A Clash of Hard Market Philosophies: Strict Underwriting Vs. Adequate Pricing

I would suggest that the weight of the argument favors the advocates of adequate pricing.

Here are the reasons:

Public relations spillover:

Stricter underwriting guidelines involve non-renewals, called "cancellations" by customers, which, in turn, tend to generate very bad media attention. When The Wall Street Journal, the friend of business, runs a Page One story on cancellations ("Harsh Policies: Hit With Big Losses, Insurers Put Squeeze on Homeowners," May 14), the industry knows it is in trouble.

The article has the following opening sentence: "Marion and Dorthea Sherrill of Monroe, Ga., were loyal insurance customers of . for 20 years." Articles like this make the issue ripe for demagoguery, with negative implications for industry efforts in many areas, including getting regulatory approval for adequate rates.

Aggregation effects:

From an overall industry point of view, the strict underwriting approach in the presence of overall inadequate rates is a no-win proposition. Too often, firms that shed unprofitable risks as a matter of policy discover that they soon reappear in a modified but no less unprofitable form.

Lets take an example of Acme Insurance Company writing 10 percent of the market for Product X insurance. The pricing of this insurance is under-priced, and Acme is losing money. Acme non-renews a large number of its risks, which it regards as unprofitable.

It is then left with a portfolio that it believes will produce profits. However, every other company in the industry adopts the same strategy, thus swelling the ranks of the residual market. Acme will now be subject to a higher residual market charge as the pool grows.

If we now assume that rates in the residual market are inadequate–a fairly normal situation–Acme could end up with a financial result not too different from where it started.

If we further question the ability of Acme's stricter underwriting guidelines to produce the projected improved underwriting profit, Acme could possibly end up with a worse situation than where it started.

Historical record:

The 1990s witnessed repeated examples of the underwriting approach in terms of the homeowners line, including "shorelining" after Hurricane Andrew and a threatened meltdown in residential insurance in California after the Northridge earthquake. Yet the industry had only one year of profitable underwriting (1997) in the decade.

International experience:

Outside the United States and Canada, there are few residual market mechanisms. Such facilities are a peculiarly North American institution, reflecting a wide number of cultural and institutional factors.

Given the absence of residual markets, and yet a societal interest in universal availability of insurance, the emphasis by insurers in Europe tends to be on adequate pricing.

All of these points favor the adequate-price philosophers. This is not to say that underwriting discipline should be discarded. Rather, it is suggested that a policy of stricter underwriting discipline in the absence of overall adequacy of rates is likely to be self-defeating.

Sean F. Mooney, CPCU, is senior vice president, research director and economist at Guy Carpenter & Company in New York.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, May 27 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.