depending upon whether they are
calculated/allocated to the relevant level of analysis. As discussed, a target earned loss ratio
may have been agreed with actuarial incorporating various assumptions which permits
underwriting managers and staff to focus on a smaller number of variables on a monthly
basis.

The rationale and basis for all assumptions used in the creation of the annual budget should
be thoroughly reviewed prior to their use and an ongoing process of review should monitor
their continued validity. See chapter 9, section A for a list of the key measures and
assumptions which need to be monitored.

Insurance companies also produce financial accounts on a monthly basis and public
companies publish summaries of these accounts for external scrutiny on a regular basis.
Financial accounts are designed to permit comparison between all companies (not only
insurers); they include measures relating to issues which are not within the remit of
underwriting managers and they are typically compiled at a high level without many sub-level
splits. There are a number of reasons why management and financial accounts do not produce
matching figures, including:

differences in how certain items are measured;

timing differences;
different methods of expense allocation; and
reserve movements.

Although you and your unit’s performance will be primarily measured by the relevant
management account, it is important to understand something of your company’s financial
accounts for a number of reasons:
It is what the public and the rest of the market (including intermediaries and reinsurers)
see and you may well be asked to comment on your unit’s performance in that context
(by staff as well as external parties).
Refer to M92, chapter 7
If you are responsible for a group of products or businesses separately reported within
your company’s financial accounts, it is important that you understand how the two
types of account may be reconciled and continue to monitor the significant elements
within that reconciliation monthly.
It will help you understand some of the underlying assumptions used by finance and
actuarial in the creation of target ratios.
I Your plan and budget
At the end of the planning and budgeting process, you should be able to answer the following
questions in the affirmative:

Are the resources necessary to accomplish your plan reflected in your budget?
Is your budget realistic? Is it phased (month-by-month) appropriately, taking into
account seasonal variations?
Can and your staff identify the priority elements within both the plan and the budget?
Do you understand how the assumptions and forecasts have been arrived at?
Do you know which assumptions and forecasts have to be monitored closely?
Have appropriate contingencies been allowed for (e.g. weather worse than expected, new
business lower than expected, claims intimations higher than expected)?
Do you understand how the accomplishment of the plan and adherence to the budget will
be measured and monitored?
Have key performance indicators (KPIs) have been agreed?
Refer to chapter 9, section B

I1 A meaningful process?
Sometimes planning and budgeting can seem extremely process-driven and removed from
the ‘real’ world. Maybe next year’s plan and budget closely resemble those of last year and the
year before that – are they still appropriate?

Underwriting managers are particularly aware that the underwriting cycle is a fact of life and
that, to be useful, plans and budgets must therefore reflect its influence. Not everyone in the
company will be aware of the influence of the cycle. Given that ‘managing the cycle’ (managing
the transition from hard to soft markets and back again) is a key determinant of success in
general insurance, the planning process must pay particular attention to the stage of the cycle
and timing issues. A highly collaborative approach to planning, which draws information and
data from a wide range of sources and shares it appropriately, is best suited to achieving this
awareness and capability.

I2 A quality process?
Plans and budgets can only be as good as the data, information and assumptions they are
based on. In the next chapter we will look at claims, which represent the single largest cost in
any general insurance budget and the most significant source of uncertainty.

In chapter 9 we will follow the planning and budgeting processes through to monitoring,
which enables underwriters not only to identify what is performing or not performing
according to plan but also helps identify the reasons for variances.
Summary
The main ideas covered by this chapter can be summarised as follows:

Plans articulate and guide the implementation of strategies, projects and policies.
Budgets translate plans into financial measures which specify inputs and outputs and are
used to manage performance.
Underwriting managers are likely to be involved in agreeing high-level planning
guidelines in conjunction with the company’s central planning function.
Underwriting managers will constantly be liaising with other staff, such as actuaries,
compliance, sales/marketing, senior management, and claims.
Insurance companies produce financial accounts on a monthly basis and public
companies publish summaries of these accounts for external scrutiny on a regular basis.

Bibliography
www.lloyds.com/the-market/operating-at-lloyds/performance-framework-of-minimum-
standards/underwriting_management/underwriting_strategy_and_planning

Scenario 4 – Question

The sales manager says that staff members are frustrated by the mass of targeting information provided by the
underwriting department. A far more straightforward approach is required for next year: simple premium income
targets.

As underwriting manager, what is your response and why?

See overleaf for suggestions on how to approach your answer

Scenario 4 – How to approach your answer

Aim
This scenario focuses on the uses to which outputs of planning and budgeting are put. You are asked to consider how
underwriting works with other areas to achieve corporate objectives.

Key points of content

You should aim to include the following key points of content in your answer:

Company requirements:

Quality standards and the agreed mix of business (exposure and class) need to be achieved as per the budget, as
capital levels and allocation, reinsurer expectations and the suitability of reinsurance programmes depend on
business mix as well as overall performance. In addition, if the rest of the organisation has little idea what business
will be written, how can they plan to service and support it appropriately?

It is necessary to manage top line growth against bottom line profit in order to achieve the targeted return on capital
employed (ROCE).

Sales staff requirements:

What can we (underwriting) do to help? Can we rationalise the targeting information or present it more effectively?
Would it help if senior members of the underwriting team spent time with sales staff to explain the targets set?
 6 Claims and reserving

Contents Syllabus learning

outcomes

Learning objectives

Introduction

Key terms

A Reserving policy and practice 2.6

B Claims reserving and underwriting 2.6, 3.5, 5.1

C Forecasting to ultimate: approaches and techniques 3.3

D Interpretation and use of claims information 3.3

Summary

Bibliography

Appendix 6.1: Claims development triangles

Learning objectives
This chapter relates to syllabus sections 2, 3 and 5.

On completion of this chapter and private research, you should be able to:

explain the implications of claims reserving practices for individual policy and portfolio
underwriting management;
describe the different approaches and techniques used to forecast ultimate claims costs
and their uses; and
adopt a considered approach to the selection, interpretation and use of claims data.
Introduction
Total claims costs are the major determinant of profitability in general insurance: claims data
is therefore used in financial accounts, statutory returns and internal budgets and in
decisions regarding pricing, the evaluation of exposures, capital requirements and the
purchase of reinsurance. As well as considering the use of claims data, the main focus of this
chapter is claims reserving.

Be aware
The extent of an insurer’s claims reserves (the funds set aside to pay for current and future claims liabilities) is a
very significant indicator of a company’s financial strength, closely scrutinised by regulators and external analysts.

Key terms

This chapter features explanations of the following terms and concepts:

Accident year basis Benchmark development Bornhuetter-Ferguson Case estimates

factors

Catastrophe claims Chain ladder technique Claims data quality Claims development triangles

Claims inflation Claims practice Claims reports Claims reserves

Claims run-off Development pattern Discount rate Incurred but not enough
reported (IBNER)

Incurred but not reported Latent claims Link ratios Reserve releases
(IBNR)

Reserving pattern Stochastic methods Time value of money Ultimate claims cost

Underwriting year (incurred)

basis
A Reserving policy and practice
Claims reserving takes place in two stages within general insurance companies. Individual
claims, once intimated, are case-estimated in order to establish their likely eventual total
cost. In addition, actuaries monitor the overall level of case reserves by regularly projecting
their likely total (ultimate) claims cost as a whole and may recommend a general adjustment
(positive or negative) to aggregate claims reserves in the company’s financial accounts. This
process allows for the fact that within every group of intimated claims, a number will not be
pursued and will be settled at nil; some will prove more costly than estimated and others will
settle for less than estimated.

This does not imply that individual case-estimating is necessarily inaccurate: it merely
demonstrates the degree of uncertainty inherent in claims handling and the need to ensure
that overall reserve levels are more than adequate to meet claims liabilities. Owing to this
inherent uncertainty, general insurance companies must demonstrate not only that their
reserve levels are more than adequate but that the relevant review processes (for both
individual outstanding claims and groups/classes of claims) are conducted regularly and
systematically.

Think back to M80, chapter 5, sections D and F

In addition to the reserves held as specific case estimates, actuaries assess the requirement
for further general claims reserves to account for incurred but not reported (IBNR) and
incurred but not enough reported (IBNER) claims costs. When all the elements which make
up the company’s claims reserves are reviewed (usually quarterly), senior management
decide whether to increase or reduce them based on analysis of the general level of case
reserves (too low, too high or about right?) and views of claims trends and costs (including
the future impact of inflation, claim frequency, legislative changes and earnings from
investment income). They may wish to reserve additional capital to deal with a potential
increase in industrial disease claims in the future or to make provision for a very significant,
recent event until a clearer view of total costs emerges (for example, immediately after a
catastrophic event).

In making these decisions, senior management may be supported by both internal and
external actuaries and will consult senior claims and underwriting managers. While their
objective is to ensure that the company is more than adequately funded to meet current and
future claims liabilities, it is not in any company’s interest to be grossly over-funded due to
the cost of capital and the necessary impact on pricing. In addition, reserves regarded by the
authorities as excessive will be liable to taxation.

Therefore, insurance companies’ general claims reserves move frequently in order to

maintain an acceptable balance between prudence and cost, as well as reflecting the ongoing
intimation, estimation and settlement of claims.

Be aware
 The net result of movements in claims reserves is shown on the income statement in a company’s financial results.
Sometimes a company will specifically refer in the results commentary to the fact that reserves have increased in
respect of a particular type of claim (for example, asbestos-related claims). The timing and scale of reserve releases
can be very important in maintaining underwriting profitability/an acceptable combined operating ratio (COR). The
detail of claims reserve movements will be available internally at class level.

Research activity
Ask your manager for claims reserving information for a familiar class of business. If access to current information is
confidential, you could see if older, out-of-date information is available which will still provide an overview of the
approach adopted.

Although general claims reserves can be (and are regularly) adjusted at an aggregate level,
insurers remain anxious to demonstrate the accuracy of their case-estimating and general
reserving processes. Claims run-off (the eventual outcome of these processes as claims are
settled) is monitored closely by a number of external parties and will often be used as an
indicator of a company’s competence and the degree of security offered. A company’s external
credibility is likely to be undermined if its claims run-off is either significantly negative (that
is, claims have been under-reserved and have cost much more than expected) or significantly
positive (claims have been over-reserved and the company has held capital in reserve
unnecessarily).

Critical reflection
How would the following groups view an insurer which produced significantly positive or negative claims run-off?

Regulators
Shareholders
Intermediaries and their clients
Other insurance companies
Internal staff – underwriters and claims handlers
B Claims reserving and underwriting
Consideration of how underwriters use claims experience (number of claims and claims cost)
to evaluate and price individual risks, accounts and products highlights three points in
respect of claims reserving:

The confidence with which risks, accounts and products can be evaluated and priced is
dependent upon the quality, accuracy and consistency of case-estimating and reserving
processes undertaken by claims and actuarial staff and underwriters’ understanding of
those processes and their outputs.
In many instances, data consisting solely of paid plus outstanding claims will not provide
sufficient information to indicate the total cost of claims. At any point in time, the
actuarial assessment may indicate the need to adjust these values to produce a true or
ultimate cost.

Be aware
Adjustments should not be contemplated without actuarial advice.

The need for close liaison between claims, actuarial and underwriting is apparent.

B1 Individual policies
Good practice dictates that renewal underwriters check for recent claims intimations and any
updated estimates before offering renewal terms on individual policies. It is necessary to
review any large or potentially contentious claims with claims colleagues in order to be fully
informed regarding the circumstances of the claims and claims department’s approach to
their handling and estimation. With this background information, underwriters are then well-
placed to discuss the risk’s claims experience with the insured and/or their intermediary and
avoid prolonged debate regarding the accuracy of individual reserves.

While resisting the temptation to accede to intermediaries’ requests to discount claims

estimates (based on the assertion that ‘your company’s estimates are always too high’),
underwriters may over time recognise a bias in the claims estimating process in respect of a
particular type of claim and this should be discussed with the claims department.

Underwriters need to have confidence in the company’s claims handlers and their approach
and, therefore, should be assisted and encouraged by their managers not only to monitor how
individual claims develop but how the overall account’s claims development patterns and
run-off are reflected in the actuaries’ assessment of the overall performance of the account.

B2 Portfolios
It is evident that a simplistic approach to profitability or pricing, which ignores general claims
reserves (and their movements), could lead to highly inaccurate conclusions. Thus, in a
liability account which has incurred several exceptionally large claims in a single year, all of
which are still outstanding, the actuarial assessment may be that while each individual case
estimate looks appropriate in the light of current knowledge, the aggregate value of these
estimates is possibly excessive. If agreed, a negative adjustment could be applied to the
general claims reserve for liability and this adjustment (and its value) should be used in any
concurrent profitability review or pricing exercise for relevant liability products.

In the case of a high volume product, such as personal motor, actuaries will monitor closely
the number of claims intimated each month. If the number intimated reduces (due to
backlogs, sickness or holidays in claims department), the actuaries are likely to increase the
allowance for IBNR in the motor claims reserves until productivity resumes its former level.
As above, this adjustment should be utilised in any work involving profitability or pricing for
the motor account.

B3 Liaison
Think back to M80, chapter 4, section G and chapter 5, section C

The value, or rather necessity, of good liaison between underwriting, claims and actuarial is
highlighted most clearly when considering the uses and interpretation of claims data. Each of
the three parties has their own clear responsibilities and requirements but each needs to
consult with the other two in order to achieve a full understanding. Changes in underwriting
policy and/or practice can have knock-on effects on claims numbers and costs and their
subsequent development patterns. As noted above, even temporary backlogs in claims
department can affect claims experience and its interpretation. If actuarial decides to
increase an account’s IBNR/IBNER reserves but fails to advise the relevant underwriting
manager, there is the likelihood that risks in the account will be under-priced.

Be aware
Liaison between underwriting and claims staff is also essential in respect of policy wordings and cover changes,
emerging risks and trends, anti-fraud initiatives and, of course, individual claims.

It should be noted that such liaison is made more difficult where any of the functions are
outsourced or delegated. In such circumstances, greater efforts are required to ensure that
very regular formal liaison takes place.
C Forecasting to ultimate: approaches and techniques
As we have discussed, in determining overall claims reserve levels, members of senior
management are advised by actuaries who use a range of statistical techniques to forecast
the ultimate cost of claims. Although underwriters are not required to conduct such statistical
analyses, you will be expected to discuss and help validate the results (to identify any
underlying changes which may be affecting the incidence of claims or claims costs, for
example) and to utilise the information in your own work (particularly in pricing and
planning). It is therefore important that underwriters have an appreciation of how actuaries
approach this work and why the use of different techniques can produce different results.

The first main approach is the projection and monitoring of specific groups of claims from
intimation to their eventual settlement. Claims are normally analysed at class level (for
example, liability or property) to ensure that the dataset is as large and representative as
possible.

Be aware
Prior to their inclusion in datasets used for reserving, the quality of claims data is assessed by testing for unexpected
values and internal consistency.

Short- and long-tail claims, very large claims and groups of claims arising from specific
exposures (e.g. industrial deafness claims) may be projected separately. For this type of
analysis, claims are selected on an accident year basis (relating to the period of exposure
rather than when a claims cost is incurred). This ensures that important underlying factors
such as the rate of claims inflation or judicial guidelines are common for the claims selected.
It also enables the projected claims costs to be measured against the appropriate earned
premium and exposure figures to create ultimate earned loss and burning cost ratios.

C1 Claims development triangles

Claims development triangles are the most effective way of presenting this data and separate
triangles may be created for the:

number of claims intimated;

value of paid claims only; or
value of incurred claims (paid plus outstanding estimates).

Be aware
Essentially the methods used seek to identify patterns in the development of claims data: their progression from
year to year.

Figure 6.1: Claims development triangle – claims numbers

 Number of intimated claims as at 31/12/2015

Development year

Accident year 1 2 3 4 5 6

2010 720 1,010 1,200 1,205 1,205 1,205

2011 514   928 1,178 1,188 1,190

2012 750 1,050 1,250 1,258

2013 729   979 1,115

2014 762 1,065

2015 770

NB: Claims settled at ‘nil’ cost have not been removed from the above.

Figure 6.2: Claims development triangle – incurred claims costs

Incurred claims costs (£) = Paid plus outstanding as at 31/12/2015

Development year

Accident year 1 2 3 4 5 6

2010   779,040 1,924,050 2,268,000 2,289,500 2,417,230 2,385,900

2011   514,000 1,866,208 2,404,298 2,387,880 2,859,570

2012   936,750 1,899,450 2,755,000 2,893,400

 2013   920,727 1,965,832 2,654,815

2014 1,120,140 2,252,475

2015 1,178,100

Please turn to appendix 6.1 to see how data in claims triangles may be used, including the use
of link ratio techniques.

Is there a typical reserving pattern and mix of methods?

For many classes of business a typical reserving pattern will be one in which the account is
under-reserved at first, over-reserved at a certain point and then, as the larger claims finally
settle, the ultimate total cost emerges.

Not only are there many ways in which this data may be projected but actuaries will
deliberately use a number of different methods in order to test the validity and robustness of
the answers they derive. Some methods involve the projection of loss ratios and burning
costs, as well as the number and cost of claims. The selection of methods will be determined
by the nature, size and maturity of the claims dataset in question.

Bornhuetter-Ferguson method
The Bornhuetter-Ferguson method/technique is an example of the combination of reserving methods: it uses a
loss ratio projection in the early years of development and assigns increasing weight to the paid or incurred claims
development pattern over time.

Referring to the incurred claims costs triangle shown in figure 6.2, if you knew that the earned premium for Accident
Year 2010 was £3.7m, you could present the pattern of claims development for that year as a succession of loss
ratios: 21%; 52%; 61%; 62%; 65% and, finally, 65% for 2010 as at end 2015. The Bornhuetter-Ferguson technique is
designed to assist the development and monitoring of claims reserves for accounts whose incurred (or paid) claims
amounts are very low in the years immediately after the year of exposure. Rather than the pattern of loss ratio
development illustrated above, the early years of a long-tail account might start with loss ratios around 5%, building
to a final ratio of, say, 65% after ten or more years.

The Bornhuetter-Ferguson technique utilises an account’s anticipated final loss ratio and its typical loss ratio
development pattern to arrive at the ultimate cost and an appropriate claims reserve for each year of development.
In this example, if the typical loss ratio in the first year of development is 5%, the ultimate cost will be assumed to
equate to the first year’s ratio plus 60%: thus equalling the anticipated final loss ratio of 65%. However, if at the end
of the first year the actual ratio is 6%, the ultimate cost would be assumed to equate to 66% (60 plus 6%) of
premium income and the claims reserve would be the equivalent of 66% of premium income less any paid claims. As
years pass and the actual claims experience becomes better developed, the calculation of the ultimate claims cost
becomes increasingly based on the actual experience rather than the anticipated loss ratio.

C2 Stochastic methods
Think back to M80, chapter 4, section F3
The second main approach involves stochastic methods, which examine the randomness or
variability of the incidence and cost of claims. Rather than restricting the projection of
ultimate claims costs to an analysis of historical costs, this approach considers the likelihood
of different numbers of claims and different claims costs occurring. It is easy to see how
useful and necessary this approach would be if the account in question was newly established
or relatively immature.

Even for large, long-established accounts, actuaries must consider different claims scenarios
to reflect:

underlying trends in exposures;

catastrophe claims (for example, the incidence and cost of floods); and
latent claims (for example, disease claims arising from modern industrial processes,
which are as yet unrecognised).

Even the largest claims dataset does not contain the cost of the largest claim possible because
it has not happened yet. However, in their assessment of overall claims reserves, actuaries
and senior management must consider the potential impact of such extreme values (by
modelling the statistical distribution of claims severity and frequency). This is a very difficult
judgment to make and the decision is critical to the success and survival of the company: it
impacts the amount of capital raised and set aside, the amount of reinsurance bought, pricing
and the company’s profitability. Much depends upon the actuaries’ assessment of the relevant
claims dataset: does it already contain an adequately representative number of very large
claims? The company may contract external actuaries, with a broader view of general
insurance claims experience, to assist with issues of this sort.

C3 The value of claims now and at settlement

The ultimate claims cost is intended to represent the total anticipated cost of claims at their
dates of settlement. In arriving at these values, inflation presents particular challenges,
irrespective of the method used: what is the appropriate rate or rates to use when projecting
ultimate claims costs? Different inflation rates apply to different types of claim and to
different elements within individual claims.

Example 6.1
The cost of settling bodily injury claims in the UK continues to outstrip rates of general inflation. As bodily injury
claims represent some of the largest and potentially longest-outstanding individual claims in a general insurer’s
account, the choice of inflation rate to use in projections is critical as its impact will be compounded over a number
of years until the projected settlement date. Of course, as individual case estimates for bodily injury claims already
include an allowance for inflation to the date of assumed settlement, the actuaries’ task involves both assessing the
likely current and future applicable rates of inflation and evaluating the effectiveness of claims estimation processes.

With the assistance of finance colleagues, actuaries must also consider what return might
reasonably be achieved on the investment of claims reserves. Between the payment of
premiums and the eventual settlement and payment of the largest liability claims, there could
be a time lag of many years, if not decades. Although the typical time lag is generally much
shorter for most property damage claims, any time lag between the receipt of premium
income and the payment of claims provides an opportunity to invest available funds: the
longer the time lag, the greater the return. Of course, the actual return achieved by insurance
companies also depends upon prevailing rates of return in the market, their control of cash
flow and investment management skills.

The settlement value of outstanding claims can therefore be discounted by ‘the time value of
money’ in the assessment of current claims reserves. If the settlement value of a group of
claims, anticipated to settle in three years’ time, is estimated at £10m, the claims reserve
which must be put aside today is £10m less three years’ compounded investment return. The
assumed, reasonable level of investment return is referred to as the ‘discount rate’.

Be aware
For most classes of general insurance, discounting is not permitted under Solvency II when an insurer calculates
solvency capital requirement (SCR).

Refer to chapter 1, section B.

The interaction of rates of inflation and typical rates of return on investment varies
considerably over time and therefore has a very marked impact on claims reserving and
company profitability. The current high rates of claims inflation in respect of bodily injury
claims are not in any way compensated for in prevailing investment returns, which have been
at particularly low levels in recent years.

C4 Validating approaches and techniques

As well as recommending general reserve adjustments which are reported in the financial
accounts and statutory returns to the regulator, actuaries monitor the accuracy of their
processes and models. Having determined an agreed ultimate cost for a particular class of
business by accident year, actual claims payments are then measured as a percentage against
the assumed ultimate cost.

Figure 6.3: Development of employers’ liability claims payments

Figure 6.4: Development of property claims payments

These graphs compare the development of two classes of business, employers’ liability and
commercial property insurance. The graphs are scaled to eliminate differences in the size of
the portfolio from year to year and therefore clearly highlight the claim development
patterns. For example, the employers’ liability claims payments only approach the 100% level
(of ultimate claims cost) around years 8 to 10, whereas commercial property claims
payments reach the 80–90% level after about two years. It can be seen that even with
commercial property claims, a small number will remain open several years after the year of
exposure.

