The old adage claims there is an exception to every rule, but inmeasuring an insurance carrier's appetite for risk, too manyexceptions slow the process of policy issuance and too fewexceptions create risks the carrier might not be interested incarrying.

Such is the challenge for rules-based underwriting andexception-based underwriting, which Deloitte principal John Luckerdescribes as "intertwined." Rules-based underwriting uses amainstream process flow and is more narrowly designed to includethe basic rules a company has established in its underwritingdepartment to induce straight-through processing. Informationenters the underwriting process, and the rules-based system reviewsthe information and processes a logic flow.

Exception-based underwriting, explains Lucker, takes place whendata proceeds through the normal flow and the system detectssomething different about the particular policy application. Thesystem automatically channels that risk to either a humanunderwriter or a subordinate process to deal with it.

"What's particularly important about this process is, in thepast, most of these types of logic flow were binary," Lucker says."Things were done manually and somewhat subjectively."

The benefits of today's process flow are objectivity andconsistency in how processing is done–traits that previously didnot exist. "There are a variety of expense-based reasons why thatis beneficial and a variety of underwriting benefits that can beachieved," says Lucker. The most specific underwriting benefitcomes from eliminating much of the subjectivity of theunderwriting; the randomness of some decision-making no longertakes place. "By randomness I mean if you don't have theseexception rules in place, a number of people can look at something,and based on their own learning or training, they can come tosomewhat different decisions," says Lucker. "Any one of thosedecisions can have shades of rightness or wrongness to it. Onecould be completely right or completely wrong. What you end up withis a statistical distribution of behavior, which isn't necessarilyoptimal."

Exception-based underwriting is an evolving area for insurersworking in commercial lines, indicates Steve Sumner, a directorwith PricewaterhouseCoopers. In the commercial lines space, thereis a combination of some sophisticated rules on the front end andthe exceptions to those rules so the risk receives an appropriatelevel of underwriting attention. "Sometimes your underwriting rulescan be so restrictive nothing actually passes through and isaccepted into the binding and policy issuance process," saysSumner. "Other times, you run the risk of too much going throughwithout that level of oversight."

By using quantitative and analytical tools to analyze how toconstruct these exceptions, carriers end up with an optimal processflow that is more statistically correct in how it proceeds becauseit is based on a consistent process, adds Lucker.

"If you don't create these rules, which the industry has workedon over a large number of years, you move too close to subjectivityand inconsistency because you don't have facts on which to baseyour decisions, and that tends to be suboptimal," says Lucker. "Ifyou create a total no-touch environment around underwriting–andsome insurers don't believe that is the best way to do it–you endup with potentially a highly rigorous and statistically accurateprocess that may not make the most business sense. Exception-basedunderwriting allows you to work away from that dark line of highlyno-touch, highly objective, and highly consistent to a more livableprocess that tends to make more business sense and is more towardcorrect than having no rigor or analysis at all."

AUTOMATED PROCESS

ICW Group has been running an exception-based underwritingsystem in its workers' compensation book of business for the lastsix months, but as company president and CEO Kevin Prior explains,it is a culmination of an idea the carrier has been working on forthe last three years. "Our idea was to take many of the manualprocesses out of the underwriting decisions so we could have theunderwriters concentrating on agency relationship management," hesays. "From there, it grew into the development and automation ofunderwriting criteria we felt were more germane to each individualrisk."

Today, the underwriting criteria ICW has in place serve as atraining tool for new employees and give the carrier consistencyacross the organization, according to Prior. "When we enter toughtimes, we at least have hard numbers and consistency arounddecision-making so the decisions are not being made blind," headds.

ICW co-developed the solution with FirstBest Systems, notesPrior. The vendor has a history of being successful with itsentrepreneurial ventures, so for ICW it was a good situation. "Theproduct was designed exactly to our specifications without ourhaving to pay the full price of customization," says Prior.

Paul Zamora, vice president, workers' compensation, for ICWGroup, believes FirstBest's vision of what this product would looklike, its functionality, and the level of automation matched thevision of ICW. "We were confident it had the skill set to developthe final product to our satisfaction," he says.

CREATING THE RULES

Using edits and rules to determine underwriting appetite at PennNational is nothing new, according to Helena Vendrzyk Gordon,director of projects and planning for the carrier. But prior to theinstallation of a rules-based system from Pegasystems, mostpolicies ended up being touched by an underwriter.

In 2006, the carrier looked at improving its ability to useexception-based underwriting, including predictive analytics. Aftersettling on Oracle's Skywire Software Insbridge rating engine,implementation kicked off in the first quarter of 2007.

"We designed and built an agency portal, we implemented the Pegarules engine to do a lot of our editing around what business wewant to underwrite, and we are using the Skywire Insbridge ratingengine that integrates into our legacy back end," says Gordon.

Carriers need to make sure the business going through thepipeline fits their underwriting appetite. "If your appetite is fora lower-hazard type of business, you want to make sure that's thetype of business getting through," says Sumner. There always willbe a high degree of oversight and monitoring of the business, so ifthere is a deterioration in loss ratios, an insurer is going tozero in on where that deterioration is coming from, he continues."The idea is to drive toward a level of profitability that iswithin a company's level of acceptability," he says.

Penn National worked primarily with analysts from itsunderwriting division to develop its rules, relates Gordon. "Wewent through existing logic and underwriting guidelines andtranslated that into rules," she says. "We then reviewed them tosee which ones we want to go forward with in the future."

In ICW's experience, writing the rules for the system was verycomplex, remarks Zamora. "We pooled our best underwriters andstarted talking about how we approach underwriting a risk," hesays. Ideally, the carrier would like to ask potential customersupward of 50 questions, but in order to achieve straight-throughprocessing, such a number is impractical, he adds, advising, "youhave to be smart about the questions you ask and make sure theyhave an impact on the final price."

