Is homeowners insurance a commodity? That question has been afrequent topic of debate in the industry. But whether it is or not,hardly anyone can dispute that the homeowners insurance market canbe highly competitive. For most insurance buyers, price is oftenthe No. 1 factor when making a purchasing decision. In otherindustries, the way to succeed in a highly competitive market isoften through volume: The more you sell, the more profitable you'lllikely be. But for homeowners insurers, that may not be an option.In fact, that approach can quickly lead to bankruptcy if poorunderwriting decisions cause excessive claim losses.

The key toward winning in the homeowners insurance marketplaceis strong growth coupled with a lower loss ratio. That's usuallyeasier said than done. However, one way for insurers to helpachieve that goal is to incorporate by-peril rating—informed bybuilding characteristics—into their rating plans.

Rating by peril is much the way it sounds: developing adifferent rate based on the risk to the property from differentperils. For example, a property in Minnesota may be more exposed tohail risk than one in Florida, where wind risk may be a greaterconcern. With by-peril rating, a carrier can build a policy quotebased on the risk of as many as nine individual perils, includingwater (weather-related), water (nonweather-related), wind, hail,lightning, fire, liability, theft/vandalism and all otherperils.

This rating technique has been gaining traction. Dozens ofinsurers have already implemented it, with each taking a differentapproach as to which perils are rated individually and how theresults are used for rating purposes.

Early Adopters Show Promising Results
Tohelp determine whether by-peril rating is effective or simply aninteresting theory, ISO conducted a research project thatidentified 25 insurers that implemented by-peril rating plans andmonitored their collective progress. The research showed the 25carriers collectively gained an additional 6% market share over afive-year period while maintaining loss ratios 6.6 points lowerthan their competitors not rating by peril. The increase in marketshare, according to ISO's research, equated to $4.6 billion inpremiums, while the lower loss ratios saved the insurers nearly $5billion in losses.

In fall 2014, a follow-up study of homeowners insurers by ISOand Earnix, a provider of integrated pricing and customer analyticssolutions for banking and insurance, found that more than 65% ofinsurers not currently rating by peril plan to start within thenext three years. The speed with which insurers adopt a by-perilapproach is critical. Early adopters can capture the best risks fortheir books, often resulting in the largest impact on growth andprofitability.

More Granular Results Attainable
Beyondspeed of adoption, insurers can differentiate themselves and theirofferings by implementing even more granular approaches to by-perilrating. The vast majority of carriers that have a by-peril ratingplan today are capturing only the territory aspect of the risk.However, all perils that threaten properties cause damage indifferent ways based on individual property and buildingcharacteristics. Insurers implementing a by-peril rating plan thataccounts for individual property characteristics have theopportunity to hone  in on risks that meet their riskprofile with a level of granularity not previously available.

For example, by-peril rating informed by buildingcharacteristics lets insurers see the interrelated effect ofdifferent weather-related perils (such as wind, hail, and water)and building characteristics (such as roof materials and roof age)on the overall risk. In fact, ISO has identified as many as 20different building characteristics that can influence property riskat the peril level. That approach lets insurers offer differentpolicy premiums for those neighboring houses that would haveidentical premiums using a by-peril rating methodology accountingfor location only.

Let's look at two houses located in the same ZIP code that haveidentical replacement cost estimates of $300,000 and the samePublic Protection Classification (PPC) rating. (The ISO PPC programgives insurance companies and fire departments a standardmeasurement of the effectiveness of fire protection in more than47,000 fire districts throughout the country.) If both housesburned to the ground, let's assume for this example that the costto rebuild would be the same. But that doesn't mean they have thesame likelihood or severity of fire or any other peril threateningthe property. One house is a two-story colonial with a brickexterior and an attached garage. The other is a single-story ranchwith a carport, pool, wood siding and 1.5 fewer bathrooms than thecolonial. Those differences can have a significant impact on therisk of loss when you consider that:

• houses with multiple stories, such as the colonial, have higherwater (nonweather) risk due to potential second-floor flooding inbathrooms or laundry rooms
• houses with brick exteriors have lower risk from fire
• more bathrooms increase water (nonweather) risk
• wood siding on a single-story house increases theft andvandalism risk
• pools increase liability risk

Those are just a few examples of how characteristics of theproperty can affect the risk to the property at the peril level. Itbecomes easy to see how capturing that data and applying it to aby-peril rating model can make a big difference in how insurersrate homeowners risks.