Before considering claims data quality and interpretation more generally, there are a few
points regarding reserving processes that underwriters might bear in mind:

It is well worth taking every opportunity to be involved in reserving reviews: there is a

lot to learn that will be to your and your account’s advantage. You will note that many of
the methods used in pricing (see chapter 7) are directly comparable to those used in the
estimation of ultimate claims costs.
The actuaries are likely to be keen to encourage your involvement as reserving feeds into
the capital and risk work associated with Solvency II and you will be required to
demonstrate how consideration of risk has influenced your own work on pricing and risk
selection.
Think about the extent to which ‘uncertainty’ increases the cost of writing certain types
of business. Liability claims are intimated and settled over an extended period of time:
the uncertainty over their ultimate cost increases the amount of capital which must be
held in reserve and thus its cost. Property damage insurance, both domestic and
commercial, is subject to an increasing number of severe storm claims in the UK: how
much capital needs to be held in reserve to cover the unexpired risk of such policies?
You may feel that the overall approach adopted by the actuaries does not entirely suit
your own account. This may not be material at the level of the company’s reserves but
your concern needs to be acknowledged and borne in mind when general reserve
adjustments are considered for use in lower-level pricing exercises or when the ultimate
profitability of different accounts is being evaluated.
Of course, no model is perfect: none can replicate reality. Models and techniques need to
be chosen and utilised correctly; they require the appropriate volume and quality of data
and appropriate parameters to be applied (such as rates of inflation or exchange rates).
D Interpretation and use of claims information

D1 Claims practice
Be aware
The importance of consistency in the interpretation and use of claims data should not be underestimated.

Examples of changes in practice or performance which may lead to misinterpretation:

At intimation, claims are given a formula or standard estimate until they can be properly
case-estimated. If the formula estimate is increased without notice, underwriters could
easily assume that an account’s overall claims experience had deteriorated.
In some classes of business, notably liability, a significant proportion of claims are
intimated but not subsequently pursued. Such claims will be formula- and then case-
estimated but will eventually be settled at ‘nil’. If the claims department reduces the
standard period they allow to elapse before closing such claims and settling at ‘nil’, the
relevant account performance will appear to have improved. If a higher proportion of
claims have to be subsequently reopened as a result of this change, this too could affect
the interpretation of the account’s performance.
As already noted above, the general pattern of productivity within claims departments
and any changes to this pattern can affect the interpretation of claims experience figures.
For example, if backlogs increase in intimating claims, reviewing case estimates or
settling claims, the relevant claims experience will be affected but some of the effects will
be more immediately evident than others. If case estimates are not being reviewed as
regularly as they should be, claims development patterns will be affected with possible
effects on reserving and eventual run-off. This latter development could be particularly
damaging if actuarial and underwriting are unaware of the issue.

D2 Claims data
Claims data is collected, categorised, manipulated and used for different purposes by a range
of internal and external groups and this presents significant challenges in its interpretation
and use.

Example 6.2
While underwriters are very interested in analysing the causes of claims in considerable detail, most claims handlers
have limited time to consider the fine distinctions between such causes and may not have the necessary information
to make an appropriate choice of cause code until some time after the claim has been intimated. An inappropriate or
default value may be entered at intimation and never subsequently reviewed or rectified. Senior claims staff are
likely to review text describing the cause rather than looking at the allocated code.

This is only one example of the data demands placed on claims handlers which, taken
together, can prove counterproductive. This comment is intended as a warning to
underwriters, rather than a criticism of claims handlers.
An underwriter’s claims data checklist:
When requesting new claims data fields, please distinguish between necessary and nice-
to-have items and look for ways of rationalising your requirements rather than adding to
them.
Be careful to validate extracted claims data which plays no functional part in the claims
handling process, particularly if you are using the data for the first time or after a long
interval. Often a common-sense check (How well-spread are the values chosen? How
often has the default value been chosen?) and some sampling will provide a fairly quick
indication of whether the data is of value or not.
Please do not assume that a field is being used in accordance with its label (or how you
interpret the label): check with claims handlers first.
You should request that claims quality control procedures include checks on the fields
you regard as critical.

D3 Claims reports
These warnings necessarily extend to claims reports: both pre-existing reports you may be
given and reports you specifically request.

Be quite certain you understand the following:

Where was the base data used in the report extracted from? Sources, fields and their use?
How has the data been selected and ordered? Which time periods? Incurred or accident
year basis?
What has been included/excluded? Recoveries? Settled claims only? Claims over or under
certain values? Formula as well as case estimates? Nil claims?
Have any adjustments have been made to the data? Reserve adjustments? Removal of the
cost of catastrophes or particularly large individual claims?

Just because an existing claims report is produced for the actuaries or some other group, it
does not automatically follow that it must be what you require for your own purposes. The
report may have been designed for a very specific purpose and could easily be
misinterpreted. There are many ways of analysing and interpreting claims experience and in
order to arrive at a valid interpretation (one suited to the nature of your inquiry), it is
necessary to identify suitable data and an appropriate method of analysis. Although these
remarks could be applied to all areas of statistical analysis, they are particularly pertinent in
respect of claims data.

You need ‘the right tools for the job’ but often the hardest part of determining what kind of
statistical analysis, report or data is required is formulating the precise enquiry. We will
consider this issue again in later chapters as part of our examination of pricing and
monitoring, but at this point we can review why the same claims data is presented in different
ways for reporting purposes.

What form do your company’s monthly (management account) results take? Are they
presented on an incurred (also referred to as underwriting year basis) or accident year basis?

Figure 6.5: Example of accident year basis of reporting

Accident year (January to December)

Year of GWP As at end Earned Claims Claims Outstanding Total Earned

account £ premium count paid £ loss ratio
£ £ £

2012 100 2012 50 2 5 20 25 50%

2013 100 10 20 80 100 100%

2014 100 11 50 150 200 200%

Jun-15 100 11 75 100 175 175%

2013 120 2013 60 2 10 20 30 50%

2014 120 8 20 60 80 67%

Jun-15 120 9 20 100 120 100%

2014 200 2014 100 4 15 40 55 55%

Jun-15 175 8 50 50 100 57%

2015 100 Jun-15 25 1 10 10 20 80%

(as at Jun-
15)
 Figure 6.6: Example of incurred (or underwriting year) basis of reporting

Underwriting year or incurred basis

As at end GWP Earned Claims Change in Total Earned

£ premium paid in outstanding £ loss ratio
£ period
£ £

2012 100  50  5  20  25  50%

2013 120 110 25  80 105  95%

2014 200 160 55 150 205 128%

Jun-15 100 100 70  10  80  80%

The accident year basis shows the cumulative position for each individual year of account, at
specified intervals.

The incurred or underwriting year basis summarises the changes in all years of account
which have taken place since the last report, resulting in a total of earned premium and claims
incurred in the period.

Example 6.3
An illustration of the calculation of incurred claims as at end June 2015:

Year of account Claims payments Outstanding claims

2012 as at June 2015 (£75 minus 50) = +25 (£100 minus 150) = −50

2013 as at June 2015 (£20 minus 20) = 0 (£100 minus 60) = +40

2014 as at June 2015 (£50 minus 15) = +35 (£50 minus 40) = +10
 2015 as at June 2015 +10 +10

Total incurred claims at June 2015 +70 +10

Some insurers, notably those based at Lloyd’s, reinsurance companies and those providing
capacity to managing general agents through binders or to scheme brokers, need to keep
track of the performance of different years (or periods) of account until they are fully run-off
because their participation in specific risks or arrangements may vary considerably from
year to year. Although all insurers regularly analyse their performance on an accident year
basis, many use the incurred or underwriting year basis of reporting as a more convenient
method of monitoring the performance of an account on a month-by-month basis.

Example 6.4
In a long-standing commercial combined account, there are likely to be a small proportion of claims which remain
outstanding ten years after the year of exposure. There will also be an even smaller proportion of claims which are
first intimated many years after the year of exposure (typically employers’ liability or environmental liability
claims). Although these outstanding/late claims may be amongst the largest claims incurred, is it worth restating
every single accident year of account each month to track the progress of these few claims? For most years of
account, nothing will change in the course of an individual month and there are easier ways to track the progress of a
small number of specific claims.

It should be noted that accounts which are changing rapidly are more easily understood using
accident year data and should be planned/budgeted and monitored on that basis. As noted
earlier, actuaries use accident year data to project ultimate costs as all the claims share a
common period of exposure. If analysis is based purely on incurred or underwriting year data,
it may miss key trends and result in poor management decisions.
Summary
The main ideas covered by this chapter can be summarised as follows:

Claims reserving takes place in two stages within general insurance companies.
Individual claims are case-estimated in order to establish their likely eventual total cost.
In addition, actuaries monitor the overall level of case reserves by regularly projecting
their likely total claims cost as a whole and may recommend a general adjustment to
aggregate claims reserves in the company’s financial accounts.
The value of good liaison between underwriting, claims and actuarial is highlighted when
considering the use and interpretation of claims data. Each of the three parties has their
own clear responsibilities and requirements but each needs to consult with the other
two in order to achieve a full understanding.
Claims development triangles are the most effective way of presenting claims data and
separate triangles may be created for the number of claims intimated, the value of claims
paid or the value of incurred claims. The claims development triangles can be used to
calculate average claim costs and burning costs.
Claims data is collected, categorised, manipulated and used for different purposes by a
range of internal and external groups, and this presents significant challenges in their
interpretation and use.

Bibliography
Institute and Faculty of Actuaries. (1997) Claims reserving manual.
www.actuaries.org.uk/search/site/Claims%20reserving%20manual
Appendix 6.1: Claims development triangles: scenario
analysis and discussion

The purpose of this discussion is not to look for concrete answers but rather to prompt awareness and consideration
of techniques and issues.

The two claims development triangles in figures 6.1 and 6.2 (below, as A and B) presented
claims numbers and incurred claims cost data relating to a particular account over the period
2010 to 2015. For the purposes of this discussion, the nature of the account (class, cover-type
or mix) is unspecified.

A: Number of intimated claims as at 31/12/2015

Development year

Accident year 1 2 3 4 5 6

2010 720 1,010 1,200 1,205 1,205 1,205

2011 514   928 1,178 1,188 1,190

2012 750 1,050 1,250 1,258

2013 729   979 1,115

2014 762 1,065

2015 770

NB: Claims settled at ‘nil’ cost have not been removed from the above.

B: Incurred claims costs (£) = paid plus outstanding as at 31/12/2015

Development year
 Accident year 1 2 3 4 5 6

2010   779,040 1,924,050 2,268,000 2,289,500 2,417,230 2,385,900

2011   514,000 1,866,208 2,404,298 2,387,880 2,859,570

2012   936,750 1,899,450 2,755,000 2,893,400

2013   920,727 1,965,832 2,654,815

2014 1,120,140 2,252,475

2015 1,178,100

In this scenario, you are completely unfamiliar with the account which has produced the
above claims experience but you know that you will be asked to forecast the ultimate claims
cost for the period 2010 to 2015. Before considering how best to project the claims cost, you
must assess the data in front of you.

As noted in the chapter text, claims data must be subjected to quality and consistency checks:

Is the data comparable?

Have all the claims arisen from the same or very similar coverages?
Regarding the accounts or policies which have generated the claims experience, has
anything of significance changed in the period?
Have the claims been handled and presented in a consistent manner?
Have all the claims been updated to a common point in time?

When actuaries assess huge volumes of claims data, they use computer programs and
statistical techniques to highlight and attempt to explain unexpected values and trends, in
order to validate the data. They will consider whether they have enough data to rely upon any
projections they might make and they will assess the volatility of the data: based on this data,
how credible will the projections be?

Without the benefit of computer programs, what do you notice about the data in triangles A
and B?

Possible answers
Numbers:
By Development Year 3, the claims numbers appear to be close to a ‘final’ number but the
experience of 2011 Accident Year demonstrates that new claims may be intimated even in
the fourth year after the year of exposure.

The overall number of claims intimated per year appears to be rising (look at the
Development Year 1 column). What’s happening to exposure?

In Development Year 1 for 2011 Accident Year something unusual happened: far fewer
claims were intimated than in other years but by Development Years 2 and 3 the 2011
number of claims looked more typical. What might have caused this? An internal cause such
as processing delays? External causes?

Incurred claims costs:

Typical incurred claims costs appear to be rising over the period 2010 to 2015.

The incurred claims cost for 2011 Accident Year in Development Year 1 looks unusually low:
solely due to the low number of intimations?

Overall the number of claims and level of claims costs do not appear to be particularly
volatile: with the exception of 2011 Accident Year, no obvious signs of very variable
numbers of intimations, year-on-year, or any very large claims.

One of the techniques used to highlight development patterns in claims triangles is to

calculate the differences from one development period to the next.

C: Differences in intimated claims

Development period

Accident year 0 to 1 1 to 2 2 to 3 3 to 4 4 to 5 5 to 6

2010 720 290 190  5 0 0

2011 514 414 250 10 2

2012 750 300 200  8

2013 729 250 136

 2014 762 303

2015 770

D: Differences in incurred claims costs (£)

Development period

Accident year 0 to 1 1 to 2 2 to 3 3 to 4 4 to 5 5 to 6

2010   779,040 1,145,010 343,950   21,500 127,730 −31,330

2011   514,000 1,352,208 538,090  −16,418  471,690

2012   936,750   962,700 855,550  138,400

2013   920,727 1,045,105 688,983

2014 1,120,140 1,132,335

2015 1,178,100

For the number of intimated claims, the ‘differences’ triangle certainly highlights how
unusual the 2011 Accident Year experience was in Development Year 1 and the extent to
which a higher-than-average number intimated in Development Year 2 largely compensated
for this.

Similarly, for incurred claims costs the ‘differences’ triangle highlights the extent to which
costs typically rise in Development Year 2 (not solely due to the intimation of new claims) and
the variability in experience after Development Year 3.

Ten new claims were intimated for 2011 Accident Year in Development Year 4 but the total
incurred claims cost fell by £16,418. This might suggest that a number of larger claims or a
single large claim was settled for significantly less than expected and the release more than
compensated for the additional cost of the new claims. What happened in the following year:
were one or two of these large claims re-opened or were the two new claims intimated in
Development Year 5 responsible for the apparently high incurred cost that year?

By this stage in the analysis it is apparent that the use of claims triangles without access to
the underlying claims data is severely limiting. Although the level of total incurred claims
costs does not suggest the presence of any very large claims, there may be a number of larger
claims which, particularly if concentrated in a particular year, could have a distorting effect.

Nor can the rate of settlement be assessed. By Development Year 3 or 4, what proportion of
claims are still outstanding? And what relationship does the total outstanding amount bear to
total claims payments? Although the incurred claims costs triangle shows the total cost
generally stabilising after Development Year 3, if a significant proportion of claims remain
outstanding (or the outstanding amount is particularly high) then the ultimate cost remains
highly uncertain.

For 2010 Accident Year, no additional claims have been intimated since Development Year 4
and the incurred claims cost fell in Development Year 6 (which may indicate the settlement of
a larger claim) but all these ‘run-off’ signals could be quite misleading without the
confirmation of separate paid and outstanding claims amounts.

In an attempt to discern and monitor development patterns in claims costs (paid, outstanding
or total incurred), report-to-report or link ratios can be created. The ratios are calculated by
dividing later claims values by earlier values. This is the basis of the chain ladder technique,
which is widely used in projecting the claims cost of individual accounts and in claims
reserving at class/company level.

E: Link ratios for incurred claims

Link ratios (incurred claims costs)

Accident year 2/1 3/2 4/3 5/4 6/5

2010 2.47 1.18 1.01 1.06 0.99

2011 3.63 1.29 0.99 1.20

2012 2.03 1.45 1.05

2013 2.14 1.35

 2014 2.01

Average  2.32* 1.32 1.02 1.13 0.99

* The calculation of the average ratio reflects the weighting attributable to the total value of claims costs in the relevant development periods: although
2010 and 2011 have very high Year 2:Year 1 ratios, 2012 and 2013 have higher total claims costs (see Triangle B). A ‘volume’ weighted average of
2.32 is therefore more appropriate than an average of the discrete Year 2:Year 1 ratios (2.46).

Particularly when a claims development triangle includes data from many accident years, it is
worth considering the ‘average’ factors based on all years (as above), as well as from a more
recent group, say, the last six or three years. This process may highlight relevant changes or
trends over a longer period of time which an overall average might disguise.

It is worth noting that the validity of this technique relies upon the fundamental compatibility
of the data: it assumes that any differences from year to year are caused by random variations
rather than inherent differences.

As regards this particular triangle of link ratios, how useful might it be in projecting ultimate
claims costs?

Possible answers
To provide a reasonably reliable ultimate claims cost, you would want to have at least a
couple of accident years which had produced ‘1.0’ ratios (that is, no change) in succeeding
years, as well as knowledge of the nature of the account: how likely are late-reported claims?
In this example, there appears to be too much variability in the individual ratios after
Development Year 3. Knowledge of the amounts outstanding might counteract this
impression, if relatively low.

Although weighted, the average ratio for Year 2:Year 1, at 2.32 still appears high due to the
influence of 2010 and 2011 Accident Years. The average ratios for Year 5:Year 4 and Year
6:Year 5 also appear unreliable due to scant data.

This is, of course, an illustration of the use of a link ratio technique at its most basic form of
application. In reality, not only would actuaries work with far larger claims databases and
examine the data in far greater detail (for example, separating attritional and large losses and
identifying distortions and trends), they also have at their disposal a range of link ratio
techniques which are designed to use the data to best effect and produce more considered,
credible projections.

Actuaries would also look at the development of other, similar accounts as a source of
potential benchmark development factors. For example, if the account in our example had
just been acquired from another insurer and you already had a similar account, with a longer
run of developed claims experience, you might have the confidence to either confirm the
average Year 2:Year 1 ratio of 2.32 as valid or to amend it, based on ratios derived from the
existing account.

In this particular example, we will use the average link ratios to project a developed – but not
necessarily ultimate – claims cost for the Accident Years 2011 to 2015 inclusive.

F: Incurred claims costs, actual and projected, using link ratios (£)

Development year

Accident year 1 2 3 4 5 6

2010   779,040 1,924,050 2,268,000 2,289,500 2,417,230 2,385,900

2011   514,000 1,866,208 2,404,298 2,387,880 2,859,570 2,830,974

2012   936,750 1,899,450 2,755,000 2,893,400 3,269,542 3,236,847

2013   920,727 1,965,832 2,654,815 2,707,911 3,059,940 3,029,340

2014 1,120,140 2,252,475 2,973,267 3,032,732 3,426,988 3,392,718

2015 1,178,100 2,733,192 3,607,813 3,679,970 4,158,366 4,116,782

The figures in bold are the projected claims costs. (For 2015 Accident Year, for example, the
incurred claims cost has been projected to its 2020 level by the use of the ratios 2.32, 1.32,
1.02, 1.13 and 0.99, successively.)

The projection indicates that the IBNR amount for 2011 to 2015 inclusive should be a
minimum of £4,768,301. This was calculated as follows: the sum of the Development Year 6
projected incurred claims costs for 2008 to 2012, inclusive, LESS the sum of incurred claims
costs for 2011 to 2015, inclusive, as at 31/12/2015: £16,606,661 less £11,838,360 =
£4,768,301.

Based on the available information, it is not safe to assume that 2010 Accident Year is fully
run-off and therefore an IBNR will be required for Development Year 7 onwards: hence the
above calculation for 2011 to 2015 Accident Years should be regarded as a minimum. If more
was known about the nature of the account, we would be able to assess the likelihood of late-
reported or latent claims.

Are you satisfied that the available data has been used as effectively as possible? What else
could be done with the data and what value might further analysis produce?

Possible answers
You could calculate average claims costs. This might provide an indication of the presence
of large claims or an influx of smaller claims; also, an indication of rates of claims inflation.

G: Average claim (£)

Development year

Accident year 1 2 3 4 5 6

2010 1,082 1,905 1,890 1,900 2,006 1,980

2011 1,000 2,011 2,041 2,010 2,403

2012 1,249 1,809 2,204 2,300

2013 1,263 2,008 2,381

2014 1,470 2,115

2015 1,530

A simple assessment of average costs in Development Years 1 and 3 would seem to indicate
that costs are increasing by 7 to 8% per annum.

With information on exposure two further forms of analysis may be undertaken: the
calculation of claim frequency and burning cost. The objective of the exercise remains the
projection of a developed or ultimate claims cost for reserving purposes: by examining the
development of claim frequency and burning cost (as well as average claims cost, above), we
may be able to identify impacts and/or trends which will help to refine and validate our
assessment of developed claims costs.
 H: Claim frequency = number of intimated claims divided by exposure units (%)

Development year

Accident year Exposure units 1 2 3 4 5 6

2010 5,000 14.4 20.2 24.0 24.1 24.1 24.1

2011 5,020 10.2 18.5 23.5 23.7 23.7

2012 5,040 14.9 20.8 24.8 25.0

2013 5,060 14.4 19.4 22.0

2014 5,080 15.0 21.0

2015 5,100 15.1

The claims frequency triangle confirms that the rise in the number of claims intimations is
due both to a rise in exposure and to an increase in claims frequency. Although Year 1 claim
frequency has breached the 15% level in the two latest years, 2014 and 2015, will it develop in
a more typical fashion by Year 3?

I: Burning cost (actual and projected incurred claims costs divided by exposure units) (£)

Development year

Accident year Exposure units 1 2 3 4 5 6

2010 5,000 155.8 384.8 453.6 457.9 483.4 477.2

2011 5,020 102.4 371.8 478.9 475.7 569.6 563.9

2012 5,040 185.9 376.9 546.6 574.1 648.7 642.2

 2013 5,060 182.0 388.5 524.7 535.2 604.7 598.7

2014 5,080 220.5 443.4 585.3 597.0 674.6 667.9

2015 5,100 231.0 535.9 707.4 721.6 815.4 807.2

Finally, the burning cost triangle (which also uses the claims costs projected with the
internally derived link ratios) provides a summary of how the claims costs for this account
have developed and may continue to develop, independent of changes in exposure.

As noted above, we are not confident regarding the validity of some of the link ratios derived
from the account and this uncertainty bears most heavily on the projection of 2015 Accident
Year claims costs. If claims inflation is indeed running at 7 to 8% per annum, the developed
cost of 2015 Accident Year by 2020 (Development Year 6) will be heavily influenced by how
quickly the intimated claims are settled. Each year’s delay in settling a claim could increase
the outstanding amount by the prevailing rate of inflation.

Would it be helpful to know the written premium for each year from 2010 to 2015, inclusive?

Possible answers
In some instances, written premium might have to substitute for exposure, where no other
suitable measure exists.

In other circumstances, written premium might be regarded as a more sensitive and

comprehensive measure of exposure to risk than other more conventional measures which
focus on a single feature (such as, sum insured or EML).

On the other hand, because other factors – independent of insured risk – affect premiums
(such as competition and the competence of underwriters), written premium could prove to
be a very unreliable proxy measure for exposure, particularly in an unfamiliar account.

No further information will be provided in the time available for your assessment: are you
happy to recommend the use of the projected claims cost figures as they stand (triangle F)?

Possible answers
Before making your recommendation, you must consider the integrity of the process which
has helped you to arrive at these answers:

Appropriate techniques?
Sufficient, comparable data?
 Valid assumptions?
Adjustments based on justifiable and documented considerations?

Even if the process has had integrity, you may still not be confident in the result.

You must express your reservations to those who may use any projected figures.

In this scenario:

knowledge of the nature of the account;

access to the underlying data or, at least, separate paid and outstanding claims costs;
and
comparison with similar accounts;

would greatly enhance the confidence with which the developed cost – and possibly, the
ultimate cost – could be projected.
 7 Pricing

Contents Syllabus learning

outcomes

Learning objectives

Introduction

Key terms

A Data for pricing 3.1

B Projecting claims experience 3.3, 3.5

C Rating structures and prices 3.2, 3.3

D Other pricing components 3.3, 3.4

E Experience rating 3.3

F Conclusion: collaboration and judgment

Bibliography

Scenario question and answer

Appendix 7.1: Risk premium projection

Appendix 7.2: Impact of pricing, expenses and volumes on profitability

Learning objectives
This chapter relates to syllabus section 3.

