A dash of qualitative judgment is still in the recipe for commercial insurance underwriting excellence, but “technical pricing” can start conversations to bring carriers and brokers in sync, analysts from McKinsey said in a February 2019 article.
The article, “From art to science: The future of underwriting in commercial P&C insurance,” noted the growing use of model-driven technical insurance pricing over the last two decades. Authors Ari Chester, Susanne Ebert, Steven Kauderer and Christie McNeill added, however, that the technical price is neither the adequate price nor a “real price” that reflects competitive considerations. Instead, it can be a benchmark indicating pricing direction for a portfolio over time and a “tool to support discussions with clients and negotiations with brokers,” they wrote in a subsection of the report titled “Even when technical pricing is wrong, it’s ‘right.'”
Explaining the limits of technical pricing, they noted that “it sometimes results in prices that are overly biased by input factors, creating under- or overpriced guidance.”
“Successful companies mandate technical pricing as guidance but make allowances for deviation,” they said, advocating that carriers engage in regular debates about deviations from technical pricing during internal discussions about underwriting performance.
The section of the article about pricing is part of the authors’ analysis of five essential building blocks of successful underwriting. Besides pricing, the four other building blocks are:
- Portfolio steering decisions, balancing the need for appetite consistency against the need to respond to market dynamics and other loss-ratio impacts. Great underwriters steer portfolios with a mix of quantitative analysis and qualitative—forward looking—judgment about future exposure changes.
- Risk selection, balancing quantitative black-box models with human judgment.
- Capacity optimization decisions about retention and limits.
- Coverage wording decisions.
As for the pricing building block, leading underwriters view technical pricing as “a critical input” to maintaining price adequacy but also recognize “that it cannot be the sole basis for pricing risks,” the article said.
In a similar vein, the authors assert that “underwriting excellence requires more than underwriting.” It also depends on four “critical enablers”—namely distribution, culture, technology and strategy.
“Leading companies build data-driven analytics to inform broker and agent relationships, including the optimal number of appointments, where and how to shift volumes, and the negotiation of performance-based commissions,” the article said, describing “distribution that combines analytics and ‘art'” as the first enabler.
Explaining how the right culture enables successful underwriting, the article described how rigid underwriting controls can lower morale and discourage creativity among front-line underwriters. A mix of front-line autonomy and a “clear cascade of authority” to escalate issues is a hallmark of great underwriting companies, the article said.
Throughout the discussions of building block and enablers, the authors delivered some eye-opening observations about the best and worst underwriters.
First, they noted that loss ratios for the best and worst quintile performers in the U.S. differ by 23 points—ranging from 40 for the best quintile performers and 63 for the worst. In the U.K., the differential is 27 points. (For the U.S. comparison, McKinsey reviewed results for 35 insurers; 20 insurers were in the U.K. sample.)
Turning to the building block of “capacity optimization,” the authors suggested that discipline here should apply to small risks as well as large syndicated placements. A sample of pricing and limits available from five U.S. insurers for a small business general liability policy revealed coverage ranging from $300,000 to $1 million for roughly the same price ($500).
As for the coverage wording building block, the article noted that “thoughtful debate around breadth of coverage” is a common theme among great underwriting companies. When it comes to the use of artificial intelligence in attempts to translate qualitative contract wording into parametric variables, the insurance industry lags behind other industries, the report said. Outside of insurance, “intelligent contracts and rules-based, data-centric clause management have become commonplace.”
A final section of the report looks to the future of underwriting and underwriters’ potential roles as “builders” of third-party relationships to bring risk prevention services to clients, as “data scientists” or as translators and co-developers of analytics, and as managers of “digital direct” offering for SMEs and midmarket risks.
Finally, in a section of the article titled “Underwriter and #renaissance woman #renaissance man,” the article envisioned underwriters moving outside of a monoline focus that is typical today to build skills across short-tail and long-tail lines.