Homeowners coverage: Insurers get a leg up when using by-peril ratings, building characteristics

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

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

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

This rating technique has been gaining traction. Dozens of insurers have already implemented it, with each taking a different approach as to which perils are rated individually and how the results are used for rating purposes.

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

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

More Granular Results Attainable
Beyond speed of adoption, insurers can differentiate themselves and their offerings by implementing even more granular approaches to by-peril rating. The vast majority of carriers that have a by-peril rating plan today are capturing only the territory aspect of the risk. However, all perils that threaten properties cause damage in different ways based on individual property and building characteristics. Insurers implementing a by-peril rating plan that accounts for individual property characteristics have the opportunity to hone  in on risks that meet their risk profile with a level of granularity not previously available.

For example, by-peril rating informed by building characteristics lets insurers see the interrelated effect of different 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 20 different building characteristics that can influence property risk at the peril level. That approach lets insurers offer different policy premiums for those neighboring houses that would have identical premiums using a by-peril rating methodology accounting for location only.

Let's look at two houses located in the same ZIP code that have identical replacement cost estimates of $300,000 and the same Public Protection Classification (PPC) rating. (The ISO PPC program gives insurance companies and fire departments a standard measurement of the effectiveness of fire protection in more than 47,000 fire districts throughout the country.) If both houses burned to the ground, let's assume for this example that the cost to rebuild would be the same. But that doesn't mean they have the same likelihood or severity of fire or any other peril threatening the property. One house is a two-story colonial with a brick exterior and an attached garage. The other is a single-story ranch with a carport, pool, wood siding and 1.5 fewer bathrooms than the colonial. Those differences can have a significant impact on the risk of loss when you consider that:

• houses with multiple stories, such as the colonial, have higher water (nonweather) risk due to potential second-floor flooding in bathrooms 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 and vandalism risk
• pools increase liability risk

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

In addition to pricing individual risks, by-peril rating informed by building characteristics can help insurers with loss cost modeling. Companies that want to optimize their portfolio with ideal risks can understand the impact of adding properties with varying risk profiles to see how different combinations of risks can affect future losses. Insurers can also conduct rate-tiering analyses using the output to model profitability in relation to price and risk.

More Than Just Rating
Insurers can also use the output of a by-peril model informed by building characteristics to support underwriting and marketing functions.

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

The insurer can also use the output to trigger additional underwriting steps, such as justifying the need for an on-site inspection or the need to collect additional information from the property owner.

Marketing
Rather than spending millions of dollars a year on advertising, insurers can use the output of by-peril rating informed by building characteristics for prospecting new customers. Because of the granularity of the output, insurers can know what combination of building characteristics is optimal for every location in the country. Using public records data and other sources, insurers can often access building characteristic data for tens of millions of properties in the United States. Processing those addresses through a by-peril rating model informed by building characteristics helps give insurers the information needed to handpick their ideal portfolio.

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

Once Difficult, Now Doable
While it may be easy to see the benefits of by-peril rating informed by building characteristics, implementation is more complex. By-peril rating has a high barrier to entry from both an actuarial and a workflow perspective.

In the past, only the largest national or regional insurers had the volume of claims data to develop by-peril models based solely on location. Adding the component of by-peril rating by building characteristic requires even more granular data, significantly adding to the challenge. Besides the availability of data, insurers often need to employ teams of data analysts to correlate previous loss experience with likely future losses.

From a workflow perspective, rating by peril is relatively simple, because the only information needed is the property address. However, adding in the building characteristics component requires detailed property-specific information for each property under consideration for underwriting. Many companies already rate using some building characteristics, but few come close to the 20 building characteristics that ISO determined have an influence on property risk. As the need for more detailed rating information becomes apparent, more and more companies are investing in creating solutions to identify, capture, and quantify the data needed.

For insurers interested in taking a by-peril rating approach informed by building characteristics, the good news is that most of the data required to do so is often the same data needed to estimate the replacement cost of a property. Virtually every insurer estimates the replacement cost as part of the underwriting process, so insurers can reuse that data for the by-peril rating analysis without significantly affecting their underwriting workflow.

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