On completion of this chapter and private research, you should be able to:

identify the nature and source of data used in pricing, including the input of other
professional groups;
explain how the adequacy of available data is assessed;
describe different statistical methods for risk pricing and evaluate their output;
explain the principles behind the creation of rating structures; and
explain how pricing components impact upon profitability.
Introduction
What do you associate with the word ‘pricing’?

Or

Pricing involves all of these activities and many other variations. It is not the intention in this
chapter to cover any of these activities in detail but rather to consider the common inputs,
issues and techniques which these activities share.

It is likely that your company uses its own specific blend of methods to assess the profitability
of different accounts and products and to arrive at appropriate prices and rates.
 Research exercise
Ask to see a recent example of a profitability and pricing review and try to identify the use of methods described in
this chapter.

Key terms

This chapter features explanations of the following terms and concepts:

Attritional and large claims Base period Burning cost method Cost of capital

Contribution Experience rating Frequency Generalised linear modelling

Investment income Multi-way analysis Non-conventional pricing Price elasticity of demand

plans

Pricing components Product rating structure Prospective risk analysis Risk premium

Severity
A Data for pricing

A1 Internal data
Insurers ought to derive competitive benefit from having access to their own claims and
exposure data: the data may be analysed in detail and allowance made for known
imperfections. For most large insurers the issue is not an overall lack of data but rather
managing access and ensuring effective, appropriate use. Correctly matching claims to
exposure data over long periods of time is a complex task and professional skills are required
to store, extract, manipulate and analyse data appropriately. In particular, determining
whether sufficient, representative claims data exist for use in profitability and pricing
exercises needs to be assessed statistically. Insurers are focused on ensuring data is of a
sufficient quality to enable analysis and drive action. This is dependent on the quality of input
from external and internal sources, and then requires significant analytical capability to drive
insight.

Insurers are now more conscious of the competitive advantage which access to large
databases confers and have become less willing to share even aggregated, anonymous data
with competitors. They are also aware of the need to avoid any kind of collaboration which
could appear to be anti-competitive.

A2 External data
The concept of ‘external data’ from a pricing perspective is now an extremely broad area to
consider. External data can range from aggregated industry reports and government data, to
data provided by an intermediary or individual on a portfolio of risks. More recently, external
data has become more synonymous with the vast volume and variety of data that has become
available to insurers in the data rich environment in which they now operate.

A2A Aggregation of industry data

Regulatory or professional bodies

Some external data sources rely on insurers contributing their claims and policy data either
voluntarily or compulsorily (via regulated reporting obligations) to a third party that
produces aggregated reports showing market data or trends. Examples of entities whose
reports can assist in monitoring a portfolio and checking an organisation’s trends/experience
relative to the market include:

the Association of British Insurers (ABI);

the Prudential Regulation Authority (PRA);
professional bodies such as the CII or Institute and Faculty of Actuaries (IFoA);
reinsurers and trade bodies; and
the Office for National Statistics (ONS).
Being able to compare large claim/catastrophe experience, bodily injury trends, claims
inflation and other similar metrics is essential in pricing a successful product. If an
organisation’s experience is different from the market’s, it important to understand the
reason for this variance. In addition, it will also provide a benchmark against the industry that
will help determine strategy.

Market premium information

In addition to professional and regulatory bodies mentioned above, there is another category
of external data that looks to provide information about market premiums and competitor
rates. For example, certain price comparison websites will provide an aggregated and
anonymous view of winning premiums based on the quote information they collect. Others
provide information on a ‘basket’ of risks and obtain the premium for these policies to give an
indication.

Regular price comparison exercises are essential to identify risk segments where internal
prices appear to be either too cheap or too expensive or where competitors’ actions are
affecting conversion and renewal rates. Investigation of such pricing differences may indicate
the existence of errors (internal or external), the existence of niches worth exploiting or the
opportunity to adopt other tactical approaches.

A2B Intermediary or individual risk data

An external party may provide data about an individual risk or portfolio of risks. For example,
an intermediary or insurance company may look to transfer a cohort of motor risks to
another insurer due to it deciding to leave the market in which it operates. The data provided
to the acquiring company is used to support the due diligence process associated with a
company acquisition.

A2C Things to consider when using external data

Data of this nature is generally compiled by a third party and/or supplied by the insured,
some of which may have been drawn from the records of other insurance companies. It is
important to examine such data critically: other companies’ definitions, processes and
methods of presentation do not necessarily equate to those of your current company and you
cannot afford to accept data at face value. For example, when was the information last
updated? What do you know about the holding insurer’s claims reserving philosophy? Are
they noted for under or over-reserving?

Underwriters are also familiar with the situation where data may be missing from a
presentation (for example, updated outstanding claim cost estimates or declaration-adjusted
exposure measure).

The increasing use of different forms of electronic data exchange, based on shared formats,
may also mean that particular data items used in an insurer’s standard rating algorithm are
not provided. In the former situation, the appropriate action may be to refuse to price the risk
until the necessary data is provided or to proceed on the basis of recorded assumptions until
the correct data is supplied or the assumptions validated. In the latter situation, a new rating
algorithm must be devised to ensure that the available data is used appropriately. In neither
situation is it appropriate to ignore the issues affecting data.

Although general information and data from public databases can be extremely useful (when
considering individual risks and examining issues more broadly), it is important to consider
the source of the information and the original purpose for which it was compiled.

A2D Big data

Big data is a term used to describe the rapid expansion of raw data available to insurers and
other organisations. Harnessing this data effectively can facilitate a profoundly deeper level
of intelligence and understanding of an insurer’s business model, from risk selection,
marketing, claims and the general customer journey, which is vital in gaining competitive
advantage.

Big data is characterised in common literature by having four characteristics. They are:

1. volume;
2. velocity;
3. variety; and
4. veracity.

Big data deals with high quantities (tera/petabytes) of data, from a variety of sources and
formats. The speed of the data production is colossal and the need to validate and understand
the information you are collecting is crucial. Examples of big data at work could be the use of
external or internal data to pinpoint fraud or the identification of cross-sell or up-sell
opportunities. Looking at an individual’s social media interactions, website click stream data
and other sources can help build a model to assist in these activities. A topical example of big
data is telematics.

Useful article
IBM Global Business Services. (2013) Integrating the value of data in the underwriting process. White Paper.

A2E Telematics
Telematics relates to the granular collection of data about the insured’s driving
characteristics to assist in understanding risk and predicting claims propensity. This
information is passed to the insurer (in real time) via a ‘black box’ installed within the car that
uses GPS, inertial sensors and mobile phone technology.

The link to the previous definition of big data is clear. Typical telematics boxes will be
recording and transmitting second-by-second data on an individual’s speed, location, driving
behaviour and other relevant metrics; this requires insurers to hold millions of lines of
varying data collected over a policy period. Of course, the data will need to be validated as
they can dictate continuance of a policy or changes in premium or policy conditions. For
example, some insurers will cancel a policy if a driver is habitually speeding or driving in a
dangerous manner. Once armed with a vast amount of validated data the underwriter/pricing
analyst has the task of distilling this granular information into something that can enhance a
premium or support a policy change.

What big data has facilitated in telematics and other areas is a more intrinsic understanding
of a risk and what driving behaviours cause claims, such as rapid acceleration or harsh
braking and cornering. Before telematics, insurers relied on rating factors to try and proxy
this underlying behaviour, using measures such as no-claims discounts, annual mileage or,
more recently, sociodemographic factors.

The advent of this technology does start to question the relevance of these more orthodox
risk factors and their use in future pricing models. Annual mileage is a widely used rating
factor used to understand the level of exposure for a risk. The more miles an individual drives,
the more likely they are to have to claim, all else being equal. With telematics this question
has less significance as the insurer knows exactly how many miles the driver is doing as well
as when and their driving behaviour.

Useful articles
Barrett, S. (2013) ‘The bigger the better’, Post Online, 21 March 2013.

Marriner, K. (2014) ‘Telematics: the future of motor’, Post Online, 24 June 2014.
Please contact knowledge@cii.co.uk if you wish to receive a copy of either of the above articles via email. (Please note, under UK Copyright
Law the number of copies we are able to email is restricted to one article per issue per CII member.)

A2F Underwriting considerations with big data

The process of analysing big data and drawing conclusions that can benefit your business
is complicated. In addition, this analysis has to be done quickly as some of the decisions
will have to be made in real time.
Housing this data, and implementing the intelligence derived from it, requires
infrastructure and systems that are both complex and expensive. Big data is pushing the
storage capability of current systems. As mentioned above, the need to potentially
respond in real time requires agile systems that deliver responses in sub-second
timescales.
Data needs to be validated. Data of this variety and magnitude can be prone to error and
will require cleansing. If underwriters are making decisions based on such data, it is
essential that they are assured of the data quality and that it is justified for use in pricing
or underwriting decisions. If data cannot be validated then it should not be used.
Any information security processes used within a responsible business are going to
apply to big data as it would to any other information collected about an individual.
Using individual data has significant ethical and regulatory considerations. The rules
regarding data protection, treating customers fairly and the ethical framework that their
 company operates under must be at the forefront of an underwriter’s mind when
embarking on using big data. If it is not, a business could be exposed to significant
reputational and regulatory risk.

Useful article
See ‘Big data and data protection’, Information Commissioners Office
http://ico.org.uk/for_organisations/data_protection/topic_guides/big_data for a comprehensive discussion of the
risks associated with big data.

A3 Price elasticity of demand

Be aware
Price elasticity of demand can be defined as a measure of the relationship between a change in the quantity
demanded of a particular good or service and a change in its price

Although, as underwriters, there is a tendency to focus on those aspects of pricing which

relate to risk premiums, it has already been noted in earlier chapters that a number of
behaviours and preferences can impact pricing which have little or nothing to do with
insurance risk. Understanding the elasticity of demand (particularly, the price elasticity of
demand) for your company’s products – and those of your competitors – is essential and this
can only be based on careful monitoring and evaluation of internal and external data and
information.

If a company increases its prices, how high can they be raised before different customer
groups seek alternative quotes from other insurers and decide to move their business? If
prices are rising across the market, at what point might customers reduce the level of
cover they purchase or cease to purchase insurance (and possibly look for substitutes)?
If a product enhancement leads prices to rise, to what extent will the additional volumes
sold to customers demanding enhanced cover compensate for those opting for a cheaper
cover?
What level of price reduction would deliver a 10% increase in volumes?

In attempting to understand and predict customers’ buying behaviours, many factors come
into play as well as price, such as inertia/loyalty, the strength of a company’s brand and its
perceived financial security. However, as has been discussed earlier, price is a dominant
competitive feature in many markets.

Based on how customers have reacted to your company’s price changes in the past,
assumptions can be devised for each product under consideration, such as:

a price reduction of A% might increase volumes by around B%; or

a price increase of C% might reduce volumes by around D%.

With sufficient information, full demand curves can be mapped, illustrating the volume
changes associated with a range of price changes, all other things being equal.
 Useful website
See the following website for more information on the price elasticity of demand:
www.economicsonline.co.uk/Competitive_markets/Price_elasticity_of_demand.html

As well as understanding how price influences customers’ decisions (and thus volumes), it is
necessary to understand how changes in price and volume affect profitability. This will be
discussed later in section D4.

Useful article
Minty, Duncan. (2016) ‘Price optimisation for insurance – optimising price; destroying value?’, CII Think Piece 122,
March 2016.
B Projecting claims experience

B1 Selection of a base period

In the previous chapter on claims and reserving, the main input to the pricing process –
claims data – and the forecasting of ultimate claims costs at company and class level have
already been discussed. In this chapter we discuss the use of claims data to project claims
costs at product or account level in order to set prices or rates for the forthcoming period
and the use of experience rating for the pricing of individual large risks.

Be aware
The term ‘prospective risk analysis’ may be used to describe the process of projecting historical claims costs to
future occurrence periods.

Claims data only becomes informative once it is related to the corresponding exposure data;
depending upon the type of insurance product, this could be represented as:

number of policies;
number of vehicle years;
property sum insured;
turnover;
wage roll; or
number of bedrooms.

Claims and exposure data can be transformed into relevant measures of claims frequency,
severity and cost of claims per unit of exposure (burning cost).

In order to create a coherent set of base data (or base period) with which to project future
claims costs, claims and exposure data organised on an accident year basis must be selected.

Underwriting management decision: selection of base period

Which accident year or years should be selected?

Criteria for selection

Claims costs should be well-developed (that is, as high a proportion of the ultimate cost as
possible should have been paid) and the underlying exposure and claims experience should
be as representative as possible.

The claims experience for older years will be better-developed than for more recent
years but the corresponding exposure may have less in common with the current/future
account and will need, in any case, significant compounding adjustments to allow for the
impact of inflation, in particular. The claims experience for more recent years will be far
less developed and estimates of the ultimate claims cost will include a significant
allowance for this degree of uncertainty.
 In considering particular accident years as potential base periods, did the account have a
similar mix of business and cover to those anticipated for the projected period? Did any
particular untypical features affect the experience, such as severe storms, an unusually
high level of arson claims or an upsurge in a particular type of fraudulent claim?
Untypical features could be positive as well as negative, of course. Are claims data from a
single accident year sufficiently representative: are there enough claims to make the
experience credible?

Be aware
The careful selection of a base period – the accident year or years whose claims and exposure data will be used to
project claims costs for a future period – is critical to the successful outcome of the pricing exercise.

All things considered, the number of claims and the extent to which claims costs are
developed/run-off are the main criteria and adjustments can be made to allow for other
issues within the base period and to re-evaluate the costs to levels likely to apply in the
projected period. Based on typical development patterns, a liability account will usually need
to use claims data from an older period than a property damage account.

B2 Adjustments to base data

In order to calculate the future risk premium, the claims costs from the base period selected
are projected (claims frequency and severity, separately) to represent those anticipated in
the forthcoming period. The pricing exercise would start with an actuarial view of ultimate
claims costs for the base period at a gross level (reinsurance recoveries not deducted). The
following typical adjustments would then be made:

High severity/ Adjust for the impact of individual high severity or high frequency events to align with the
frequency events anticipated longer-term pattern.
This may involve adding costs as well as removing them, to allow for the smoothing of these
events over a number of years.

External influences/ Consider any external issues with particular relevance to the product which have impacted
trends frequency or severity since the base period and/or may impact in the future, such as
legislation, socioeconomic, technological or environmental trends.

Mix of business Has the product’s mix of business (types of risk, levels of exposure) changed significantly
since the base period?
If, for example, a particular type of risk is or will be excluded from product eligibility in the
forthcoming period, you may wish to strip out the historical claims experience for those
risks.

Cover changes Adjust the claims experience for cover changes, such as different levels of indemnity,
excesses and deductibles or new benefits.
Claims inflation Adjust for the impact of claims inflation, from the base period until the date of the typical
claims settlement in the projected period (see figure 7.1).
As previously discussed, the rate of inflation varies for different types of claim and will
generally be above the rate of general inflation.
It should be noted that while inflation also affects exposure values (property sums insured,
wage rolls etc.), claims costs generally inflate at a greater rate: the net effect cannot
therefore be assumed to be neutral.

Reinsurance The projected claims costs, still at a gross level, should then be adjusted by removing
recoveries assumed reinsurance recoveries (based on planned reinsurance purchase).
Although the cost of reinsurance, along with other expenses, will be added to the risks
premium in the insurer’s rates and prices, reinsurance purchase should smooth the impact
of extreme events on the risk premium over a number of years.

Example 7.1
In July 2014 you are asked to determine product rates for business written (incepted or renewed) during 2015. Note
that business written from January 2015 to December 2015 will be exposed for 12 months during the 24-month
period from January 2015 to December 2016.

Which base data will you use for your analysis and projection? Which accident year or years?

Figure 7.1 illustrates your options.

Figure 7.1: Percentage of ultimate cost paid by accident year

The exposure and cover mix of the product account in 2013 is probably closest to that of the
prospective 2015 account but, as at July 2014, the paid to ultimate claims cost for accident
year 2013 is only around 20%. (Ultimate cost having been assessed by the actuaries.) Even
by choosing 2009 as the base period, the paid to ultimate claims cost is still only around 70%.
However, the actuarial assessment of ultimate claims costs for 2009 is far more certain than
that for 2013 (new intimations for 2009 exposures represent a trickle now, whereas there is
a steady flow of new claims for 2013) and that relative certainty should convey a benefit to
prices/rates based on 2009 claims costs (as less uncertainty is priced-in).

It may be decided that the 2009 Accident Year alone provides too few claims to form a
representative sample and, instead, data from 2008, 2009 and 2010 are to be used together,
once adjusted for inflation.

For business written in 2015, when will claims on those policies be paid? If previous patterns
of claim settlement are indicative, around 70 to 80% of the ultimate cost of these claims may
have been paid by the middle of 2020. This implies that while up to 70 to 80% of claims
payments will reflect rates of claims inflation applying to that point (mid-2020), the
remaining 20 to 30% will continue to incur further inflationary increases and this must be
allowed for in the pricing.

An illustration of the impact of inflation on claims costs:

For every £100 of claims cost at 2009 values, at an extremely modest claims cost inflation
rate of 2% per annum, by 2014 the cost is £110.41 and by 2020, £124.34 (1.0211 × £100). As
noted earlier, bodily injury claims currently sustain inflationary increases in excess of this
percentage.

Please see appendix 7.1 for an example of a risk premium projection.

C Rating structures and prices
So far product risk premium has been considered at an overall level: representative historical
claims data and the associated exposures have been used to project overall claims frequency
and severity values. It is likely, however, that most products will require rates or prices for
individual risk types, characterised by key rating factors, and for different levels of cover.

Be aware
The product rating structure will be unique for each set of products. For example, general/public liability rates need
to reflect:

third party bodily injury claims;

third party property damage claims;
the trade of the risk;
limit of liability provided; and
any additional cover.

Very few products, even in the largest insurance companies, will have many segments
(representing discrete cover/customer group and risk combinations) which have sufficiently
numerous historical claims to be projected and priced entirely independently. When actuaries
review the experience of whole class accounts at company level, they rely upon the
experience of as many accident years as possible and are keen to receive market input (from
external actuaries) regarding the representativeness of their own data. Similarly, individual
products need to be reviewed and projected in the broadest possible context to ensure that
the basic pricing is as robust as possible.

How then are different employers’ liability rates created to be applied to wage roll estimates
for agricultural contractors and nursing homes; for package rates for grocers and chip shops;
for 50-year-olds driving Honda Jazz or Mercedes A-class cars in Manchester or Northern
Ireland?

C1 Rating factors and features

In all these cases, the overall projection of future claims costs (frequency and severity) for the
product provides a specific risk premium framework. More detailed statistical analyses are
required to examine:

a. the ways in which rating factors can be used to generate appropriate risk premiums for
specific risks; and
b. how rating features – such as introductory discounts, NCD scales or voluntary excesses –
may be costed and applied.

Be aware
Irrespective of how the rates are created or adjusted, they must recover the overall risk premium required to meet
the projected claims experience of the group of customers/risks in question.
Rating structures and features form part of an insurer’s marketing approach – as well as
reflecting how underwriters understand relative risk exposures – and they have a significant
impact on the degree to which an insurer can attract and retain target customers, over a
period of years.

The relationships between variables can be identified and weighted, such as the relationship
between average cost of household claims and number of bedrooms and number of motor
claims and driver’s age, through statistical methods such as correlation and regression. These
straightforward relationships may seem very obvious but for high volume insurance products
multiple rating factors are used, which may themselves be correlated, and the resulting inter-
relationships are not always immediately apparent.

Example 7.2
A simple example will illustrate the issue, as observed in a particular account:

Factor 1: Age of driver – drivers under 25 make more claims than those over 50.

Factor 2: Type of car – sports cars generate more claims than superminis.

Can you spot a potential correlation between the factors?

One might assume that more drivers aged over 50 may drive superminis than those under 25, and more drivers
under 25 may drive fast sports cars than those over 50. On the other hand, that assumption could be incorrect as it
could be argued that older drivers can afford a sports car but younger drivers have more accidents – and therefore
the correlation is weak.

These factors (and their respective influence on claim frequency) are not independent and therefore we cannot
simply conduct a series of one-way analyses (factor by factor) and compound the results in order to build rating
tables. In the case of the simple example above, we need to establish four separate claim frequencies for under 25s
and over 50s driving sports cars and under 25s and over 50s driving superminis.

C2 Multi-way analyses
Multi-way analyses need to be conducted, firstly, to establish the true independent influence
of the various rating factors on frequency and severity and, secondly, to allocate to the chosen
factors appropriate values for use in the rating algorithm. This process utilises a statistical
method known as generalised linear modelling (GLM) which helps use the available data to
best effect. Given the number of possible combinations of factors (for example, a product with
five rating factors, each with five levels, produces 3,125 possible combinations (55), many
cells will contain limited data. While statistical techniques may be used to compensate for
this, judgment also needs to be applied regarding the credibility of the base data and which
rating factors should be used.

The distinction between high volume products such as home and motor and other, notably
commercial, products is extreme in this respect. Home and motor claims databases are
interrogated on the basis of multiple rating factors, to identify the influence of rating factors
on severity and frequency by type of claim (for example, the influence of location on vehicle
theft claim frequency or of vehicle make/model on the average cost of accidental damage
claims). By contrast, SME commercial package business has to rely on a far more limited
range of rating factors (such as area and trade) due to the limited quantity, and thus
credibility, of claims data available.

Be aware
The scale of the commercial customer base can only support limited multi-way analysis: few cells will contain
sufficient representative data.

In fact the rating of many SME products is heavily influenced by location-related claims data
(which might be regarded as ‘benchmarks’) drawn from household accounts (such as the
incidence of theft, flood and subsidence). As regards larger commercial risks, the rating
categories become increasingly broad and the rates used (based on burning costs)
increasingly indicative rather than prescriptive.

Useful article
There are, from time to time, attempts to rationalise and simplify the rating of volume products – see Swift, J. (2010)
‘Start-up claims motor insurance first with Moneysupermarket’, Post Online, 14 June 2010.

In this case, a direct measure of exposure (record of mileage, when, where and how driven) is being substituted for
the normal proxy measures (age/location/occupation) and the insurer will have direct access to current data.

Once the use of multiple rating factors for a particular product becomes the norm or the conventional approach, it is
very difficult to introduce a product with fewer rating factors in the open market. Insurers introducing such a
product may be selected against by consumers (those who would normally pay a higher premium) and under-cut by
other insurers (whose more extensive rating structures highlight groups with superior performance). In order to
avoid these potential pitfalls, more rigorous initial selection criteria may have to be applied before access to the
simplified product is permitted, as is the case in many scheme arrangements.
Please contact knowledge@cii.co.uk should you wish to receive a copy of this article via email. (Please note, under UK Copyright Law the
number of copies we are able to email is restricted to one article per issue per CII member.)

Whatever decisions are made regarding the product rating structure to be used, at the
conclusion of the pricing exercise it must be demonstrated that the rates or prices are
equitable (that they bear a direct relationship to the degree of risk brought to the common
pool) and that they will achieve the planned level of income and earned loss ratio (ELR) or
combined operating ratio (COR) for the product.