After developing the questions and guidelines, ICW's businessleaders and IT staff sat down with the vendor to walk through theworkflow to ensure the rules provided the automated functionalityand underwriting capability to preclude those risks the carrier didnot wish to write from slipping through.

Zamora believes companies should analyze their data quarterly tomake sure their decision tree makes sense. The system tracksexceptions, and when the exceptions take place, the carrier thencan decide on the risk. "If we have consistently said this is [arisk] we want to write, we don't want to make it an exception," hesays. "Based on the results, we would work with IT to makecorrections to the system."

UNDERWRITERS

The likely outcome of the changes at ICW is the carrier uses itsunderwriters on policies that have a higher value. "We've expressedto the staff members we are going to elevate their value to theorganization by eliminating a lot of the remedial workload, andthis elimination allows us to cast a broader net," says Prior.

Zamora agrees exception-based underwriting changes the role ofunderwriters. "They become agency relationship managers," he says."We need underwriters to help service the business, especiallylarger policies. There always is going to be a need for goodunderwriters, but what they do is going to be far different. Theywon't be analyzing every aspect of every account."

ICW expects about 80 percent of its workers' comp policies willbe handled through straight-through processing. "It's a largenumber of policies, but probably only 30 to 40 percent of our totalpremium," says Prior. "We wouldn't automate a $5 million to $10million account, but we're definitely looking to automate accountsunder $100,000."

The challenge for the industry, Sumner contends, isn't so muchthe quality of the underwriting but the fact underwriters are goingto take on a different level of responsibility. "There will be atransformation from historical manual processes to a more automatedenvironment," he says. "Technology has to be viewed as an enablerof the underwriting process. By default the industry will have tolean this way and increase a reliance on technology."

That means the underwriting responsibility will be different,particularly in the small- to middle-market commercial arena. "Ifyou are writing a very complex risk, you may decide that's going tohave to go to the underwriters," says Sumner. "Down the road, weare going to see a different approach to the process, particularlyin the small to middle market."

SOFT MARKET

The market cycle also plays a factor in underwriting decisions."In a hard market, companies can be more firm about their rules andmaking further exceptions," says Lucker. "In a soft market,insurers have to be more flexible and make more exceptions, butthey want to work toward being right rather than not."

Depending on how those rules drive their growth or theirshrinkage in the soft market, carriers need to be adaptable andchange those exceptions and rules to make sure they are achievingtheir business objectives in a timely fashion. "The exception-basedsystems and processes, rules engines, and predictive models need tobe flexible and rapidly changeable," says Lucker. "That's driven awhole new movement toward enterprise rules engines and flexiblerules that allow these systems to be changed more rapidly andwithout IT involvement in some cases."

Today's insurance market has softened, so insurers, particularlyin commercial lines, have been active in expanding class appetitesin terms of the types of risk they are willing to consider, pointsout Lucker. "What they've been doing with that is not only from theperspective of leveraging predictive models but leveraging the needfor new and additional data that supports the application for thoseexpanded classes," he says.

For example, if an insurer has never insured oil deliverycompanies, the carrier needs to gather different information thanit has ever gathered before. "You need a flexible solution to dothat," he says. "Every time you expand into a new class, you can'thave a massive systems undertaking to adapt. Your underlyingrules-gathering and processing systems need to be flexible to allowyou to expand and contract your appetite accordingly."

SPEED VS. ACCURACY

More underwriting attention needs to be applied for complexrisks, according to Lucker. In particular, he cites dealing withagents a carrier has less experience with, risks where the data hasbeen gathered in an incomplete fashion, and determining how to usemore experienced vs. less experienced underwriters.

"There are a variety of different rules you can devise to carveup your book of business into risks or profiles of risk that have ahigher propensity for needing attention," he says.

The time savings realized from entering the policies into PennNational's policy system have been huge, affirms Dean Kimball,project manager for the carrier. "When a piece of new business cameto us prior to this project going live, we had a seven-day expectedturnaround to have that business entered into our policy adminsystem," he says. "Now, when the entry is made and submitted intothe new agency portal, it will be uploaded into our policy adminsystem that night and run through our policy admin system's edits.As long as it passes all edits, it will be accepted in the policyadmin system that night. We went from potentially up to seven daysdown to the same day."

Sumner contends when independent agents get bogged down with acarrier's underwriting system, the agents turn to other carriers."Agents will use the path of least resistance, so you have to findsomething that is simple enough and user-friendly so agentsactually will use it," he says. "When you think of these peoplehaving to deal with a half dozen or more underwriting systems, andif they don't understand the rules or it is too complicated forthem, they might have a tendency to go another direction to asystem that is more user-friendly to them. This is where agencymanagement comes into play. You have to know your good distributorsfrom your bad distributors and what your control environment needsto be."

EXCEPTIONS

The typical process with Penn National is for exceptions to bekicked off to the underwriters if, for example, there is a class ofvehicles or a type of driver characteristic the carrier would notwant to underwrite. "Once underwriters see [the exception], theycan work with the agent to gather more information and make adecision as to whether the customer wants to accept the policy withchanges–perhaps changing the limits of the deductibles–or theyreject the policy," says Gordon. "We think the rules are correct.It's a matter of the business appetite of what we want towrite."

Such rules will improve underwriting in the commercial lineswith the key being access to the data, states Sumner. "Astechnology improves and the data improves, you can begin to drawcorrelations with some of the risk attributes, and you will seeimprovement in underwriting, much as we've seen in the personallines space," he predicts. "Over the last 15 to 20 years, it isamazing how far the personal lines companies have come. I thinkwe're going to see that in the commercial lines space, aswell."