In addition to pricing individual risks, by-peril ratinginformed by building characteristics can help insurers with losscost modeling. Companies that want to optimize their portfolio withideal risks can understand the impact of adding properties withvarying risk profiles to see how different combinations of riskscan affect future losses. Insurers can also conduct rate-tieringanalyses using the output to model profitability in relation toprice and risk.

More Than Just Rating
Insurers can alsouse the output of a by-peril model informed by buildingcharacteristics to support underwriting and marketingfunctions.

For example, if an insurer wants to limit its exposure inhail-prone states, it can set guidelines requiring the hail riskrelativity be 5% less than the norm for underwriting consideration.By incorporating the by-peril rating output using buildingcharacteristics, properties located in the same ZIP code could beconsidered acceptable or unacceptable risks based on thecombination of roof age and material. Once the guidelines are set,the insurer can build them directly into the quoting process tohelp determine the acceptability of the risk at the very beginningof the sales process.

The insurer can also use the output to trigger additionalunderwriting steps, such as justifying the need for an on-siteinspection or the need to collect additional information from theproperty owner.

Marketing
Rather than spending millions ofdollars a year on advertising, insurers can use the output ofby-peril rating informed by building characteristics forprospecting new customers. Because of the granularity of theoutput, insurers can know what combination of buildingcharacteristics is optimal for every location in the country. Usingpublic records data and other sources, insurers can often accessbuilding characteristic data for tens of millions of properties inthe United States. Processing those addresses through a by-perilrating model informed by building characteristics helps giveinsurers the information needed to handpick their idealportfolio.

When an insurer wants to grow its book in a specific area, itcan launch highly targeted marketing campaigns showing individualproperty owners how much premium they can save. While the companymay be able to give the property owner a great offer, it may alsogrow a book optimized to limit losses. Furthermore, being proactivein targeting good risks often means the less desirable risks willbe left for competitors.

Once Difficult, Now Doable
While it may beeasy to see the benefits of by-peril rating informed by buildingcharacteristics, implementation is more complex. By-peril ratinghas a high barrier to entry from both an actuarial and a workflowperspective.

In the past, only the largest national or regional insurers hadthe volume of claims data to develop by-peril models based solelyon location. Adding the component of by-peril rating by buildingcharacteristic requires even more granular data, significantlyadding to the challenge. Besides the availability of data, insurersoften need to employ teams of data analysts to correlate previousloss experience with likely future losses.

From a workflow perspective, rating by peril is relativelysimple, because the only information needed is the propertyaddress. However, adding in the building characteristics componentrequires detailed property-specific information for each propertyunder consideration for underwriting. Many companies already rateusing some building characteristics, but few come close to the 20building characteristics that ISO determined have an influence onproperty risk. As the need for more detailed rating informationbecomes apparent, more and more companies are investing in creatingsolutions to identify, capture, and quantify the data needed.

For insurers interested in taking a by-peril rating approachinformed by building characteristics, the good news is that most ofthe data required to do so is often the same data needed toestimate the replacement cost of a property. Virtually everyinsurer estimates the replacement cost as part of the underwritingprocess, so insurers can reuse that data for the by-peril ratinganalysis without significantly affecting their underwritingworkflow.

Douglas Wing is assistant vice president of AnalyticProducts at ISO Insurance Programs and Analytic Services.ISO is a Verisk Analytics (Nasdaq:VRSK) business.