Part of the pricing exercise (in conjunction with planning and budgeting activities) is to
consider the level of sales and thus exposure in the forthcoming period. The planning
assumption may be that policy numbers will increase by a certain amount but the mix of
business will remain stable. Alternatively, the plan may be to attract specific customer
groups/types of risk and the mix of business is anticipated to change. In both cases (and,
indeed, if the mix of business changes but not in the planned manner), it is essential that each
risk is priced as equitably as possible to ensure that the targeted level of profit is achieved. If
the rates or prices contain errors or significant cross-subsidies, a change of business mix
could significantly undermine the product’s planned result.
D Other pricing components
Having established the projected risk premium and rating structure for the product, a number
of other future costs must be calculated and added in order to arrive at the final premium. Just
as the assistance of actuarial colleagues is essential in the assessment of projected claims
costs, in addition you will typically rely upon finance colleagues to determine the other costs
which need to be assessed and applied in the pricing process.

The relevant costs include both fixed and variable expenses, such as:

Think back to M80, chapter 5, section A2 and section A3

sales, underwriting and administration costs;

claims handling costs;
reinsurance;
levies and taxes;
intermediary remuneration; and
profit and return on capital employed (ROCE).

D1 Assessment and allocation

It is worth emphasising that it is future costs which must be assessed and included in
prices/rates: some may be forecast with a reasonable degree of accuracy; others, such as
levies, can only be based on current assumptions. Of course, all of these costs have already
been assessed at a higher level as part of the company’s planning and budgeting process. The
task now involves the appropriate allocation of costs to individual products and possibly risk
types.

As discussed in chapter 5, the approach adopted by your company may be to provide general
cost guidelines and/or target claims ratios which already make allowance for various
expenses, as well as for the required return on capital employed (ROCE) and profit. In
whatever manner the information is supplied, your task is to consider the individual product
in question and the ways in which its expense allocation (and ROCE/profit contribution)
should differ from the norm and how that difference should be reflected in its pricing.

For example, if the product pays a significantly higher or lower level of intermediary
remuneration than standard or if a profit share scheme applies, the costs should be modelled
and adjustments made. If a product benefits particularly or exclusively from features such as
an instalment scheme, risk management service or facultative reinsurance arrangement, the
costs associated with these features should be considered for inclusion in its pricing. If a
particular product is required to produce a higher than standard ROCE or profit contribution
then this must be included in the pricing calculation. However, if the product’s conversion
ratio (the ratio of new business cases to quotes) is declining – implying that the acquisition
cost of each new business case is increasing – should the increased cost be allocated to that
particular product, or would that simply make the situation worse?

Clearly, a balance must be struck between the administrative burden and cost of allocating
expenses in infinite detail, and the usefulness of understanding a product’s ‘true’ cost and
thereby charging equitable, appropriate premiums.

The ways in which costs are recovered and targets met through the pricing process is specific
to individual insurers and is closely associated with their planning and budgeting processes.

D2 Investment income
Although investment income returns continue to be of critical importance to insurers, they
should not normally be treated as a direct component of pricing.

In the past, at times of high investment returns, insurers wrote business at low premiums on
the assumption that investment income would compensate for underwriting losses. It was
observed therefore that movements in the investment cycle affected overall pricing levels in
general insurance. At the current time, and for the foreseeable future, not only are investment
returns low and uncertain but underwriters should not assume that the insurer’s investment
returns, such as they are, are available to subsidise pricing levels. As noted in chapter 6, the
value of current claims reserves is usually ‘discounted’ by the assumed investment income
potential of these reserves: this particular, significant source of investment income is
therefore already being utilised.

Investment returns have been reduced as a result of the economic crisis of 2008–2012 as
equity volatility and an ultra-low interest rate environment has led to reduced returns. An
underwriting loss is now more likely to lead to erosion of the capital base on a reduced
operating profit/operating loss, once investment returns are factored in.

D3 Cost of capital
Under Solvency II, the cost of capital and the degree of risk presented by individual insurance
products or accounts are key inputs to all profitability and pricing exercises.

For some time a number of insurers have been using a capital asset pricing model (CAPM) to
support their business and pricing decisions. The CAPM is a general finance model which can
be used to compare the underwriting margin achievable on different accounts or classes of
business – weighted by the degree of risk associated with each account or class – with the
returns achievable on other forms of investment.

A key issue in the use of the CAPM is how to accurately assess the ‘degree of risk’.

Research activity
Ask your manager to explain the capital allocated to a class of business or an account with which you are familiar.
Investigate how and why this differs from other classes of business or accounts.
D4 Pricing, expenses, volumes and profitability
Pricing is necessarily a dynamic discipline as change is constant and those involved must
consider how best to react to external challenges, as well as internal requirements, and how
to evaluate the impact of their proposed actions.

Underwriting management decision: renewal discounts

In the face of competition, the renewal rate for your product is under pressure. What discount on renewals is
justifiable in order to avoid the cost associated with replacing lapsed renewals with new business cases?

A straightforward response to this question might be to focus on administrative savings:

renewing a policy costs less than acquiring and setting-up a new one, therefore might not a
discount equivalent to this saving be justified? Unfortunately the level of discount necessary
to retain a renewal case often goes far beyond that of administrative savings. Although the
underlying assumption of the question about renewal discounts is that it is in the insurer’s
interest to retain profitable customers and thus maintain volumes, the question remains: are
all customers worth retaining and at what discount?

The relative value of customers might be assessed based on how long (in the future) their
business is likely to be retained by the insurer, their typical claims experience, future
investment returns and the value of any other business they may consider placing with the
same insurer. This kind of detailed consideration is commonplace amongst underwriters of
large commercial risks. For underwriters devising pricing criteria for customer service staff
handling volume motor or home business, they too must use similar considerations in
relation to identifiable groups of customers. Their understanding of customer behaviour and
assessment of the price elasticity of demand for their particular products (see section A3), in
the context of anticipated levels of market competition, will enable them to assess how
different types of customer may react to varying levels of renewal discount.

How far may renewal premiums be reduced, in order to protect volumes, before a product’s
profitability is affected? The answer to this question depends upon the contribution each
product makes to the insurer’s fixed expenses and profit (those components of the pricing
equation which must be covered for the company to stay in business). A product’s
contribution is defined as its selling price less its variable expenses (including claims cost).

Therefore, the balance between fixed and variable expenses in the make-up of an individual
insurer’s cost base is a critical influence on the company’s approach to business development,
competition and the insurance cycle. This can also explain differences in approach to
individual products within an insurer’s portfolio.

Please see appendix 7.2 for an illustration of how this question of pricing, expenses, volumes
and profitability might be evaluated.

Although risk premiums tend to dominate underwriters’ thoughts regarding pricing – as

claims costs are almost always the largest single pricing component – the absolute value of
the other components and the balance between fixed and variable expenses are of
considerable importance, particularly when evaluating business development options. As
most insurers wish to pursue strategies of ‘profitable growth’, underwriting managers must
incorporate the overall volume and profitability planning targets provided to them into the
plans (and prices) for their individual products in a balanced manner. The example provided
in appendix 7.2 illustrates how precarious that balance can be.
E Experience rating
The techniques known generally as ‘experience rating’ might be considered to be at the
opposite end of the scale from the creation of rating structures for high volume products such
as home and motor. In fact, although the output may appear to be different, the inputs, issues
and many of the statistical techniques involved are exactly the same.

Think back to M80, chapter 5, section B

Experience rating is used to price unusual or very large individual risks or

schemes/portfolios of risks, which are assumed to have sufficiently large (and thus credible)
individual claims experiences. The burning cost method has been described elsewhere, along
with its potential drawbacks. While the experience rating of a risk is generally accomplished
by an individual underwriter, it is of particular importance that underwriters of this type of
business understand the relative credibility of claims data and the need to price for
uncertainty. In many companies there is an increasing trend to involve actuaries in the
analysis of experience rating.

Critical reflection
How credible can the experience of an individual risk really be?

Clearly an individual claims experience based on 1,000 claims has more credibility than one
based on 20 claims but when one considers the efforts made by actuaries at class/company
level to understand the development of ultimate claims costs over many years, based on
claims arising from multiple accident years, the relative credibility of the data used in most
burning cost calculations is brought into proper perspective.

There are approaches, such as link ratio techniques, which attempt to project more realistic
ultimate claims costs using an individual risk’s claims cost triangles on an accident year basis.
However, due to the limitations of the available claims data (its relative development and
credibility), it is clear that the use of experience rating methods can place disproportionate
emphasis on run-of-the-mill, attritional claims costs and insufficient emphasis on the cost of
exceptional claims (which are infrequent but very costly).

A typical claims distribution would be one in which almost 99% of all claims by volume fell
within the lower claims value bands, amounting to around 55% of total claims cost. The
remaining 1% of large and very large claims would account for around 45% of total claims
cost. The very largest claims, whose numbers barely register as a percentage, would typically
cost around 15% to 20% of total claims costs.

If the cost of the large and very large claims (1% by volume) was removed entirely from
experience rating calculations, (‘just a one-off claim’, ‘it won’t happen again’) the risk
premium based on the attritional net losses would have to be loaded by 82% to recover the
total claims cost.
 Underwriting management decision: how large is a large claim?
How would you treat the cost of large claims in experience-rated cases?

E1 Severity or frequency?
Experience rating can only be expected to deliver planned profitability if the true cost of large
claims is understood and their treatment is consistent. Within an account of experience-rated
cases, only risks which can bear the cost of a large claim (of predetermined size) in a three- or
five-year experience should be eligible for experience rating. Accepting that the cost of very
large claims must be spread across the account, excess claims amounts (above a
predetermined limit) can be removed from the experience-rating calculation for individual
risks and every risk within the account should then be loaded by a standard amount designed
to compensate for this ‘top-slicing’. The adjustment for the excess cost of very large claims
should be calculated on as wide a basis as possible, not solely based on the account’s recent
experience.

Example 7.3
It is deemed that a large claim for a sizeable motor fleet case is £100,000. A few years ago, there was a claim for
£250,000. In setting the future price for the risk, only £100,000 of this claim (after adjustment for inflation) would
be taken into consideration in the pricing process, with the other £150,000 to be paid for by a ‘large claim fund’
accumulated by charging an amount to every vehicle in the whole of the insurers fleet account adjusted by the
vehicles likelihood of drawing from the large claims pot. An articulated lorry is more likely to inflict a large claim
than a small car due to its size and exposure on the road.

As in product risk pricing, the claims experience of individual large risks must be adjusted to
account for their likely ultimate cost (including IBNR and IBNER). Past and future inflation,
relevant claims trends, cover and exposure changes must be factored into the calculation.

It is contrary to accepted insurance wisdom that so much effort goes into the adjustment of
an individual risk’s average claims cost, when its claims frequency is generally regarded as a
far better predictor of future performance. The incidence of claims is a telling measure of an
insured organisation’s approach to risk management: once an incident has occurred, its
eventual severity is extremely random and not particularly indicative of the quality of the
risk.

Having established a projected risk premium/burning cost for the forthcoming period, it is
well worth making a few comparisons:

How does the proposed rate, and the claims experience from which it has been
calculated, compare with those of similar large risks?
How can differences be explained?
How different are the proposed rates from the conventional rates applied to smaller
commercial risks?
If the difference is substantial, is this credible?
Which risk features explain these differences?
 Be aware
In order to support underwriters as they exercise judgment on these matters, underwriting managers must ensure
that they have as much relevant, contextual information as possible.

E1A Input of reinsurance expertise

The concern is not that the attritional claims experience has been misinterpreted but rather
that insufficient allowance has been made for the risk’s proper share of large claims costs.
Bearing in mind the limitations of all insurers’ internal claims datasets in respect of very large
claims, the assistance of reinsurers should be sought to build more appropriate loadings or
risk premiums for this level of exceptional claim. An appropriate benchmark might be a class-
based assessment of exceptional claims costs expressed as a burning cost combined with the
individually projected attritional burning cost, plus expenses, ROCE and profit allocation.

E1B Non-conventional pricing plans

This description covers a multitude of insurance arrangements, most of which rarely apply to
any but the largest commercial risks. It includes the pricing of arrangements involving self-
insurance and captives, retrospective rating and other variations on these themes.

As in every other form of pricing, the proper evaluation of claim data and its prospective
adjustment, as well as the use of appropriate benchmarks, is fundamental. Issues such as the
impact of inflation on aggregate deductibles serve to highlight the fact that these
arrangements often place even greater emphasis on the underwriter’s appreciation of claims
settlement patterns, notably, the long-tail. As these arrangements are generally designed to
leave the risk of exceptional losses with the insurer, a clear focus on their true costs is
essential.

Underwriting management decision: assessing bespoke pricing components

What other costs, beyond the norm, need to be considered?

As well as additional general administration, these arrangements may involve:

particular claims handling arrangements, the cost of which must be assessed;

where deferred premium payments are involved or claims funds are to be established, a
careful assessment of the time value of money (investment income foregone) will be
integral to the negotiations; and/or
the assessment of credit risk (Is it acceptable and at what price?).
F Conclusion: collaboration and judgment
Pricing is self-evidently a highly collaborative activity within general insurance, involving
actuarial, finance and marketing, as well as underwriting. Data and models will never be
perfect but experience and judgment can improve the use of both.

Underwriters and customer service staff can only exercise proper judgment in the pricing of
individual risks if they understand the basis on which risks are intended to be priced, the
extent of their own authority and the relevant plans which define the agreed balance between
pricing, volumes and profitability. Underwriting management is therefore responsible for
both the quality of rating structures and the timeliness and accuracy of pricing adjustments,
as well as for the effective communication of matters relating to pricing to all relevant staff.

While making full use of the data and statistical techniques available, the uncertainty at the
heart of any pricing process should be acknowledged and emphasis placed on the centrality of
appropriate risk selection in the achievement of underwriting profitability.

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Barker, S. (2012) ‘Tussle over telematics standards’. Insurance Times, 4–10 May 2012.†

Bury, L. (2012) ‘The Knowledge: personal lines motor. Can telematics save the day?’ Insurance Times, 15–21 June
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Cummings, D. (2014) ‘Big data can make a big difference in modern underwriting’. Visualize.
www.verisk.com/visualize/visualize/q1-2014-big-data-can-make-a-big-difference-in-modern-underwriting.html

Dollings, G. (2012) Recent developments in general insurance underwriting, 10 July 2012. CII Fact File*

Ferris, A. et al. (2013) ‘Big data’. The Actuary Magazine, December 2013/January 2014. Volume 10 (issue 6).

Murray, E. (2014) ‘Big data’. Lloyd’s Market Magazine, Summer 2014.

Ordnance Survey. (2013) ‘The big data rush: how data analytics can yield underwriting gold’.
www.ordnancesurvey.co.uk/about/news/2013/the-big-data-rush.html

StackIQ. (2012) Capitalizing on big data analytics for the insurance industry. White paper.
http://cdn2.hubspot.net/hub/173001/file-18488782-pdf/docs/stackiq_insuranceind_wpp_f.pdf

Towers Watson. (2013) Telematics: what European consumers say. September 2013.

Woolgrove, T. (2014) Telematics – niche or core in motor insurance? 8 April 2014. IIL lecture.*

Xuber. (2014) ‘Big data. The devil in the detail’ in Mind the gap – the changing landscape of the London insurance
market. White paper.
* CII Fact Files and IIL lecture content available to CII members via the Knowledge Services website (www.cii.co.uk/knowledge).
†
Please contact knowledge@cii.co.uk if you wish to receive a copy of either of these articles via email. (Please note, under UK Copyright Law
the number of copies we are able to email is restricted to one article per issue per CII member.)

 Scenario 5 – Question

You have just been given responsibility for Product Y. A long-established product, it has had a reasonably profitable
history but has recently slipped into unprofitability. While profitable, Product Y was largely ignored and other
products received management attention.

You don’t know a great deal about Product Y but have been advised that, apart from a few minor amendments, little
has changed regarding its cover and policy limits over the years. Another feature drawn to your attention is that a
degree of discretion (limited by user profile) is permitted in the application of discounts for both new and renewal
business.

You have decided that Product Y must be the subject of a full review before any further plans for its future can be
considered.

Outline the objectives you wish to set for the review. List the information and data which needs to be assembled and
indicate how each item is to be used. Remember that you are able to ask your colleagues for their assistance.

See overleaf for suggestions on how to approach your answer

Scenario 5 – How to approach your answer

Aim
This product management scenario encompasses issues considered in chapters 3 to 7 inclusive. It tests your grasp of
the range of information, data and input required to manage a product; the identification of essential elements and
understanding of their use.

Key points of content

You should aim to include the following key points of content in your answer:

Objectives:

1. To understand nature of Product Y; demand for the product; short- and medium-term prospects.
2. To assess Product Y’s financial performance and identify source of current unprofitability.
3. To assess the consequences of making no changes to Product Y.
4. To identify and evaluate options and make recommendations regarding the product’s future.

Information, data and input:

To support Objective 1
Current plan for Product Y (and/or for relevant product group).
Detailed description of Product Y: scope of cover, optional covers, policy limits, rating basis (factors and
features); relevant underwriting guidance; commentary on changes to product, with details and dates of
changes.
Current risk profile; exposure split by key cover/rating factors; commentary on significant changes or trends
in exposure.
From Marketing: report on Product Y’s target market; current position in the market; views on future
potential; customer/broker views.
Feedback from underwriters, intermediaries and customer service staff: attractiveness of product; issues.

To support Objective 2
Current Budget for Product Y.
Management account for Product Y (figures on incurred/underwriting account basis), for current year and
for as many past years as available; figures split by cover-type, branch, region or distribution channel, if
relevant.
Product Y performance on accident year basis, for as many years as available.
Claims data: claims triangles; list of large claims; trends in average attritional claims and claims frequency.
From Actuarial: view of reserving pattern, run-off and ultimate cost.
Current base rates; effective rates (once discretionary and other discounts applied); rating history; Product Y
expense allocation and commission costs (current and historic).
To support Objective 3
Use the above data to conduct a prospective risk analysis in which no pricing or cover changes are projected
for the forthcoming period (but forecast trends in inflation, the incidence of claims and assumptions regarding
economic conditions are projected forward). In addition, marketing, sales and distribution support for
Product Y are assumed to remain unchanged.
This exercise will demonstrate whether Product Y’s recent unprofitability is likely to continue around current
levels or whether there may be a slow or rapid deterioration. Is action required urgently or can it be delayed?
Are the actions required major or minor?

To support Objective 4
Based on the above, a range of options can be identified and evaluated, not simply in terms of Product Y’s
development but in cost-benefit terms for the whole account bearing in mind current corporate and strategic
business unit strategies and plans.
Appendix 7.1: Risk premium projection: scenario analysis and
discussion
The claims triangles used in chapter 6 in the discussion about reserving and projecting the
ultimate claims cost (see appendix 6.1) can be used to illustrate – in a simplified manner –
how a projection of risk premium based on historic claim frequency and severity (average
claims cost) might be accomplished.

You have been asked to determine an appropriate risk premium for business written and
renewed in the course of 2016.

What base period will you choose?

The claims triangles indicate that the best-developed claims experience relates to
Accident Year 2010: although total claims cost is still changing, no additional claims have
been intimated for two years. As this account appears to have a moderately long-tail
development pattern, the choice of a more recent year as base period would not be
advisable. With over 1,000 claims in the experience for 2010, this represents a
reasonable sample.
On the basis of the available information, the account does not appear to have undergone
any marked changes since 2010 and there is no evidence of any very large claims or
incidents causing marked peaks in claim frequency. Access to the underlying data would
confirm or contradict these assumptions and enable any necessary adjustments to be
made. You have been advised that the cover offered throughout this period has not
changed and the mix of business has changed little.
You are unaware of any external issues which may have affected the account’s
experience or may do so in the future, apart from general trends in claims inflation.
The assumption that the claims experience relating to Accident Year 2010 is virtually
run-off could be challenged but on the basis of this assumption, it can be seen from
claims triangles G and H that the average claims cost stands at £1,980 and claims
frequency 24.1%, as at the end of 2015.
What will the average claims cost and claim frequency be for Accident Year 2016, when
business written in that year is at a similar stage of development in 2021?
From claims triangle H, it can be seen that claim frequency appears to have been rising
(particularly obvious in the Year 1 column, at an average rate of 0.095% per annum
between 2010 and 2015) and that, irrespective of a few late intimations, the close-to-
final claim frequency appears to be evident by Year 3. Based on the experience of
Accident Year 2010 (a pattern followed by Accident Year 2012), this account’s claim
frequency appears to increase by around 10% (ten percentage points) from its Year 1
level to a stable developed position.
If the Year 1 claim frequency for 2016 is projected to be 15.2% (Accident Year 2010 claim
frequency at Year 1, 14.4 multiplied by 1.00956) and 10% is added, does a final developed
claim frequency of 25.2% look realistic? If the Accident Year 2010 claim frequency at Year
6 of 24.1 is increased by the same factor (1.0095) over 6 years, the answer is 25.5%.
 H(p)

Claim Frequency = Number of Intimated Claims divided by Exposure Units as %

Accident Exposure Development year

year units

1 2 3 4 5 6

2010 5,000 14.4 20.2 24.0 24.1 24.1 24.1

2011 5,020 10.2 18.5 23.5 23.7 23.7 24.3

2012 5,040 14.9 20.8 24.8 25.0 24.6

2013 5,060 14.4 19.4 22.0 24.8

2014 5,080 15.0 21.0 25.0

2015 5,100 15.1 25.3

2016 25.5

This is clearly not a sophisticated analysis of the rate of change in claim frequency but a
projected figure for 2016 in the region of 25.2% to 25.5% appears reasonable: you decide to
use the higher figure of 25.5%.

Turning to claims triangle G: as in this instance you cannot adjust the average claims cost to
allow for either the presence or absence of particularly large claims in the experience, the
main focus of attention is on the applicable rate of claims inflation for use in the projection. As
previously stated, the Year 1 and Year 3 averages appear to show a rate of inflation in the
region of 7 to 8% per annum: is this rate consistent with the experience of other similar
accounts? If you use a rate of 7.5% per annum and inflate the Accident Year 2010 at Year 6
figure of £1,980 (1980 multiplied by 1.0756), a projected average claims cost of £3,056 is
derived.

G(p)
 Average Claim (£)

Accident year Development year

1 2 3 4 5 6

2010 1,082 1,905 1,890 1,900 2,006 1,980

2011 1,000 2,011 2,041 2,010 2,403 2,128

2012 1,249 1,809 2,204 2,300 2,288

2013 1,263 2,008 2,381 2,460

2014 1,470 2,115 2,644

2015 1,530 2,843

2016 3,056

The risk premium per policy can be calculated by multiplying the claim frequency by the
average claims cost: therefore the projected risk premium for 2016 is (0.255 × 3,056) = £779
per policy.

How can you check the validity of this projected risk premium?
The account’s burning cost was projected earlier using the link ratios method (see
original claims triangle I) and as no adjustments were made to the underlying data in
either the burning cost projection or the risk premium projection for 2016 (above), any
differences must be result of the assumptions used, the method and/or the projection of
the risk premium amount a further year ahead (from 2015/as at 2020 to 2016/as at
2021).
Based on the same factors used in the risk premium projection above (1.0095 per annum
for change in claim frequency and 1.075 per annum for change in average claims cost),
the Accident Year 2015 at Year 6 figure would be (0.253 × 2,843) = £719.

This compares with a figure of £807.20 as the projected burning cost for 2015 as at Year 6 in
claims triangle I. A substantial difference – how can this difference be resolved?
This dilemma illustrates why actuaries and statisticians often use several different methods
when considering projections, particularly when there are limitations to the available data. It
was noted in the earlier discussion that the link ratios derived from the account were quite
variable year-on-year and that this uncertainty would have most impact on Accident Year
2015, as it was least developed. In addition, the assessment of rates of change in claim
frequency and average claims cost were not based on a sophisticated analysis.

You can however test your claim frequency and average claims cost assumptions by inserting
them into the burning cost calculation:

Burning cost = Total claims cost ÷ Exposure

Claims frequency = Number of claims ÷ Exposure

Average claims cost = Total claims cost ÷ Number of claims

Therefore:

Burning cost = Average claims cost × Claims frequency

In respect of Accident Year 2015 at Year 6:

If the Burning Cost is £807.20 and the Claim Frequency is 25.3% then the Average Claims
Cost is (807.20 divided by 0.253) = £3,190.
If the Burning Cost is £807.20 and the Average Claims Cost is £2,843 then the Claim
Frequency is (807.20 divided by 2,843) = 0.284 or 28.4%.

The choice of 7.5% per annum may well have underestimated the impact of inflation on
average claims cost. Based on the experience of other similar accounts, a higher rate may be
justified. A rate of 8% would move the 2015 figure to £2,909 or 9% to £3,046. However, the
average claims cost figure derived from the burning cost calculation, at £3,190, still looks
high.

Claim frequency is generally a far steadier reflection of underlying experience and the figure
of 28.4% derived from the burning cost calculation appears excessive in the context of this
account’s past experience.

Without access to the underlying data, the most considered approach may be to increase the
projected risk premium for 2016 above the projected level of £779 per policy, particularly in
respect of claims inflation, but not as far as the level suggested by the link ratio projection of
burning cost.

Points to note:
Access to and the full use of data is critical in making sound pricing decisions.
Even with a good sample of data, no one method should be relied upon.
Judgment must be exercised: the adequacy of the sample, the methods used, the
selection of suitable benchmarks, as well as common sense.
Are the results credible? If not, why not?
Appendix 7.2: Impact of pricing, expenses and volumes on
profitability: scenario analysis and discussion

Projected product costings

Per Policy Costings Totals

Volume Gross Claims Variable Contribution Income Claims Contribution to fixed

premium cost expenses to fixed and expenses and profit
(excl. expenses variable
IPT) and profit expenses

1 100 £100 £60 £30 £10 £10,000  £9,000 £1,000

(Current costings)

2  85 £100 £60 £30 £10  £8,500  £7,650 £850

(15% reduction in
volume)

3 100  £95 £60 £29  £6  £9,500  £8,900 £600

(5% reduction in price)

4   ?  £95 £60 £29  £6 ? ? £900

(What volume required?)

150  £95 £60 £29  £6 £14,250 £13,350 £900

For the purposes of this discussion, claims costs are assumed to remain at £60 per policy in
the forthcoming period. Variable expenses include commission at 20%. While total variable
expenses vary with volume, commission also varies with price.

Line 1 shows the current costings applicable to the product in question: the current total
contribution to fixed expenses and profit at £1,000 is regarded as acceptable as fixed costs
are covered, with a small contribution towards profit.

However, renewal premiums are under pressure and the sales department anticipates a 15%
reduction in policy volume if prices are maintained at current levels.

Line 2 illustrates the projected impact of a 15% reduction in volume. Although individual
policy costings remain the same, overall income is reduced, and although overall claims and
variable expenses also reduce, the product’s contribution to fixed expenses and profit is
reduced to an unacceptable level. Senior management advise that the product must make a
minimum contribution of £900.

What are the options? Sales department suggest that current volumes could be maintained
with an overall reduction of 5% in prices (the level of discount could vary between
customers).

Line 3 illustrates the outcome of a 5% reduction in price. Although the absolute amount of
commission paid is reduced, the reduction in price reduces the product’s contribution to
£600 – a far worse outcome than the reduction in volume previously anticipated.

But sales department are convinced that much more new business could be sold as a result of
the reduction in price: how much new business would they have to acquire to meet senior
management’s requirement for a minimum contribution of £900 to fixed expenses and profit?

Line 4 poses this question and illustrates the answer. The required minimum contribution
(£900) is divided by the individual policy contribution (£6): 150 policies must be sold to meet
the minimum requirement. How many policies must be sold to match the product’s current
level of contribution of £1,000?

Answer: 167 policies.

The punchline of this scenario is a question for sales department to consider: how confident
are they that they can achieve a total policy volume of 150 or more in the forthcoming period
(a 50% increase on current volumes)? If they are not entirely confident (and even if they are),
further options should be evaluated which balance smaller overall reductions in premium
(possibly restricted to more limited categories of customer) with an acceptance that the loss
of some volume (ideally less than 10%) may have to be accepted in order to maintain the
level of profitability required by senior management.

Be aware
This type of simple evaluation of options can also be used to consider the impact of price increases: how far would
volume have to fall before a price increase could be regarded as counter-productive in terms of contribution to fixed
expenses and profitability?

Of course, when volumes change markedly the level of variable and fixed expenses are also
likely to change. As volumes grow, better deals may be done when insurers purchase external
services and current fixed expenses, such as office accommodation, may be utilised more
effectively. Conversely, shrinking volumes will push per policy costs upwards. However
significant changes in variable and fixed expense levels tend to emerge over a longer period of
time and in an uneven fashion and are unlikely to impact greatly the evaluation of pricing
options for the forthcoming period – unless the volume changes anticipated are very
dramatic.
 8 Managing exposure

Contents Syllabus learning

outcomes

Learning objectives

Introduction

Key terms

A Risk appetite and risk acceptance 2.1, 2.9

B Accumulation and ‘clash’ 4.1

C Internal exposure data 4.1

D External environment 4.2

E Emerging risks 4.1

F Communicating exposure-related issues 4.1

G Aggregate management techniques 4.1, 4.3

H Reinsurance strategy and procurement 2.1, 4.3

I Alternative risk transfer options 4.3

Summary

Bibliography
 Scenario question and answer

Learning objectives
This chapter relates to syllabus sections 2 and 4.

On completion of this chapter and private research, you should be able to:

explain the need for the active management of exposure;

explain the impact of accumulations of exposure and the techniques used to reduce the
risk to insurers;
explain how exposure is measured and how underwriters use the data to best effect;
evaluate emerging risks;
explain how reinsurance is used as a method of enabling capacity; and
explain how alternative risk transfer is used to increase an insurer’s capacity.
Introduction
Think back to M80, chapter 6, section B

At this point in the course, you should have a clear understanding of the framework within
which underwriting managers operate in order to translate their organisation’s underwriting
strategy into practice. In chapter 3, section E, we saw that this involves establishing a control
environment to manage the acceptance of insurance risk, including limits on the financial
exposures under each policy, accumulated exposures in terms of regions or certain types of
industries, and exposures due to multiple losses from a range of policies from the same event,
such as an earthquake that damages private and commercial buildings, cars and
infrastructure, e.g. roads and railways.

The risk of ‘aggregation’ and understanding how it arises was the subject of the P80:
Underwriting practice course. The focus in this course is on understanding the techniques
available to underwriting managers to evaluate and manage these exposures both at a
strategic and operational level.

As the options available to an insurance company to fund its risks are becoming more
innovative, we shall also consider some of the alternative solutions that are being used to
enable capacity in addition to the use of reinsurance.

Key terms

This chapter features explanations of the following terms and concepts:

Accumulations Aggregation risk Alternative risk transfer Business interruption

(ART)

Capital markets Catastrophe bonds Clash Control of exposure

Emerging risks Industry loss warranties Realistic disaster scenarios Reinsurance strategy
(RDS)

Risk acceptance policy Risk appetite Risk sharing Systemic losses

Uncertainty
A Risk appetite and acceptance
We saw in chapter 3 how the broad corporate risk appetite choices are manifested in the
types of risks underwritten; for example, an insurer underwriting natural catastrophe
property insurance will have an appetite and strategy for business that may produce very
good profits in most years (in the absence of significant catastrophes) but accepts that in
some years there will be large losses when hurricanes, typhoons, earthquakes etc. result in
widespread property losses.

We also saw how these decisions are translated into practice through risk acceptance policy,
containing definitions of target and excluded business, exposure limitations and typical or
actual distributions of key exposure measures. These could be, for example:

number of policies by total sum insured (TSI) or by limit of indemnity;

number of vehicles by vehicle value; and/or
number of insured persons by age.

Unless clearly stated to the contrary, the reasonable assumption of anyone referring to these
documents is that these definitions and distributions will continue to apply whether the
account in question grows, shrinks or remains stable in income terms. Therefore, an account
with a typical distribution of risks by TSI (lots of small risks, few large risks), which suddenly
acquires a significant number of large risks (without a proportionate increase in small and
medium risks), will be subject to review by both underwriting manager and internal
actuaries. As an underwriting manager, as well as discovering the reasons behind the
acquisition of these risks, you will need to consider how your unit’s plan and budget may have
been affected.

The appropriate control of exposure therefore stems from a clear understanding of the
insurer’s risk appetite.
B Accumulations and ‘clash’
There are many ways in which risks can be anticipated to accumulate but not measured with
any accuracy for an individual insurer (for example, the sum of own vehicle damage plus
third-party damage and injury in a motorway pile-up or personal accident exposures in an
aircraft crash). These unknown accumulations (in other words, the aggregation risk) must be
dealt with by ensuring that an insurer’s net retained liability for single events is tailored to its
level of financial resource.

Similarly certain types of external event can impact several classes or accounts
simultaneously, as in the case of an aircraft crash: a single insurer could have multiple
exposures, including aviation, property and personal accident. Insurers often purchase EL/PL
‘clash’ cover in anticipation of single events involving injury both to employees and members
of the public. Other types of event can affect multiple classes over a period of time and give
rise to systemic losses.

Example 8.1
Recession, increased unemployment and the crash in UK domestic and commercial property values in the early
1990s led to a massive increase in the number and cost of creditor and mortgage indemnity claims.

Unemployed policyholders claimed when they could not repay loans or mortgages; banks and building societies
claimed when the resale value of repossessed properties failed to cover the outstanding loan amounts. As the
recession continued, surveyors and valuers who had provided original property valuations (which were believed to
have been inflated) were sued by lenders: the surveyors and valuers claimed against their professional indemnity
policies.

This sequence of events played out over a number of years and was particularly difficult to predict due to the high
number of repossessions, uncertain economic conditions, the extremely high valuations placed on some of the
commercial properties involved and the uncertain outcome of court cases. Insurers with exposure to the creditor,
mortgage indemnity and professional indemnity markets, as well as to property insurance (which was suffering high
levels of fire/arson losses) incurred very high cumulative losses which, at the time, were largely unanticipated. The
number of employers’ liability claims also increased as individuals became unemployed and looked for ways to
enhance their financial position.

Another example of an unanticipated accumulation of exposure was revealed by the upsurge

in deafness claims, reflecting the ageing of a cohort of industrial workers in the 1980s and
1990s. The lesson learned by those insurers who were particularly affected by the cost of
deafness claims was that they had been over-exposed to particular types of heavy industry.
Insurers and reinsurers are now far more wary regarding the potential cost of industrial
disease claims arising from known sources (such as asbestos and stress) as well as from
those sources which are so far unrecognised.

Internal exposure monitoring must therefore encompass:

potential product/class accumulations;

the ways in which exposures under different classes may accumulate or clash; and, most
importantly,
any evidence that new hazards are emerging.
Underwriting strategy will also be affected by these considerations. Insurers may choose to
avoid market-leading positions in respect of certain types of risk or product and limit their
exposure to classes of business which are closely related.
C Internal exposure data
Underwriting management decision: monitoring exposure
In order to monitor exposure, what internal exposure data is required?

The standard measures of exposure are not difficult to define but it is more difficult to
capture and utilise the data to best effect.

C1 Consistency and interpretation

The calculation of measures such as estimated and possible maximum loss (EML and PML)
requires particular attention and, critically, an internal consistency of approach. Similarly,
internal conventions must be established to ensure that measures such as floating sums
insured are recorded on computer systems in a consistent manner. Everyone who may use
the data must understand how such measures have been calculated and recorded to avoid
double counting or other forms of misinterpretation. Exposures on products with standard or
maximum sums insured (for example, household buildings cover ‘up to £1m’) need to be
estimated by other means, not simply counted at the maximum level.

Be aware
When assumptions are made in the measurement of exposure levels, they should be clearly recorded wherever the
measures are used.

In earlier chapters on risk assessment and rating, we discussed the ways in which risks are
classified and categorised according to degree of hazard. Similarly, in any examination of
exposures, you might consider how best to subdivide the portfolio in order to highlight any
changes in exposure to significant hazards. The following illustrates some examples:

Account type Significant hazard features

Tradesmen’s Application of heat or no heat used in trade activities.

Product liability Exports to North America or (knowing) exports excluded.

Property Values at risk in low/medium/high risk flood areas.

Research activity
Investigate how different exposures are or could be sub-divided in the underwriting area in which you work.
Consider whether this could be improved and outline how you would do so.
C2 Location
In property classes there are obvious difficulties in understanding how individual risks relate
to other insured risks and how to measure the potential impact of that interaction on an
ongoing basis: risks may be located in close proximity or may be adjoining or communicating.
In the UK, postcode level risk data has been superseded by the monitoring of exposures based
on latitude/longitude risk coordinates, which can identify individual premises. For insurers
with property exposures in many countries, risk zoning on a global basis is required.

Useful articles
MacDonald, M. (2010) ‘NIG launches mapping tool’, Post Online, 11 June 2010.
Please contact knowledge@cii.co.uk if you wish to receive a copy of this article via email. (Please note, under UK Copyright Law the number
of copies we are able to email is restricted to one article per issue per CII member.)

LexisNexis. (2013) ‘LV= invests in Mapflow’s Geo technology to maximise its underwriting profitability and reduce
its flood exposure’, 7 June 2013. www.mapflow.com/news/129/lv-invests-in-mapflow-s-geo-technology-to-
maximise-its-underwriting-profitability-and-reduce-its-flood-exposure

Using an insurer’s logged property exposures, catastrophe modellers can carry out event simulations (for example,
flooding in the Thames basin or Tokyo earthquake) and extrapolate the potential future cost from the cost of past
events and their interpretation of current trends. Having assessed the estimated loss for different return periods (for
example, 1 in 50 or 1 in 100 years), insurers can set aggregate exposure limits for the relevant peril, in line with
company risk appetite.
D External environment
A number of the examples above reflect the influence of external factors. Identifying such
factors, assessing their influence and monitoring them appropriately are essential aspects of
controlling exposure.

Typically, there will be a number of individuals (and/or functions) within an insurance

company with responsibility for scanning the external environment. Internet access provides
everyone with the ability to access external information far more readily than ever before.
Underwriters, along with claims staff and surveyors, have their own window to the external
environment which they access via clients, claimants and intermediaries. While gaining
access to information presents few challenges, sifting through this mass, selecting those
items which are more likely to impact current or future exposures and sharing the filtered
information with the appropriate individuals or functions presents a far greater challenge.
Those responsible for the control of exposure must ensure that, by whatever means, they
have access to relevant information and that the information is used appropriately.

The appropriate response to changes in the external environment is rarely straightforward,

as their impact is often uncertain and existing risks or client groups are likely to be impacted
by any action taken. In some instances the insurers’ initial approach may be to lobby the party
making the change or regulating the activity in an attempt to lessen the potential impact.
E Emerging risks
Emerging risks may be generally defined as those risks an organisation has not yet
recognised or those which are known to exist, but are not well understood. The former US
Secretary of Defense, Donald Rumsfeld, is quoted as saying: “There are known knowns. These
are things we know that we know. There are known unknowns. That is to say, there are things
that we know we don’t know. But there are also unknown unknowns. There are things we
don’t know we don’t know.”

By contrast the Lloyd’s definition is more specific and defines an emerging risk as:

"an issue that is perceived to be potentially significant but which may not be fully
understood or allowed for in insurance terms and conditions, pricing, reserving or
capital setting".

Emerging risks:

should be considered as part of an insurer’s risk management framework;

may include non-underwriting as well as underwriting issues, for example the impact of
leaving the European Union and the impact of new technology;
can represent opportunities as well as threats; and
include things which might, over the longer term, impact the next generation of
underwriters.

The difference between an ‘emerging risk’ and a ‘risk’ can be summarised by the items in the
table below, although there is an area of overlap, especially as emerging risks develop into
quantifiable risks that should be logged on a company’s risk register.

Emerging risk Risk

Understanding of uncertainty Nature of risk is not well Causes of uncertainty are well understood even
understood by the market if outcomes are not predictable

Time horizon 3 years plus Here and now

Availability of research Limited research available Significant research exists

Consequences Ambiguous – relevance may not be Well understood – if it happens, we know the
obvious impact

Emerging risk can come from new processes, inventions, lifestyle choices and technological
advances. A non-exhaustive list is shown below:
 Big data.
Climate change.
Cloud computing.
Driverless cars.
Electromagnetic fields.
Environmental risks.
Genetic engineering.
Google Glass.
Intellectual property.
Meta Spaceglasses (augmented reality).
Obesity.
The Internet of Things (IoT).
Wearable technology.
3D printing.

By their very nature some emerging risks will apply to all insurance related businesses and
others will be more specific depending upon the markets in which the insurer/reinsurer
operates. For example, driverless cars may only be of interest to motor and liability
underwriters.

Lloyd’s has identified over 40 emerging risks and categorises them into one of three
categories:

Natural environment, e.g. climate change.

Society and security, e.g. obesity.
Technology, e.g. Internet of Things.

Useful websites
www.lloyds.com/news-and-insight/risk-insight

www.thecroforum.org/emerging-risk-initiative-2/

However, there are other ways of classifying emerging risks that have a closer link to
underwriting strategy and this is can be done by completing a PESTEL analysis.

In respect of emerging risks, such as climate change or the impact of new technology, insurers
and insurance organisations are working together to build as comprehensive an
understanding as possible of these risks but it is the responsibility of individual insurers to
update their own corporate risk assessments and take action to manage their own exposures.

Through research to enable a better understanding of emerging risks and those that impact a
particular insurer it is possible to plot the emerging risks on an impact/time chart similar to
the one that follows.

Research activity
Investigate the emerging risks that could impact your particular area of business and create an impact/time chart.
Consider the mitigating actions that could be taken.

Useful articles
Marriner, K. (2014) ‘Climate change modelling’, Post Online, 21 August 2014.†

Lechner, R. (2015) ‘Liability Claims Trends: Emerging Risks and Rebounding Economic Drivers’, The Geneva
Association, March 2015. www.genevaassociation.org/media/917968/ga_17th_acce_meeting_lechner.pdf
†
Please contact knowledge@cii.co.uk if you wish to receive a copy of this article via email. (Please note, under UK Copyright Law the
number of copies we are able to email is restricted to one article per issue per CII member.)
F Communicating exposure-related issues
The exposure norms and limits derived from corporate risk appetite and the relevant
underwriting strategy need to be translated into a series of unambiguous, practical
descriptions and measures which can be utilised by underwriters and surveyors in assessing
individual risks and potential accumulations and fed into unit plans, underwriting authorities
and processing systems. Underwriting managers must actively support two-way
communication with underwriters and surveyors on exposure-related items, so as to ensure
that issues are identified and approaches agreed at the earliest possible opportunity.
G Aggregate management techniques
All exposures require active management; for some this will involve more effort than others.
Most large UK insurers now manage their property flood exposures (household and
commercial) in considerable detail in order to ensure that they are not exposed to a
disproportionate accumulation of flood-prone risks. In certain sectors or segments, specific
high-hazard exposures will be monitored closely to ensure an acceptable balance is
maintained. Underwriting plans may include exposure targets to manage certain aggregate
exposures up or down in the course of the year through acceptance and renewal criteria
and/or pricing.

The techniques employed are dependent on the nature of the insurances being underwritten.
Some examples are as follows:

Risk Aggregate management techniques

UK household insurance Systems are used to aggregate the policy sums insured (buildings, contents and personal
flood risk effects) by postcode, overlaid with mapping software to identify the higher risk flood zones.
The insurer will keep a real-time total of values insured across all policies in the areas
concerned and should the maximum value per area be approached or reached then no further
policies will be written in that area.

UK household insurance Postcode systems are used to monitor theft losses in different areas and insurers will wish to
burglary risk limit their exposures in higher risk areas. As above, if the values concentrated in one area
reach the insurer’s maximum exposure then no additional insurances will be written at that
location.

Terrorism insurance The specialist area of underwriting terrorism cover (outside of the Pool Re, the Government-
backed scheme) involves careful assessment of aggregate exposures from the proximity
perspective (i.e. accumulation of insured properties within a certain postal code). Insurers
also monitor their insured exposures using blast zone mapping.

Property insurance Much the same as monitoring insured values in areas susceptible to windstorm or flooding
earthquake risk risk, insurers map their insured values within known earthquake regions. As well as reviewing
the proximity to (or distance from) the likely epicentre of an earthquake in order to estimate
the potential loss, insurers also take into account the nature of the construction of the insured
property and are naturally willing to take higher insured values for properties with damage-
resistant construction.

Property insurance In addition to looking at the susceptible areas, insurers will look at the likely path a windstorm
windstorm risk may follow – especially when risks are written in a number of territories that fall within the
path of a typical windstorm. For example, across Northern Europe.

Group personal accident Insurers seek to limit their major event exposure when underwriting policies where insured
 persons may be travelling together (such as in a helicopter flying to a North Sea oil rig) or are
working in close proximity to each other (such as in mining or hazardous manufacturing
operations). The methods of controlling aggregate exposures could be to identify existing
clients who operate at the same location and restrict underwriting of new clients. Also,
limiting the number of insured persons travelling in the same aircraft is a technique used to
control aggregate exposure.

Health insurance Health insurers are addressing the threat of multiple claims from an outbreak of contagious
epidemics disease, such as bird flu, by considering the sums insured per person and limiting the
concentration of exposures from group healthcare schemes.

Supply chain risk
Business interruption policies generally provide an extension of cover for suppliers (and even
suppliers’ suppliers), where damage at the supplier’s premises that results in interruption to
the flow of materials to the policyholder, and consequent loss of sales, is covered. Insurers
must take all steps to identify the accumulated exposures from all insured suppliers to the
policyholder and potentially place an inner limit on the extent of cover provided by this cover
within the policy.

The same applies where the policy is providing a customer’s extension.

Much of the risk information that helps insurers monitor the growth in aggregate exposures
can be drawn from the core underwriting system. However, there are software systems
available that help to capture the exposure data for any particular scenario and provide
aggregated values-at-risk information.

In the example of a terrorism insurer, the address of each policyholder is entered into a
mapping system that will provide a 100 metre or 250 metre circle around the insured
premises. This is the ‘blast zone’ that will suffer damage around a location where there has
been an explosion. The underwriter will manage carefully the values insured under any
further policies that are accepted within the blast zone to ensure that the total value of claims
from one event will not result in losses arising beyond the risk appetite of the firm.

Research activity
Review the websites for suppliers of aggregation software, such as www.niit-tech.com.

G1 Assessing extreme circumstances

Other systems are widely used that help model potential losses arising from major natural
catastrophes. Insurers are able to enter the location and insured values of every property
insured and overlay this with various storm tracks that have happened in the past and could
happen again, or a track very similar. Property insured that lies in the central part of the track
will be assessed as a total loss whereas insured property on the outer edges of the track are
assessed as suffering, say, 75% loss (as it is unlikely to be totally destroyed in the
comparatively slower wind speeds away from the centre of the track). The system calculates
an estimate of the total insured losses from storm tracks selected by the underwriter.
Realistic disaster scenarios (RDS)
A tool used in the Lloyd’s market is the realistic disaster scenarios (RDS) exercise where
Lloyd’s require all their member syndicates to undertake financial assessments of the impact
of certain stated scenarios on their underwriting performance. Lloyd’s publishes details of
over 20 scenarios, which includes information on the assumed total insurance industry loss
(across various classes of insurance), the geographical region (in regard to the natural
catastrophe scenarios), the assumed storm track of major hurricanes/typhoons and the
radius from epicentre of earthquake effect.

Useful website
www.lloyds.com/the-market/tools-and-resources/research/exposure-management/realistic-disaster-scenarios
H Reinsurance strategy and procurement
Think back to M80, chapter 6, sections C and D

Reinsurance has already been discussed at in connection with a number of points: the work
required to establish a new general insurer; the relationship between capital and reinsurance
in determining a company’s solvency; establishing and expressing corporate risk appetite;
and the impact of reinsurance on underwriting strategy. Its role as a key means of enabling
capacity will be explored in more depth here, focusing on the strategic and management
issues for an underwriting manager.

The reinsurance strategy is a central component of the strategy and management of an

insurance company’s risk profile. Insurers use reinsurance for various risk management
purposes. Clearly the main aim is to enable an insurer to spread (or ‘lay-off’) some of the
insured limits carried on policies underwritten, and this might be on a facultative, specific
policy or across a portfolio or book of business. Reinsurance protects the capital base of the
company as it provides a financial resource in the event of extreme losses that would
otherwise erode premium reserves and solvency capital and ultimately lead to the insolvency
of the insurer.

At the highest level, therefore, an insurance company seeks to ensure its security, continuity
and growth prospects in the most cost- and capital-efficient manner possible through the
purchase of reinsurance.

Be aware
In creating a reinsurance programme, insurers are often motivated in their choice of arrangement and reinsurer by
the desire to gain experience and knowledge of an unfamiliar class of business by working with an experienced
reinsurer. Similarly, reinsurers may choose to work with particular insurers in order to gain knowledge of less
familiar areas.

H1 Reinsurance programmes
An insurer’s reinsurance programme is made up of a number of contracts, reflecting treaty
and facultative arrangements, which are intended to be complementary. These arrangements
are developed over years and their management and interpretation are often the
responsibility of a central functional area within an insurance company. As the successful and
cost-effective operation of these reinsurance arrangements is fundamental to the survival
and success of the business, key decisions are usually made or approved at board level.

How this is achieved will vary according to the objectives of the company, its relative stage of
development and how reinsurers view the prospects of the insurer. For most underwriters,
however, the aspects of a reinsurance programme which are of most immediate interest are
those that:

permit or restrict the risks they may underwrite; and

 limit the impact of exceptional (very large or very numerous) claims on the profitability
of their accounts.

Within an insurer’s programme these may be referred to as the working layers or covers:
those which are intended to be available for use, or exposed, on a day-to-day basis. Insurers
may buy additional reinsurance covers or layers designed to protect the company’s assets in
more exceptional circumstances.

Be aware
While the reinsurance market responds by way of many types of contract based on the nature of the underlying risk,
the cedant insurer’s objectives and the ingenuity of the reinsurers, there are circumstances where individual
reinsurers feel unable to respond and reinsurance pools may be established and/or government support requested.

The process of procuring the reinsurance programme for an insurer carries risks of its own.
Should the insurer not disclose material information to the reinsurer, the potential for a claim
to be declined arises.

Reinsurance procurement practices should, therefore, be closely controlled and the following
features are some of the issues that senior underwriting managers will be concerned with
when developing and implementing their organisation’s reinsurance programme:

The reinsurances actually purchased are in line with the reinsurance strategy agreed
with the board.
An instruction to all underwriters that the purchase of reinsurance is only to be carried
out by authorised staff (usually an outwards reinsurance team).
Expected changes in portfolio mix, e.g. a cleansing of the book to improve risk selection
or widening the footprint and moving the mix to higher risk areas.
Information and data that comprise the application and disclosure pack (such as limits
insured per policy and per event, loss history and policy cover) should be checked and
countersigned for release by the director of underwriting.
When reinsurance terms are received, either the in-house legal team or an external firm
should review the proposed policy wording.
The proposed reinsurers are within the security policy of the firm (see section H2).

When losses occur that result in an insurer notifying a claim under the reinsurance
programme, an assessment should be made on how this may erode the cover remaining
available for the remaining period. For example, an insurer may have an excess of loss policy
providing £25m limit above a £25m retention by the client. The cover is a fixed amount per
annum. Should the insurer suffer losses of £35m this would ‘eat into’ the reinsurance
protection by £10m, leaving only £15m for any future losses. In these circumstances the
insurer must make risk-based decisions on ‘buying back’ another £10m or perhaps relying on
the residual cover. These decisions are of course linked to the firm’s risk appetite and
tolerance strategy.

Research activity
Consider the reinsurance purchased in your area of underwriting and investigate why the limits were chosen.
H1A Changing requirements
Over time, the types of reinsurance purchased by a growing insurance company will change.
Arrangements (such as proportional reinsurance treaties – quota share or surplus) that
provided enhanced capacity in the early years of a company’s history may be supplemented
or replaced by more specific non-proportional treaties (such as risk excess of loss) which
permit the now-established company to write larger risks without incurring the full impact of
very large claims. In its early days, an insurance company will have few, if any, significant
accumulations of risk but will need to monitor its exposures in order to identify when
additional protection may be required (such as catastrophe excess of loss). As an insurer
continues to grow, the company’s retentions (in excess of loss contracts) will increase
significantly, reflecting:

enhanced internal capital resources;

knowledge of the portfolio and its performance over time;
confidence in underwriters and internal systems; and
the desire to retain as high a proportion of the potential profit margin as possible.

In addition to those types of reinsurance contract already mentioned, others such as stop-loss
reinsurance are designed to provide protection against the excessive accumulation of small
losses rather than the cost of extremely large claims.

Be aware
Please note that this discussion reflects the perspective of the insurer or cedant; reinsurers have their own strategies
and objectives to consider, making different types of reinsurance arrangement more or less attractive in different
circumstances. See unit M97/P97 for a full treatment of the subject.

H2 Reinsurance security
Insurers carry the risk that their reinsurers may suffer an accumulation of extreme levels of
claims from one event and multiple cedants and consequently become insolvent and unable
to pay claims. The insurer remains liable to the insured for claims and, therefore, would have
to fund the non-receivable element of the reinsurance themselves.

An insurer will wish to ensure that the reinsurers providing protection for the firm have
security ratings at the highest level.

H2A Reinsurer failure

Reinsurance brokers and purchasers of reinsurance also monitor the security of all
reinsurance companies on an ongoing basis. If the transfer of risk from insurer to reinsurer is
to be effective and worthwhile, the insurer must have confidence that the reinsurer will still
be capable of paying claims many years in the future. The security committees of insurers set
minimum standards of security which all their reinsurers must meet: this standard may be
higher for long-tail than for short-tail accounts. A reinsurer’s security rating (claims-paying
ability) reflects its capitalisation: well-capitalised reinsurers need to charge higher prices to
achieve adequate returns and they can command higher prices from those insurers who want
to be, and be seen to be, highly secure.

So what if a reinsurer fails and the insurer cannot make a recovery?

The insurer is responsible to the consumer/insured and must pay legitimate claims in full.
The credit risk (the risk that the reinsurer will not be able to fulfil the contract) falls entirely
on the insurer. This is a particular problem with reinsurance on long-tail accounts where
recoveries from the reinsurer may not be sought until 40 or 50 years in the future.

H3 The reinsurer’s perspective

Reinsurers are increasingly concerned to understand all policy-related exposures, including
those stemming from contingent business interruption extensions, such as those relating to
suppliers: their concern relates to their own unidentified accumulations.

H3A Basic factors shaping reinsurer’s response

The basic factors which will determine and shape the response of the reinsurers (the type of
arrangements offered, levels of cover and price) are:

class of business (short- or long-tail);

limits of liability (or unlimited liability, as in the case of motor third-party bodily injury);
risk profile (how current and planned exposures are distributed by limit of indemnity,
sums insured, trade/activity, geographical location; significant inclusions/exclusions in
respect of cover offered and risk selection policy);
aggregate exposures and breakdown of premium income; and
perceived quality of underwriting strategy and related business targets (current and
anticipated approaches to growth, profitability and pricing).

The insurer’s perceived competence (generally and with particular reference to underwriting
and claims handling) and the quality of the relationship established between the insurer and
its reinsurers are also highly influential.

H3B What limits might reinsurance contracts provide?

As unlimited liabilities are unquantifiable and cannot, by definition, be fully capitalised,
reinsurers limit their liabilities in a number of ways. In the first instance, reinsurers will only
agree to arrangements where the primary insurer accepts an appropriate level of retention or
share of risk. Reinsurers then control their exposure by applying a range of limits (aggregate,
per risk, per event) on incurred claims and by limiting the number and cost of reinstatements
of cover available. Therefore, depending upon the shares, lines, layers, limits and/or
reinstatements purchased by the insurer, any excess incurred cost beyond the reinsurer’s
share is the responsibility of the primary insurer.
This is not a remote possibility and can arise when inflation has eroded the value of
reinsurance limits arranged many years previously; for example, in the case of late-reported
employers’ liability claims. The possibility of multiple significant weather claims in one
twelve-month period, each event incurring 100% of the insurer’s catastrophe retention, is
another example of how a primary insurer may incur very significant liabilities. This is why
insurers, having carefully considered their potential exposures, require a programme of
reinsurance contracts to mitigate and spread risk appropriately.

H3C Claims focus

Relevant claims data are, of course, of prime concern to all reinsurers. Those reinsurers who
currently subscribe to an insurer’s treaties want to know what the cost of their exposure has
been, or rather, will be when the claims are fully run-off (which may not be for many years).
For prospective reinsurers who wish to consider and price future reinsurance arrangements,
they will require as much relevant claims-related data and information as possible, including:

the incidence and cost of claims;

the speed of settlement and typical run-off patterns; and
reassurance regarding the competency and efficiency of the insurer’s claims handling
and estimating processes.

The relevance of the claims data will only be apparent once related to exposure data, at which
point the reinsurer’s underwriters can assess the historical experience of an individual
insurer’s account compared with other similar accounts in the market and consider what
level of claims costs next year’s planned risk profile might generate.

Reinsurers will not rely solely on historical claims data for their projections, as experience
has demonstrated that such an approach is often inadequate. Catastrophe modellers, in
particular, will utilise location, vulnerability and valuation data with stochastic statistical
methods (incorporated into modelling software produced by Risk Management Solutions
(RMS) or AIR Worldwide, for example) to generate projections, cover options and prices.

Useful websites
www.rms.com

www.air-worldwide.com

Be aware
Reinsurers use the same statistical and actuarial methods, as described in chapter 6, in order to evaluate ultimate and
projected future claims costs.

The same fundamental issue of uncertainty underpins both insurers’ need for reinsurance
and reinsurers’ difficulty in deciding what cover to grant and what to charge for it. Where
reinsurers only cover extreme losses (as in excess of loss treaties), the degree of uncertainty
and potential volatility is greatly heightened. In order to produce profitable returns for their
investors and shareholders, reinsurers must achieve a good spread of risk in their own
portfolios through balanced risk selection and the appropriate transfer of risk to other
companies through the retrocession market.

The quality of data and information supplied by insurers has a direct bearing on reinsurers’
understanding of their own exposures and ultimately their own performance. It should not
come as a surprise, therefore, that reinsurers will seek the best data and information possible
from ceding insurers and that poor data will attract restricted reinsurance cover at higher
prices, as greater uncertainty has been priced-in.
I Alternative risk transfer options
The whole regime of exposure control is designed to ensure that accumulation of risks is
managed on a per-location and per-event basis and to create greater spreading of risk. This
helps to retain as far as possible the predictability of the losses during the year of account in
question by limiting large losses.

I1 ‘Subscription market’ risk sharing

In many cases, the insurance requirements for major buyers are shared with a number of
insurers, thereby meeting the client’s requirements but containing the exposure to any one
insurer to an acceptable level. The Lloyd’s and London insurance markets operate much of
their business on this basis and create what is known as a ‘subscription’ market.

Example 8.2
Consider the insurance needs of a cruise ship operator with five vessels and insured values of $400m, with the
largest value being the flagship of $120m. The insurances may be shared in the following structure:

Insurer Percentage underwritten Value insured flagship Value insured fleet

(subscribed)

Syndicate A   20%  $24m  $80m

Syndicate B   15%  $18m  $60m

Syndicate C 12.5%  $15m  $50m

Syndicate D   10%  $12m  $40m

Syndicate E    5%   $6m  $20m

Insurer A   15%  $18m  $60m

Insurer B   10%  $12m  $40m

Insurer C 12.5%  $15m  $50m

Total  100% $120m $400m

This structuring of the values allows the larger syndicates and insurers who have greater risk bearing capacity and
appetite to take a larger share of the values, with a commensurate level of premium. In the event of a major incident,
the maximum loss per vessel is known and these values can be reduced through the use of reinsurance. Reinsurance
will also be in place for the extreme scenario of more than one vessel being lost at the same time.

This type of risk sharing helps to limit the risk of a major loss from one event and also
creates a diversified book of business that has many other risk reduction benefits, such as
improved credit risk where business emanates from a wider range of brokers, price resilience
by having a portfolio of clients and wider geographical spread. These benefits are slightly
offset with potentially higher administrative costs but these are not material compared to the
advantages of risk spreading.

I2 Alternative risk transfer (ART)

ART has no strict definition, although it is often said to be a ‘non-traditional way of dealing
with a risk transfer problem’. It has become increasingly important as another way to transfer
risk apart from the purchase of conventional reinsurance. One opinion is that ART is a risk
transfer to the capital markets, while others prefer a wider definition that includes any cover
containing an element of financial risk.

Be aware
Any insurance-linked security that allows investors in capital markets to take a more direct role in providing
insurance and reinsurance protection, and brings about a convergence of insurance and capital markets, can be
considered as an ART instrument.

ART is a set of risk-financing techniques. Traditional techniques were once limited in their
application to single class insurance risks, such as property. The alternative techniques
combine with the traditional to offer a powerful ‘tool kit’ for meeting more broad risk-
financing needs, including the financial management of risks that have not usually been
insured.

An ART solution is likely to contain several risk-financing techniques. ART solutions are
hugely varied and often developed uniquely to solve a specific problem.

Insurance-linked securities provide a mechanism within the financial system to transfer

insurance risk to capital markets and supply protection to investment portfolios. The
financial system benefits from the presence of insurance-linked securities, as well as other
forms of ART. As a result of securitisations, derivatives and swap structures insurers are
better positioned to spread their risks across the broad spectrum of the capital markets, as
opposed to relying on reinsurance or capital reserves, so allowing for efficient use of capital
and adding liquidity to the financial system. This ultimately benefits individuals and
institutions seeking insurance protection. Capital market participants benefit from a
diversity of risks and returns that are not dependent on the factors that usually affect them.

I2A Development and features of ART

Capital markets and the insurance industry have long held a mutually-beneficial relationship
where insurers provide risk protection to individuals and companies while capital markets
provide the insurance industry with a wealth of options to earn investment profits and
manage reserve funds. In turn, insurers have been among the largest purchasers of fixed-
income securities from capital markets. This has provided capital markets with substantial
liquidity, enhanced trading efficiencies and lowering borrowing costs for both Government
and corporate debt issues.

In recent years, the relationship between capital markets and the insurance industries has
evolved to the transferring of risk through securitisation, otherwise known as ART. Imbalance
in the insurance and reinsurance industries has given rise to new financial products created
within capital markets, providing insurers with better tools to manage risk and investors with
new investment opportunities. Traditionally, primary and secondary insurance markets have
managed risk by holding capital in reserve or by financing risk positions through reinsurance.
However, capital held in reserve is unavailable to fund business expansion and new ventures,
resulting in stagnation. The desire to free capital, combined with concerns over the
reinsurance industry’s ability to provide future coverage, has provided insurers with the
incentive to look for risk management alternatives.

To begin with, insurance-linked securities were simple fixed income structures that allowed
insurers to manage catastrophic risks. Over time, they have become more complex and have
evolved into a discrete asset class with great appeal to a wide range of investors and provide
insurers with a broader choice of risk management tools. Insurance-linked securities include
derivatives, catastrophe bonds, contingent capital contracts, industry loss warranties,
reinsurance sidecars and catastrophe futures, which further converge capital and insurance
markets.

Cost and capacity limitations in the reinsurance market have created incentives for insurers
to turn to the capital markets by creating the opportunity to convert illiquid assets into liquid
ones. Insurance-linked securities serve to manage and hedge various insurance risks while
increasing the availability of capital by drawing on alternative sources of funding.

Like most other markets, insurance-linked securities have been adversely affected by the
global financial crisis but have proved to be more resilient as issuances continue to grow
despite there being some weaknesses in certain individual sectors.

There are two segments which make up the ART market:

The market for alternative carriers consists of self-insurance, captives and other loosely-
defined risk retention groups.

The use of captives increases dramatically when insurance markets harden. Since many
multinational companies already have a captive, the number of captives is not expected to
rise appreciably, although some growth in captive formation will arise from rent-a-captives
and protected-cell captives, which primarily serve medium-sized corporations.

Captive insurance companies represent an alternative form of risk financing that has been
used for over three decades. Since the 1970s, most major banks, commercial and industrial
companies and privatised utilities have set up captive insurance companies as a way of
retaining more of their own risks. It is estimated that the total number of captive insurers
worldwide is just over 5,000, with the majority domiciled in tax-friendly locations, such as
Bermuda, the Cayman Islands, Guernsey and the US state of Vermont.

The key differential between ART and the traditional insurance marketplace is that insurance
and reinsurance markets provide catastrophic risk coverage whereas the capital markets
provide additional financial capacity for insurance coverage through self-insurance. However,
ART is intended to represent an integrated approach to supplement reinsurance needs rather
than to be a replacement.

Catastrophe bonds
These are the capital market alternative to traditional catastrophe reinsurance. Catastrophe
bonds are used by insurers to purchase supplemental protection for high-severity, low
probability events. They are risk-linked securities that transfer a defined set of risks from the
insurer to investors through fully-collateralised special purpose vehicles.

Historically, catastrophe bonds were structured to offer high yields that attracted investors
with higher risk appetites. Original catastrophe bonds only covered a single peril but now
they may include a multitude of perils. Key investors in catastrophe bonds include hedge
funds, insurers, reinsurers, banks and pension funds.

Contingent capital contracts

These are financing agreements arranged before a loss occurs. Should a named event occur,
the financier provides the insurer with capital determined by the amount of catastrophic loss.
The terms of the deal are arranged during a prior time of normal benign activity when the
borrower can negotiate access funds at favourable rates. If no catastrophic events occur,
there is no exchange of funds.

Industry loss warranties

Industry loss warranties are reinsurance contracts where payouts are linked to a
predetermined trigger of estimated insurance industry losses. They are swap contracts that
are based on insurance industry indices rather than insurer actual losses. Payment of the
warranty is made based on whether the covered insurance industry suffers a predetermined
level of loss due to natural circumstances.
 Example 8.3
An insurer has exposure to hurricanes in Florida. They could buy an industry loss warranty exposed to wind in that
region of the USA which would be triggered if the total industry insured loss rose above $10bn. They pay a premium
to the reinsurer or a hedge fund and in return could receive the limit amount if losses exceed the predefined amount,
or warranty.

An industry loss warranty can sometimes have additional clauses which must be met for a payout to be made, such
as additionally to the industry loss the insurer must also have experienced a specified amount of loss themselves.

Reinsurance sidecars
These are limited purpose companies created to work in tandem with the reinsurance
coverage provided to an insurer. Sidecars are capitalised with debt and equity financing from
capital markets and are liable for only a portion of risk underwritten. Sidecars allow insurers
to write more policies while limiting their liabilities. Unlike traditional reinsurance, sidecars
are privately financed, they dissolve after a set period of time, and the risks are defined and
limited.

Catastrophe futures
Catastrophe futures are futures contracts used by insurance companies as a form of
reinsurance. The value of a catastrophe futures contract is determined by an insurance index
that tracks the amount of claims paid out during a given year or time period. When
catastrophe losses are higher than a predetermined amount, the future contract increases in
value and vice versa. Despite ebbs and flows in their trading, catastrophe futures helped usher
in the era of insurance derivative contracts and capital market alternatives to traditional
insurance and reinsurance approaches.

Insurance derivatives
These derive value from the valuation of financial instruments, events or conditions. A few
examples of derivatives include put and call options, forwards and futures contracts, swap
contracts and credit default swaps.

Derivatives offer investors the advantage of instant liquidity, plus they enable investors to
gain exposure to underlying risk classes that may not otherwise be tradeable. They also allow
hedging or transferring of risk positions. Speculators use derivatives with the goal of profiting
from directional price movements. Derivatives are designed to have large pay-offs and tend
to be highly leveraged. Small changes in the underlying asset can lead to large price swings.
Derivatives not traded on an exchange have an increased risk of counterparty default.

The attractiveness of insurance derivatives is that they shift risk more efficiently than
institutional methods, avoid contractual costs of traditional insurance and reinsurance
methods and create liquid markets for trading. Derivatives allow insurers to purchase
protection for new pools of investors. However, the use of derivatives has received heavy
scrutiny following their role in the collapse of the financial markets.

I2B Finite risk solutions

The term finite risk is used to differentiate risk-based products from the investment-only
type products. These finite risk reinsurance contracts have certain characteristics in
common, as follows:

They provide a risk financing mechanism for near certain events.

Pricing took the time value of money into account.
Reinsurer’s maximum liability was limited, being closely related to the premium paid.
Reinsured usually participated in losses and benefited from better than expected loss
experience.
Contracts were usually multiple year.
Transaction costs were lower than for traditional contracts.
Regulators will look carefully at the amount of protection purchased through certain
types of ART.

The move towards risk-bearing transactions was assisted by new accounting rules. For
example, the US FASB SFAS 113 rules outlawed such investment reinsurances and premiums
paid under such arrangements were counted as deposits and taxed accordingly. A new test
was adopted under the rules whereby for there to be risk transfer, there had to be ‘a
reasonable probability of the reinsurer losing a significant amount of money or making a
significant loss’. Similar rules now exist under the UK regulatory regime.

Advantages of capital market solutions

Investors are attracted to the diversification of benefits and above average yields of
insurance-linked securities.
Returns of insurance-linked securities are independent of factors affecting traditional
financial markets and their returns typically exceed similarly rated investment assets.
The weak correlation of these financial instruments with traditional financial markets
enables investors to achieve greater portfolio diversification and higher yields.
Capital markets have the potential to be price competitive relative to reinsurers in the
longer term.

Disadvantages of capital market solutions

Investments in insurance-linked securities expose investors to risks that are not
typically associated with traditional investment classes.
Prior to the credit crisis, some insurance-linked securities were used to augment the
credit rating of the security provider, removing much of the insurance risk and leaving
investors exposed only to the risk that the investment bank issuing the credit would
default. While this risk was previously thought to be negligible, the collapse of Lehman
Brothers in 2008 proved that the extent of this risk was much greater than imagined.
Traditional reinsurers tend to take a long-term view. In contrast, capital markets often
require a more immediate return and could withdraw their support at critical times.
Transactional costs can be very high, particularly for smaller deals.

Insurance-linked securities carry a variety of risks

As we have seen, insurance derivatives and other financial instruments are designed to
transfer or hedge primary and secondary insurance risks amongst capital market
participants. The appropriateness of these ART strategies depends on the situation and the
size of the purchaser. These risks include:

Liquidity risk The uncertainty that results from the inability to buy or sell an instrument.

Basis risk Occurs when the cash flow from the hedging instrument does not perfectly offset the cash
flow from the instrument being hedged.

Moral hazard Takes place when one party transfers risk to another, and the party ceding the risk has less
incentive to ensure that the risk is managed as efficiently as possible.

Adverse selection Occurs when both sides of the transaction do not have access to the same information.

Credit or counterparty Arises when the counterparty to a transaction may not be able to honour their side of the
risk obligation due to financial hardship or some other cause.
Summary
The main ideas covered by this chapter can be summarised as follows:

Broad corporate risk appetite choices are manifested in the types of risks underwritten.
Unknown accumulations must be dealt with by ensuring that an insurer’s net retained
liability for single events is tailored to its level of financial resource.
The standard measures of exposure are not difficult to define but it is more difficult to
capture and utilise the data to best effect.
In order to control exposure, external factors need to be identified, assessed and
monitored.
Emerging risks should be considered as part of an insurer’s risk management framework.
All exposures require active management; for some this will require more effort than
others.
The reinsurance strategy is a central component of the strategy and management of an
insurance company’s risk profile. Insurers use reinsurance for various risk management
purposes.
Alternative risk transfer has become an increasingly important method of transferring
risk.
The convergence of the insurance and capital markets has created an alternative channel
for insurers to transfer risk, raise capital and optimise their regulatory reserves.

Bibliography
ABI. (2011) Industry good practice for catastrophe modelling. December 2011.

ABI. (2014) Non-modelled risks – a guide to more complete catastrophe assessment for (re)insurers. April 2014.

AIG. (2013) Think differently about risk. www.aig.co.uk/content/dam/aig/emea/united-

kingdom/documents/Alternative-Risk-Solutions/White-Papers/think-differently-about-risk.pdf

Banks, E. (2004) Alternative risk transfer: integrated risk management through insurance, reinsurance and the
capital markets. Wiley.

Clark, P. (2013) ‘Catastrophe models give insurers insights into disasters’, Financial Times, 30 September 2013.

Lloyd’s. (2014) Catastrophe modelling and climate change. Research report.

Lloyd’s Market Association. (2013) Catastrophe modelling. Guidance for non-catastrophe modellers.

Mathias, A. (2014) Selecting risk. IIL lecture. 8 October 2014.*

Punter, A. (2014) Third-party capital. IIL lecture. 26 June 2014.*

World Economic Forum. (2014) Insight report: Global risks 2014. Ninth edition.
*CII Fact Files and IIL lecture content available to CII members via the Knowledge Services website (www.cii.co.uk/knowledge).

Scenario 6 – Question
 On introduction, a newly-appointed underwriter tells you that her previous company’s maximum acceptance limit
for commercial property exposures was also £15m TSI, ‘…so I know precisely the kind of business you want to
write.’

What areas of potential difference would you draw to the new underwriter’s attention?

See overleaf for suggestions on how to approach your answer

Scenario 6 – How to approach your answer

Aim
This scenario requires you to explain how a company’s risk appetite (and the underwriting strategies which flow
from it) is reflected in more than a single measure of exposure.

Key points of content

You should aim to include the following key points of content in your answer:

How this company’s risk appetite and underwriting strategy affects:

the type of risks written (sector-focus or specific bias or restrictions);

the required risk profile (for example, the balance of small, medium and large risks and mix of risk types);
reinsurance purchase and retention levels (and thus the company’s total and net capacities); willingness to
purchase facultative reinsurance or to become involved in co-insurance;
approach to potential accumulations including attitude towards risks exposed to specific natural hazards;
other specific marketing and distribution initiatives and the company’s operational approach which may
influence the profile of targeted/acceptable risks;
the respective stages of both the economic cycle and underwriting cycle may also influence this company’s
approach to risk acceptance.
 9 Monitoring and operational controls

Contents Syllabus learning

outcomes

Learning objectives

Introduction 5.2

Key terms

A Plans, budgets and forecasts 5.2, 5.3

B Key performance indicators 5.3, 5.5

C Claims, reinsurance and exposure 5.3

D Audit 5.3, 5.6

E Presentation of data 5.3

F Looking ahead as well as back 5.2, 5.4

G Data mining 5.2, 5.4

H People management 5.1, 5.5

I Authority limits 5.6

J Other auditors 5.6

K Delegated authority 2.3, 5.6

 L Underwriting policy 5.6

Summary

Bibliography

Scenario questions and answers

Learning objectives
This chapter relates to syllabus sections 2 and 5.

On completion of this chapter and private research, you should be able to:

identify what needs to be monitored in an underwriting account;

select and use appropriate approaches to variance analysis and action planning; and
identify and apply appropriate processes and controls to achieve an acceptable level of
underwriting governance.
Introduction
The purpose of monitoring is to evaluate progress against plans and to guide appropriate
actions (immediate, short- and long-term). Monitoring activities are conducted throughout
general insurance companies: all levels and all functions are involved.

Be aware
Individual job descriptions and personal targets should specify key monitoring responsibilities and the company’s
planning and budgeting processes will indicate how different levels of accountability link with one another. While
straightforward duplication is to be avoided, benefit will be derived from some data and information being reviewed
from different perspectives: this will form part of standard agendas in joint meetings between underwriting and
claims areas and underwriting and sales areas, for example.

Think back to M80, chapter 1, section C3A

As well as monitoring internal performance, external information and data of many types
must be monitored: these include external factors and influences which help to explain
company and product performance and external benchmarks (such as the performance of
other insurers) which necessarily influence the company’s plans and internal targets. The
time frames involved may vary from a day (counts of claims intimated) to several years
(prospects for different types of investment) or decades (potential impact of climate change).

Be aware
When establishing a baseline against which to monitor – be that internal measures such as plans, budgets and
targets or external measures such as the financial performance of other companies, customers’ perceptions of
insurance companies and the current level of economic growth – you should note that monitoring is itself a key
element in determining what should be monitored and what the appropriate baselines might be. The internal and
external awareness that a consistent and comprehensive approach to monitoring can deliver is the best basis for
sound internal plans.

The operational controls typically used in underwriting also involve forms of monitoring.
While the productivity, effectiveness and development of all staff must be monitored, the
discretionary activities of underwriters (namely, their ability to accept and price risks on
behalf of insurers) require particular attention as the effective governance of these activities
is fundamental to the success of the company.

Key terms

This chapter features explanations of the following terms and concepts:

Contingency allowance Data mining Exception report Key performance indicators

(KPIs)

Lag indicator Lead indicator Moving annual total Pipeline premium

Underwriting governance Underwriting licence Variance
A Plans, budgets and forecasts
As discussed in chapter 5, an insurance company needs to know whether it is meeting its
planned objectives, both strategic and operational, throughout the course of the year. This
form of monitoring allows issues of underperformance to be tackled as soon as they are
identified, unexpected opportunities to be exploited and expectations (internal and external)
to be managed appropriately.

As we have established, the monitoring of plans and budgets and ongoing creation of
forecasts (or reforecasts) to the end of the budget period and beyond will follow the approach
adopted in the planning and budgeting processes of individual companies.

A1 Monthly (management account) results

On a monthly basis (a few days after the end of the month), you should receive the basic
figures which outline your account’s performance:

Written premium.
Earned premium.
Incurred claims cost (payments plus change in outstanding estimates).
Earned loss ratio.
For the month – actual/budget/last year’s actual.
For the year-to-date – actual/budget/last year’s actual.
Split by product, scheme, class, intermediary and/or branch, as appropriate.

Be aware
These figures will usually be presented on a ‘gross’ basis, ignoring the impact of reinsurance premiums and
recoveries. This is not always the case however: please check that you understand the basis of any figures presented
to you.

The board will monitor monthly performance on gross and net bases, as well as additional items drawn from the
company’s financial accounts, such as ROCE, solvency and profit.

A2 Variance analysis
This basic management account (which may or may not also include commission and an
allocation of expenses) is merely the starting point. In order to explain any variances
(differences between the actual and budgeted figures), you require access to data at a lower
level of detail, for the same time period and calculated on a consistent basis. Not all of the
following measures will be appropriate for every account and, depending upon the nature of
the account, some measures will only be meaningful at a lower product or policy-section level.

Drivers of premium:
Number of quotations and conversion rate.
 Number of new business policies and average premium.
Number of renewed policies and average premium.
Renewal lapses and mid-term cancellations (numbers and premiums).
Value of mid-term adjustments.
Average rating increase/decrease achieved on renewals.
Average change in exposure on renewals.
Individual large premium cases written/lapsed.

Be aware
The figures above will be subject to amendment for a number of subsequent months, while business relating to the
reported month is confirmed as accepted, renewed or lapsed. This generates what is referred to as ‘pipeline
premium’: the difference between what is currently debited in the system and what is ultimately expected to be
received for the period. It would be advisable to refer to the data for the last six months, at least, to observe the
relevant trends in these measures.

Drivers of claims costs:

Number of claims first intimated.
Number of claims settled.
Number of open claims.
Total claims payments.
Changes in claims estimates (total and individual large movements). For long-tail
accounts such as liability it is important to distinguish between current year and prior
year claim movements.
Individual claims first exceeding a selected amount, e.g. £100,000.
Individual large claim movements exceeding a set amount, e.g. £50,000 or £100,000,
depending upon the size of the account.

Be aware
Information is often as valuable as data in understanding variances. If the underwriting, accounts or claims areas are
experiencing productivity issues for any reason, the effects are likely to be evident in your results but you may not
understand their source, unless you ask. The company actuaries will monitor claims data closely in order to produce
IBNR and IBNER figures for the financial accounts: they may well notice changes or trends in claims numbers and
costs before they are fully evident in your own results. It is therefore important to have regular dialogue with
colleagues in other departments.

Use of exception reports

For certain types of business you may also require some monthly data relating to exposure or
change of mix. This type of query could be dealt with by exception. An exception report is
only produced if the selected measure (e.g. total sum insured, vehicle value or number of
insured persons) exceeds a pre-selected level (an amount or % of total). This approach can
also be applied to monitor the discretionary activities of underwriters or intermediaries with
delegated authority, for example, if very high premium discounts have been used frequently
(see section I and section K).

All of the above relates to what you might typically monitor on a monthly basis: in order to
satisfy yourself and those to whom you report that your account is performing in line with its
plan and budget or you know why it is not.
 It’s in black and white: must it be correct?
Do not dismiss the possibility that some figures may be incorrect, for example, an updated claims estimate may have
been re-entered as £300,000 instead of £30,000: a case of ‘fat finger’! ‘End-of-month’ figures may have been run
before the last day of the month, leaving premium and claims figures short. If the figures do not look right, they may
or may not be correct but your job is to know how to validate figures and who might help you do so.

Blip or trend?
Certain measures can be highly variable from month to month (for example, average claims
cost) and it would be wrong to conclude on the basis of one or two months’ data that an
account was either performing wonderfully well or doomed. Calculating moving annual total
(MAT) – rolling twelve-months – figures (and plotting them on a graph) may help distinguish
which measures are simply highly variable around an expected level from those which are
trending either upwards or downwards.

A3 Initiating action
Internal issues: you may know that the issue that caused a variance (for example, a
processing backlog) has already been rectified. If not, what actions do you intend to take?

Example 9.1
If the variance was caused by a failure to debit the premium for a particularly large case in good time, you may
instigate actions to ensure that this does not happen again, such as introducing warning lists in the last week of the
month or amending the targets of individual underwriters to highlight this activity.

Planning issues: variances can reflect the difficulties inherent in planning and budgeting and
may indicate that more attention need be paid to such issues.

Example 9.2
Might the problem be how a measure such as written premium has been phased, month-by-month, in the annual
budget? Or, if the trend in written premium is expected to change (from growth to decline or vice versa), have the
monthly earned premium figures (which will lag any such change in direction) been accurately predicted?

Underwriting issues: having checked that the figures are correct, that the variance has not
been caused by a planning distortion and that it is significant, what are you going to do?

Example 9.3
A significant number of large claims are intimated; total intimations are above plan for the third successive month;
many branches report that new business sales are well below plan; loss ratios are deteriorating – some typical
underwriting issues.

Underwriting management decision: variance analysis and action planning

Do you fully understand the cause of the variance and any contributory factors, or is further investigation required?

What can be done to manage the variance (reduce/remove) in the current planning period? What are the options
and what other impacts might different courses of action have? Who needs to be consulted?

How will this affect your forecast for the remainder of the planning period and beyond?
 Be aware
As you dig deeper to uncover the reasons behind variances, be aware that the data you uncover is not necessarily
consistent with the original budget data. Check that you understand how measures have been calculated and where
the data has been derived from; think about who might be able to help you understand unfamiliar data.

A4 Key variables and assumptions

The measures listed above, which might be examined monthly, have not exhausted the list of
variables and assumptions used in the original planning and budgeting exercise. Included in
this group of key variables and assumptions are:

impact of economic growth/recession (on claim frequency, sales and exposure);

rates of inflation (claims and other);
seasonality;
allowances made for weather-related claims;
internal consistency in claims reserving practice;
mix of exposures (type and size);
implementation of planned rating and product changes and their assumed impact on
income and retention;
market share; and
competitor activity, including pricing.

Be aware
It should be noted that this process of monitoring key variables serves two parallel activities:

the first is monitoring, explaining and managing current performance; and

the second is planning for the future through profitability and pricing exercises, as well as supporting the
development of underwriting strategy.

As you seek to understand variances between actual and budgeted results, other issues may
emerge for which allowances (contingency allowances) were not explicitly included in your
budget. Examples might include:

the implementation of a new computer system – initial adverse impacts on productivity

and accuracy/consistency of data;
changes to the distribution network and re-allocation of commission levels – sales
patterns disrupted; and
competitor activity (reduced prices, new products and services).

While it may have been difficult to predict how any or all of these issues would affect your
account, would it have been appropriate to make a specific contingency allowance for some of
these eventualities? As well as attending to explanations of current performance, planning
and budgeting processes should be appraised to ensure that they are continuously improved
by considering such questions.
B Key performance indicators
The ways in which insurance company staff are engaged and incentivised varies from
company to company but it is common practice to highlight particular measures of
performance in order to provide common direction and focus across large groups of people.
These measures can apply at company, as well as function/unit level, and will appear in
individual performance management contracts. The measures chosen as key performance
indicators (KPIs) reflect the nature of the function and the role of the individual. The
measures selected will vary from time to time, in line with corporate or local objectives (or
critical success factors).

Be aware
KPIs need to be chosen and managed with care in order to avoid unintended consequences. For example,
underwriting staff are likely to have KPIs that involve both income growth and profitability measures, as emphasis
on one measure without the other would generally be inappropriate.

For the majority of staff, the use of KPIs provides clearer, more focused messages about the
ongoing performance of the company, their functions or units and their own personal
performance, than could be achieved by the circulation of the monthly management account.
Your work in identifying and explaining variances and determining and initiating actions will
also support the presentation and explanation of monthly KPIs to staff (see section H).
C Claims, reinsurance and exposure
As previously discussed, your claims and actuarial colleagues will devote considerable effort
to monitoring the company’s claims experience and you should ensure that underwriting
plays its part and has appropriate access to the results of this work (notably, ultimate claims
costs, reserving patterns, IBNR and IBNER). It is highly likely that you will require access to
lower level claims data in order to understand the detailed experience of your own accounts,
schemes or products (claims frequency and severity by cause, location, trade etc.). In
particular, if you use underwriting year/incurred reporting on a monthly basis, you may wish
to disaggregate these results to examine accident year development, possibly every quarter
(see chapter 6, section D3).

An examination of accident year development is particularly important in order to

distinguish current from past performance. For example, although underwriting policy may
have changed in respect of a particular type of risk or cover, the experience of former periods
is still developing and will continue to affect incurred reporting until those periods are
entirely run-off. The account must continue to bear the cost of this run-off but accident year
reporting will clarify the impact and indicate whether current experience shows signs of
improvement (in response to the change in underwriting policy).

While claims and finance colleagues will handle the ongoing work of reporting large claims to
reinsurers and calculating recoveries due and premium payments, the underwriting area
needs to monitor the use of reinsurance arrangements.

It is sometimes appropriate to encourage all underwriters to evaluate risks on a gross basis,

as if no reinsurance protection is available to the insurer. In this way underwriters are
encouraged to apply the same standards when considering risk exposures that may impact
the reinsurers’ accounts as they would when considering retained exposures. Moreover any
business written must conform to the risk profile provided to the reinsurers at last renewal.

Be aware
Individual underwriters should be made aware of the fact that inappropriate use of reinsurance will rebound on the
insurer, either through inability to make a recovery or, at next renewal, to obtain as much cover as required at an
acceptable cost.

As well as high per risk exposures and accumulations, requests for special acceptances, the
use of facultative reinsurance and other specific arrangements such as Pool Re should be
monitored. Before next year’s reinsurance programme is negotiated, the underwriting area
needs to consider what cover is required: are opportunities to write acceptable business
being missed due to inadequate upper limits in treaties or are reinsurance premiums
unnecessarily high due to the cost of arrangements which are rarely used? Attention to
planned exposure to risk, at individual and aggregated levels, has already been discussed (see
chapter 4, section B3A and chapter 8).

Although claims tend to attract the blame for bringing uncertainty and variability to the
conduct of general insurance business, how often do the exposures that give rise to claims
appear to come as a surprise to the insurers involved? This could involve:

inappropriate per risk retained exposures;

accumulations of exposures that have not been recognised or managed appropriately;
the nature or severity of the incident leading to the claims not being recognised or being
underestimated; and/or
an unexpected clash of covers.

Be aware
As inadequate identification of exposure to insurance risk could result in company failure (reflected in the ever-
closer association of risk profile/exposure-mix, as well as exposure values, with capital allocation, adequacy and
solvency), the monitoring of exposure, its management and control rank highly on corporate and regulators’ risk
management checklists.

Having agreed the risk control strategy for your account, you should monitor productivity
monthly (are the appropriate risks being surveyed in a timely manner?) and check that the
strategy continues to fit the risk profile of the account.
D Audit
Another form of monitoring that tends to be referred to as ‘audit’ involves the review of a
unit’s or individual’s work to ensure compliance with company standards and to identify and
spread best practice. We shall discuss this in more depth in section I, section J and section K.
E Presentation of data
Our understanding of trends and relationships can be greatly enhanced by the appropriate
presentation of data. The use of moving annual total or rolling twelve-month figures has
already been mentioned. Ratios, which reflect key relationships between independent
variables (such as loss ratio, claim frequency and burning cost), can be very useful in
highlighting significant changes across an account or portfolio over time.

Example 9.4
If a private motor account was undergoing an intended change of exposure mix (say, moving from younger to older
drivers) over a period of years, it would be useful to monitor the claims frequency of each age group separately as
the change in exposure mix took place. It would confirm whether the expectations of underwriting management,
when the change was proposed, were correct and the targeted results (underpinned by an age-related claim
frequency assumption) achievable.

All three ratios mentioned above include the number or cost of claims: only claims at
comparable development periods should be used in comparative ratios. If the current
year’s earned claims ratio, at the 6-month stage, is 50% and last year’s, at the 18-month stage,
is 70%, this is not a valid comparison and reveals nothing of value. If last year’s ratio at the 6-
month stage was shown (at 40%), the comparison is valid and a worthwhile question may be
asked: why is this year’s ratio higher? Also, might we expect this year’s ratio, at the 18-month
stage, to be higher than 70%?

Individual managers may specify a ‘dashboard’ of a few key figures and ratios which they rely
upon to highlight monthly performance issues. This is entirely acceptable as a starting point
but should not be seen as fulfilling monitoring responsibilities. Whether managing a group of
products, class of business or region, monitoring results at too high a level risks overlooking
potentially important underlying trends or issues. Even when planned results are being
achieved, are you sure that the change in underwriting policy (initiated in order to improve
results) is the cause? (See chapter 4, section D1.)
F Looking ahead as well as back
Senior underwriting roles are heavily involved in planning, budgeting, monitoring and
reforecasting; investigating variances and devising and implementing action plans to address
variances; preparing risk profiles for reinsurers and addressing exposure issues. In order to
accomplish these tasks you need appropriate access to data, well-established routines and
the support of your colleagues.

Your role will also typically require attention to underwriting strategy and/or product or
scheme development, involving looking beyond the month-by-month performance of the
account or regular pricing reviews. With a longer-term perspective in mind:

What is the data telling you about the account?

Can you distinguish lead indicators (highlighting future trends) from lag indicators
(measuring what has already happened)?
What expectations do you have for the external environment (including market) in which
the account will operate in a few years’ time?
Are there investigations or actions which need to be initiated now to ensure the account
is well-placed in the future?

Underwriting management decision: product lifecycle

A radically new product may take a couple of years to prepare, from initial idea to launch. When do you need to start
to ensure you beat the competition and reap the benefit of the company’s investment? If a significant part of your
account is currently profitable but declining, what will take its place and when?

Managing a portfolio of products requires attention to the development, exploitation and replacement of current
products, as well as the search for and preparation of new products. What data and information do you need to
monitor?

You need to formulate future-focused questions appropriate to your account and then look
for answers and options before you can start to plan actions. Current data may or may not
help answer those questions but it is likely that you will have to find or compile some new
data. As noted earlier, you need ‘the right tools for the job’ which are not necessarily those
most readily available.

Example 9.5
Consider the following scenario:

It is apparent that the number and cost of household claims in respect of escape of water is moving inexorably
upwards: what should you do? Do you know why this is happening? Is there more than one reason? Is it happening
across the account (product, location, sums insured)?

Possible reasons:
Increase in average number of bathrooms, utility rooms and appliances per household.
High specification of décor in houses with highest number of bathrooms.
Rise in number of second homes (frequently unoccupied/remote).
Long-hours culture: main homes less occupied.
Carelessness.
Poor quality plumbing skills.
High-spec new homes untested by low temperatures, until a freeze happens.
 Use of plastic push-fit connectors rather than copper piping with soldered joints.
More heavily insulated lofts (water tank in loft deprived of benefit of heat rising through ceiling).

Some possible responses:

Stop writing household business.
Exclude the cover.
Try to identify features that indicate greater or lesser propensity to claim, then control exposure accordingly.
Buy additional reinsurance protection.
Apply additional terms and conditions: increase wet perils excesses to reduce attritional losses; impose
requirement to turn off water if house unoccupied for more than 24 hours.
Increase premium: across-the-board or on a bathroom-rated basis.

Although you may regard some of the options listed above as overreactions, in order to develop a robust plan of
action you should state why any credible option is not worth pursuing. If the household account represents 50% of
your company’s business, a decision to stop writing household business would not be taken lightly but, at the same
time, it serves to indicate the relative importance of the issue and the urgency with which a solution must be found.

Each credible option must be examined in turn, using the necessary data to assess the financial impacts and
indicating other impacts on customer satisfaction, reputation and market share, for example. Once the action plan
has been agreed, the assessed impacts (financial and otherwise) need to be incorporated into the relevant plans and
budgets.
G Data mining
Do not underestimate the value of dipping into datasets that you do not regularly refer to or
looking at a set of randomly selected underwriting files. Chance discoveries are legitimate
sources of good ideas and/or a deeper understanding of your account.

The term data mining has been coined to refer to larger scale, systematic versions of the
above whereby large, existing datasets are analysed or ‘mined’ in order to discover previously
unidentified correlations between factors or particularly profitable segments. This approach
is only likely to be worthwhile when dealing with very large datasets with decent data
standards (consistent, accurate recording of data over a period of time).

For those lacking the necessary scale of dataset or the financial resources to pay for a data
mining exercise, valuable insights can be gained from conducting small scale, manual or semi-
manual sampling exercises. For example:

Do policyholders who renew for more than five successive years share any marked
attributes?
If risks belonging to a current single risk classification were subdivided into two or three
new groups, would clear differences in claims experience emerge?

The information gained from, and further questions suggested by, a limited exercise may
justify a more extensive review, including the gathering of data not currently available to the
company. For example, independent market research might be conducted to identify
customer attributes not currently recorded on file. Initial small scale investigations can shape
and refine questions and objectives, as well as testing data quality, before committing to
significant research programmes or statistical analysis.
H People management
The plan for your underwriting area includes certain assumptions about people. You should
consider the head-count, structure and skill levels necessary to deliver the required levels of
productivity and effectiveness (quality of customer service, ability to achieve job role targets
and collaboration with internal colleagues) to meet your area’s objectives. These are
important assumptions that must be monitored consistently and adjusted as required.

Unlike some of the other measures and assumptions which must be monitored, certain
‘people’ assumptions and outcomes can only be properly assessed by adding personal
engagement to the collection and review of data. Managers can underestimate the influence of
their own behaviour on staff performance. The most sophisticated planning, budgeting and
monitoring systems will be of little use if individual managers are not seen to support the
plan wholeheartedly and to devote their own time to the issues that have been highlighted for
staff attention.

The strategic choices made by the board and company executives, as well as the local
conditions prevailing wherever your unit is based, necessarily shape your approach and
response to ‘people’ issues. While effective people management is a substantial topic (not for
discussion here), in the context of the operational control of underwriting, one facet might be
emphasised: the need for clarity. Do existing staff (and recruitment candidates) have a clear
understanding of what the company and its specific units have to achieve and how? As
individuals and teams, do they understand how they are expected to contribute to that
achievement? These questions are not referring to a broad or general understanding but
rather to the level of confident understanding that can support appropriate, independent
decision-making and action.

Strategies, policies and plans will not be implemented effectively if they are not
communicated, discussed and understood by all underwriting (and related) staff. Their sense
of responsibility for the achievement of the company’s and unit’s objectives and their ability
to work in a collaborative manner will be strengthened and made more tangible if the
performance management system includes a matrix of KPIs derived from the plan, which are
seen to be in use at unit and personal level.

The monthly review of budget versus actual figures, the explanation of significant variances
and the ongoing performance management of staff should be seen as a single strand of
activity focused on the achievement of objectives.

Figure 9.1
Actions devised to improve performance will naturally include the provision of training
relevant to the business being handled, as well as opportunities to participate in action-based
learning and mentoring schemes.

With individual targets (focused on ‘what?’ and ‘how?’), the key skillsets for job roles should
be more easily defined, along with the experience and motivation required. Most job roles
utilise generic elements or expressions: clarity can only be achieved if these generic elements
are accompanied by a statement that explains the particular context of the
company/unit/role and enables individuals to understand what is required of them.

Be aware
If the role description states that ’analytical skills’ are required, what does that mean? Does it mean that someone
with a questioning approach and interest in understanding how things work, in a general sense, will do well or will
the employee be required to conduct formal analyses of data?

Development can be a contentious area. Few companies nowadays will choose to spend
money and time providing staff with development opportunities unless directly in support of
current business targets or planned job moves. Underwriters need to maintain and develop
their knowledge but, if a particular type of business plays little or no part in their current
company’s portfolio, they cannot expect company support in that respect. Like all
professional staff, underwriters must take prime responsibility for their own development
and request their company’s support as appropriate. Many companies provide access to a
wide range of learning materials (including internet-based resources) and support the CII’s
requirement for continuing professional development.
I Authority limits
An important way in which individual underwriters understand their own role is through
their allocated personal underwriting licence or authority. This licence is usually expressed
in terms of various measures (maximum premium size, discount, total sum insured
(TSI)/estimated maximum loss (EML), limit of liability) by class of business or product, with
specific inclusions and exclusions. Underwriting licences are issued for a set period of time
and must be updated/reconfirmed as appropriate. These authorities/limits will often be held
in the underwriting system and apply automatically when business is processed. Cases
exceeding any of the relevant limits may still be handled by an underwriter who then refers
the case (along with their own assessment, evaluation and recommendation) to a colleague
with the necessary authority to underwrite and sign the case off.

Be aware
Technical underwriting assessments are now commonly used to establish an initial licence level for individual
underwriters and to test their continued capability to operate at that level or readiness to gain an enhanced level.
This approach can be seen as supporting the FCA’s training and competence requirements.

Think back to M80, chapter 1, section C1

The person who allocates work within an underwriting team will seek to balance the
immediate requirements of customer service and productivity with longer-term training and
development needs. Those with lower licence levels should be allocated a few stretching
cases, along with the work they are capable of completing by themselves. Those with higher
licence levels in the team, or based remotely, can establish a time each day when such cases
can be reviewed and discussed. In some companies the processes of work allocation, referral
and review are handled through the system.

Whether handled manually or automatically, it is essential that referrals and the use of
personal underwriting authority are documented:

Personal development targets for those with lower levels of underwriting authority may
include the requirement to have a certain number of cases, with higher limits, signed-off
satisfactorily before their licence level can be raised at the next review.
When other types of monitoring highlight particular cases due to their adverse features
or poor performance, it is important to know who was involved in their underwriting in
order to determine whether additional training is required, or referral procedures and
underwriting policy need to be adjusted.
Internal and external auditors also need to see the physical evidence that cases are being
handled in accordance with the stated procedure: a key requirement of corporate risk
management.

In devising a framework of authority limits for your area of responsibility, the framework
must fit the profile of the business in question and support internal efficiency. Ideally, most
underwriters in the team should be capable of (or working towards) writing the level of cases
most frequently handled. As the distribution of large cases peters out towards the maximum
limits acceptable, you will already have given careful consideration to the skill levels and
experience necessary to handle these cases and the number of underwriters with such skills
you need to employ. Clearly an incentive exists for capable underwriters to continue to raise
their authority levels towards the account’s maximum limits.

However, care must be taken to ensure that the underwriters handling the largest, most
unusual cases in the portfolio see a sufficient number of such cases to enable them to put
individual cases of this type into an appropriate, current context. The danger with sharing out
the larger cases among too many individual underwriters is that none will build sufficient
experience to underwrite them to best effect.

Be aware
‘But in my last company I could write cases of up to £1m, £20m EML etc.’

In the minds of some underwriters, underwriting licence levels have become status symbols detached from the
account they are engaged to underwrite. This can stem from poor positioning of a new job role and its context at
interview stage. A capable underwriter should be given every encouragement to exercise and develop skill and
judgment, but if the typical risk in the account has a premium of below £5,000, then these are the risks the
underwriter will generally be engaged in handling.

Underwriting management decision: operational controls

How can you ensure that the small number of very large/unusual cases in your account are being underwritten
effectively?

You may employ underwriters who wrote much more of this business in the past but what do you and they do to
ensure their knowledge of this type of risk and market terms is up to date? ‘Very large/unusual’ often equates to
‘more’ or even ‘very’ risky: is this a worthwhile use of your area’s capital allocation? In these circumstances you
might review your underwriting strategy and either reduce the maximum limits acceptable or, if you believe you
have the necessary knowledge, skillsets and capital, consider writing more of this type of business. As well as
improving underwriters’ appreciation of the risks and market terms, increased income could support the
development of a number of underwriters, acting in lead and support roles. Having a small number of any type of
risk is disproportionately risky: this situation should be avoided, at all costs, with the largest risks in your account.

I1 Approaches to underwriting governance

Good governance requires that a proportion of every underwriter’s work is reviewed: this can
be achieved in a number of ways, which can be used in combination.

Consider this…
Why should every underwriter’s work be reviewed?

Sharing real experience and knowledge is the best way to learn and to develop superior
skills.
Having ‘a second pair of eyes’ review your work from time to time can highlight different
approaches and generate new ideas.
Working with someone else can generate outcomes that neither would have achieved
 independently.
And, finally, to improve risk management: bitter experience indicates that rogue
underwriters consistently manage to avoid peer review.

Referrals Work can be allocated in such a way that underwriters are required to refer a number of risks
for sign-off. Of course, referrals also arise in circumstances where the underwriter has
sufficient authority but wants a more senior colleague’s advice or input or has to contact
regional or head office underwriters to query a risk’s acceptability to reinsurers or to request
approval for a manual endorsement. Although the risks in question may not be reviewed in
depth in these latter circumstances, this type of referral provides an important means of
sharing knowledge and best practice.

Peer review/local audit Peer review or local audit involves colleagues or teams swapping a predetermined number of
files on a weekly or monthly basis in order to confirm compliance with operational and
regulatory standards and procedures, observance of appropriate risk selection, underwriting
and pricing standards and accurate data input/document preparation. A standard pro-forma
should be created for this purpose: to promote consistency in approach and to provide a
record for training needs identification, performance management purposes and for other
auditors. Summaries of local audit results, with key areas for congratulation or improvement,
must be reported and fed into the corporate risk management process.

Regional audit Local audits will typically be supplemented from time to time by a regional or head office
underwriting audit which should, in the first instance, utilise the same pro-forma used in local
audits. Risks should be selected across all key categories, including a few risks which have
already been locally audited. The auditors may also refer to the data held on the selected risks:
in quotation, survey and risk registers. A visit to the local unit enables discussions on the
audited risks and any issues arising to take place and provides the regional or head office
underwriters with an opportunity to discuss other important topics such as local relationships
with claims and surveyors, access to and use of management information and local market
conditions. These are excellent opportunities to build relationships and learn from one
another. The auditors’ conclusions and key findings will also be reported and fed into the
corporate risk management process.

Management involvement As underwriting manager, you may wish to retain a level of underwriting authority for
yourself and/or you may specify the types of risk or circumstances in which you wish to be
involved prior to the acceptance of a new business case or before renewal terms are issued.
You would, in any case, be involved in investigating the circumstances surrounding
acknowledged underwriting errors.

Monthly results/variance The review of monthly results and the explanation of variances will highlight individual risks
analysis or categories of risk meriting further examination: regional or head office underwriters can
request sight of sample files. From time to time, risks with common attributes will be selected
for review: those in a particular location, with high values or poor claims experience, for
example. As well as attending to the exposure and/or performance issues raised by these
selected risks, the quality of the responsible underwriter’s work will also be examined.
J Other auditors
A number of other groups will conduct audits within underwriting areas from time to time:

Internal audit The company will have an internal audit function focused on corporate risk management.
They will be interested in how alert the underwriting management team are to risk
management and what they do about it: how effectively are strategy, policies and procedures
being developed, communicated, implemented and monitored? The internal audit team will
look at individual risks and detailed process implementation to assess how effectively the
management team control their staff and business.

External audit The company’s external auditors need to confirm that the financial results produced by the
company are a valid representation of the actual state of the business. They may require
access to detailed systems transactions to check the validity of certain measures and are likely
to question underwriting managers about their own month-by-month review of results,
variances and adjustments. How do you know the results produced are correct? What do you
do to check figures or establish their validity? The external auditors also review and comment
on key issues such as underwriting performance and the run-off of reserves.

The regulator The regulator will also conduct a company audit from time to time. The approach to date in
the UK primarily involves executive and senior management but the underwriting manager
will be asked to explain how exposure to risk and underwriting authorities are managed,
amongst other things.

Reinsurers Last but not least, the company’s reinsurers will conduct occasional file audits, particularly if
your account is changing, growing rapidly or performing badly. The reinsurers have their own
corporate risk management imperatives to satisfy and they too must demonstrate that they
have checked the information provided by insurers is accurate. This can be a good
opportunity to build relationships between reinsurance and company underwriters.
K Delegated authority
Refer back to chapter 3, section D1 and chapter 4, section E

Delegated authority arrangements, ranging from small scheme binders to major MGA
agreements, all require appropriate underwriting authorities and audit arrangements to be
established. Delegated authority arrangements often involve the approval (by the insurer) of
named signatories. Only these named signatories may accept business (‘bind’) on behalf of
the insurer and the submission of CVs and assessment tests may be required before
individual authority levels are agreed and granted.

As authority has only been delegated, the insurer remains wholly responsible in the eyes of
the regulator. A version of the insurer’s internal approach may or may not be suitable for use:
whatever is agreed, the approach must be efficient, cost-effective and it must address directly
the risks presented by the particular arrangement.
L Underwriting policy
This chapter has discussed people management, underwriting authorities and audit, with a
focus on the performance of individuals and their handling of individual risks. This may
appear to be at the opposite end of the scale from the discussions about corporate risk
appetite and underwriting strategy in the earlier chapters of the study text. What links the
individual risk with corporate risk appetite is, of course, underwriting policy, which describes
the full implications of strategy and underpins day-to-day practice and plans.

Figure 9.2

Just as the monitoring of monthly results helps to explain current performance and indicates
areas for improvement, regular attention to audit results provides underwriting managers
with the information needed to appraise the suitability and effectiveness of underwriting
policy and to prioritise personal development initiatives and policy updates or changes. Thus
the monitoring and analysis of all types of data and information forms an essential part of the
continuous process through which underwriting management seeks to address the external
environment and achieve corporate objectives.
Summary
The main ideas covered by this chapter can be summarised as follows:

An insurance company needs to know whether it is meeting its planned objectives

throughout the course of the year. This form of monitoring allows issues of
underperformance to be tackled as soon as they are identified, unexpected opportunities
to be exploited and expectations to be managed appropriately.
The ways in which insurance company staff are engaged and incentivised varies between
companies but it is common practice to highlight particular measures of performance to
provide common direction and focus across large groups of people.
Our understanding of trends and relationships can be greatly enhanced by the
appropriate presentation of data. Ratios which reflect key relationships between
independent variables can be very useful in highlighting significant changes across an
account or portfolio over time.
Strategies, policies and plans will not be implemented effectively if they are not
communicated, discussed and understood by all underwriting (and related) staff.
The monthly review of budget versus actual figures, the explanation of significant
variances and the ongoing performance management of staff should be seen as a single
strand of activity focused on the achievement of objectives.
Personal underwriting licenses/authorities are usually expressed in terms of various
measures by class of business or product, with specific inclusions and exclusions.
Licences are issued for a set period of time and must be updated/reconfirmed, as
appropriate.
Good governance requires that a proportion of every underwriter’s work is reviewed.
A number of groups will conduct audits within the underwriting function from time to
time: internal audit function, external auditors, the regulator and reinsurers.

Bibliography
Adams, R. (2014) ‘Managing general agents: tightening up’, Post Online, 12 March 2014.†

Hankin, N. (2009) ‘How underwriting governance is integral to a sustainable strategy’, 1 April 2009. CII Fact File.*

www.bankofengland.co.uk/pra/Pages/default.aspx, search under ‘Solvency II’ for current information regarding

insurance risk management and governance.
* CII Fact Files available to CII members only via the Knowledge Services website (www.cii.co.uk/knowledge).
†
Please contact knowledge@cii.co.uk if you wish to receive a copy of this article via email. (Please note, under UK Copyright Law the
number of copies we are able to email is restricted to one article per issue per CII member.)

Scenario 7 – Question

You are responsible for a profitable product whose volume has proved resistant to growth. The product’s rating
basis is quite simple; geographic location, for example, is not a rating factor.

Marketing department believes that more demand exists for this product and that a more differentiated rating basis
 (with additional options for voluntary excesses, for example) could generate increased sales in more competitively
rated segments. Sales and distribution departments are also keen to see direct sales introduced (previously only
intermediated sales).

Actuarial and your underwriters have worked on new rates (more rating factors and options for voluntary excesses)
and these have been agreed (different rates for direct and intermediated business). The re-launch is imminent.

From an underwriting point of view, what do you need to focus on now? What information and data do you require?
What aspects of underwriting policy and practice need to be monitored?

Scenario 8 – Question

At short notice, you have been asked to take responsibility for an unfamiliar group of products. The general manager
requires a brief results commentary in 24 hours’ time. You have been advised that there are some concerns regarding
the current performance of these products. In 2016 the group of products is targeted with achieving a total gross
written premium (GWP) of £2m and an earned loss ratio (ELR) of 65%.

End of June 2016

Year-to-date (Actual)

Product Group Z

Product GWP Earned premium Incurred claims cost ELR

A £170,000   £200,000 £100,000   50%

B £310,000   £300,000 £500,000  167%

C £400,000   £500,000  £55,000   11%

Total £880,000 £1,000,000 £655,000 65.5%

Document briefly your initial thoughts based on the above information.

Bearing in mind the limited time available, what further information and data would you request before drafting
your commentary for the general manager?

Explain why you are requesting each item of information or data.

Scenario 9 – Question

Look at the list of common risks listed in chapter 2, section E.

What might be suitable courses of action (from an underwriting perspective) in order to avoid or reduce the impact
of each of these risks?

See overleaf for suggestions on how to approach your answers

Scenario 7 – How to approach your answer

Aim
This scenario requires you to identify which aspects of underwriting policy and practice need to be monitored when
a product is subject to significant change.

Key points of content

You should aim to include the following key points of content in your answer:

Separate budget for the product (split direct/intermediated) and a comparable monthly management account.
Is income growth meeting expectations and within bounds of capital allocation?
Accident year reporting: to monitor how business on the previous rating basis runs-off and how business on
the new rating basis develops.
Risk profile: to watch for change of mix and identify any implications (e.g. for income, claims and/or
reinsurance).
Customer profile: will direct offering attract a markedly different customer profile (implications for income
and claims) or will a substantial proportion of the existing customer base move from intermediated to direct
product? Are risk premiums and other pricing components sufficiently robust to cope with either kind of
shift?
Sales and distribution departments should be monitoring (and sharing with you) actual performance against
their forecasts. These could be affected by a number of external issues, such as competitor activity or the
economy, so it is important to document, share and monitor planning assumptions.
In the longer term: how well has the differentiated rating base predicted the actual experience which
emerges? What impact has the introduction of the voluntary excess had: how popular is the option; what
actual reduction in claims costs against reduced (discounted) premium income?

Scenario 8 – How to approach your answer

Aim
To meet the demands of monthly variance analysis, underwriting managers require a clear focus on key variables
and their inter-relationship, as well as a degree of insight and ingenuity: this scenario reflects these requirements.

Key points of content

You should aim to include the following key points of content in your answer:

Initial thoughts:

Individual product performance very variable – is that typical of these types of product?
Large claim or movement in outstanding estimate affecting Product B incurred claims cost?
Total GWP lower than earned premium – is income pattern affected by seasonality or some other issue or are
this year’s sales generally lower than last year’s (for Products A and C)?
If this year’s sales are generally lower, this will become more evident in total earned premium in second half
of year and the earned loss ratio is likely to deteriorate.

Request:

Full 2016 budget information for individual products: to understand planned performance.
Monthly results (January to December 2015 and January to June 2016): to understand income pattern (GWP
and EP).
Large claims list – new intimations and significant movements in outstanding estimates (source of high ELR
for Product B?).
Sales data: numbers and value of new business cases over last 18 months; renewal retention rates; large cases
gained/lost.
Ask local underwriters/customer service staff: what is their perception of how these products are
performing?

Scenario 9 – How to approach your answer

Aim
This scenario focuses on action planning in the context of underwriting risk management.

Key points of content

You should aim to include the following key points of content in your answer:

Claims projections prove inaccurate

Seek assistance from actuarial colleagues to ensure claims projections are as realistic as possible; ensure
adequate reinsurance in place to limit any adverse impact on insurer’s net account; regularly monitor claims
intimations and costs.

Adverse economic conditions occur

Be alert to changes in economic conditions and ensure plans and budgets make allowance for potential
impacts (such as reduction in exposures and more fraudulent claims); ensure staff are alert to potential issues
and have access to necessary support (such as credit-checking facilities/fraud indicators).

Court judgments impact typical level of claims settlements in respect of bodily injury
Monitor closely trends in settlements and (with actuarial assistance) make due allowance in pricing; review
reinsurance arrangements to ensure adequacy; consider balance of underwriting account – is it too biased
towards business prone to large bodily injury claims?

Poor-quality business is written

Ensure underwriting/customer service staff understand the distinction between acceptable and unacceptable
business and have confidence to act on that understanding; ensure staff have management support when they
turn away poor business or impose terms and that they understand the system of underwriting governance;
ensure any inappropriate acceptances are discussed with individual underwriters and discussions logged on
their personal files; seek sales/distribution support to focus on acceptable business; keep operational and
referral processes under review; monitor acceptances by exception (in addition to regular audit procedures).

Management information is corrupted

Establish strict validation processes to ensure any errors/issues are identified quickly and before MI used;
explain importance of accurate data-entry to all relevant staff; share relevant unit-level data to highlight use
of data and need for accuracy; identify other data (for example, finance data) to check totals and differences;
be prepared to use manual sampling exercises to identify trends and issues rather than do nothing; from the
outset, work closely with those establishing the data warehouse/MI system to ensure the design is fit-for-
purpose.

Business flows from delegated authority brokers prove intermittent

Ensure approval process is sufficiently thorough to establish viability and suitability of any arrangement;
agreement (binder) should contain realistic premium income targets that put arrangement in jeopardy if not
met; ensure each delegated authority arrangement has an assigned underwriter who maintains regular
contact; audit programme should include regular face-to-face reviews.

Recruitment targets for underwriters are not achieved

Plan ahead and be realistic about the time and effort necessary to recruit; take great care in specifying job
roles, responsibilities and candidate requirements; be prepared to argue (with senior management and
existing, over-worked underwriters) that it is better to delay recruitment than to recruit the wrong person;
find ways to support existing underwriters in interim.

In the first year, the business experiences exceptional weather-related losses

Ensure adequate reinsurance; monitor accumulation of exposures in vulnerable areas and be prepared to limit
acceptances until account has grown larger.

Rates rise more steeply than expected: capital inadequate to write available, targeted exposures
Monitor rating trends; always be selective and write best quality business available – this should enable
company to secure necessary additional capital quickly! Consider limiting acceptance of average quality
business.

Rates decrease more steeply than expected and volumes or margins cannot be achieved
Monitor rating trends; only write better quality business. Consider withdrawing from the particular market if
pressure on margins is viewed as extended and unsustainable.
Ancillary income, such as legal expenses cover, does not sell as well as projected
Review rates against those of competitors. Deeper understanding of buying rationale and characteristics of
customer. Review factors in the external environment that may impact the sale of the product.
 Statutes

Consumer Insurance (Disclosure and Representations) Act 2012, 1D2A

Consumer Rights Act 2015, 1D2D
Competition Act 1998, 1C2, 1C2A

Enterprise Act 2016, 1D2B

Equality Act 2010, 1D2C
Equality Act 2010 (Amendment) Regulations 2012, 1D2C
EU Solvency I Directive, 1B1
EU Solvency II Directive, 1B1

Financial Services Act 2012, 1A1, 1A2, 1A3

Financial Services (Banking Reform) Act 2013, 1C

Insurance Act 2015, 1D2B, 3D3A

Insurance Block Exemption Regulation 2010 (IBER), 1C2A

Marine Insurance Act 1906, 1D2A

Mesothelioma Act 2014, 4C5