Maintaining healthy loss ratios: The challenge for South African brokers

Loss ratio is to the short-term insurance industry what tries are in a rugby match. While a high number of tries may not automatically mean that your team won the match, it goes long way to deciding the outcome in your favour.

Insurers use the term “loss ratio” to gage underwriting performance and, ultimately, a company’s profitability. While other financial ratios are also used, such as claims ratio and combined ratio, the loss ratio is the most common measure used by insurers, for themselves and when engaging with brokers.

Defining “loss ratio”

One of the interesting facets of our industry is the wide spectrum of interpretations on many concepts and terms, including acronyms and ratios. The loss ratio falls into this category. For sake of simplicity, we’ll consider the loss ratio as the ratio of “incurred claims” divided by “earned premium”, the latter being gross of commission, yet net of fees.

This definition is the first item of interest. Too often we talk about the loss ratio being too high, or not good enough. We therefore need to take corrective action, including premium increases, increasing excess levels and applying stricter underwriting rules. However, have we considered the right elements in the equation? I always urge all parties to ensure that they have a common understanding of the terms and concepts being discussed. Running the risk of sounding pedantic, it may be worthwhile checking to see what loss ratio is considered desirable, good or not acceptable by the risk carrier, and to understand the elements that are used in the specific loss ratio calculation.

Factors that may lead to confusion or differences include IBNR (incurred but not reported – a claims reserve for claims that have happened but have not been reported to the insurer), estimates and grouping of claims by date-of-loss or date-of-notification, and the inclusion or exclusion of fees and commissions. It is thus paramount that both parties - broker and risk-carrier - share the same understanding of the loss ratio.

Implications for brokers

A broker is clearly defined as the agent of the insured, and therefore acts on behalf of the policyholder. Furthermore, current “hot topics” in our industry such as the re-drafting of Section 48 and the RE exams have highlighted the fact that broker’s remuneration may not be linked to the underwriting result. The question remains, should the loss ratio be of concern to the broker? The answer is a resounding ‘yes’.

This does not mean that the broker should change his or her role and suddenly become the agent of the insurer. It does, however, mean that the broker will do well to ensure that a healthy loss ratio is maintained with every risk carrier with which it has as an agency. Nobody aims to have corrective action suggested, or even worse - unilaterally implemented, on an existing portfolio, or their agency cancelled.

Since it is in the broker’s interest to ensure that all portfolios run well – in other words, at an acceptable loss ratio or better - the broker needs to ensure that this can be achieved, without compromising the position of being an agent of the policyholder.

Some of the elements in the loss ratio can be influenced or controlled by the broker, while others are clearly beyond control.

Accurate premiums

An accurate premium will, on average, lead to the desired loss ratio on a portfolio of sufficient size. Unsurprisingly, the theoretical number can only be perfectly determined in hindsight. Nonetheless, methods are constantly evolving that improve the estimates of the correct theoretical premiums – with an acceptable degree of accuracy.

Placing a policy at a premium well below the theoretically correct risk premium will ultimately lead to a loss ratio that is too high. The risk premium should differentiate between risks and will therefore vary by risk quality. The cheapest premium may thus be attractive in the short term, but may endanger the portfolio’s loss ratio over the medium to long term.

Market conditions

The reality is that the market conditions override the theoretical premium. The insurance market is known to be subject to the so-called insurance cycle, fluctuating between a hard market and a soft market. In a hard market, insurance profits are high, loss ratios low and underwriting rules strictly applied. The opposite applies in a soft market.

Since the broker wants to maintain the policyholder as a client throughout the various stages of the cycle, and the client in turn is always looking for a “cheaper” premium, the broker will be forced to provide the policyholder with the option of the lowest premium. Is the cheapest premium the right option to choose, though?

Practical underwriting

“The path of least resistance” is a phrase repeatedly mentioned when it comes to describing the apparently onerous and cumbersome underwriting processes applied by some risk carriers. It is easier to place the business with a risk carrier that does not ask any questions and that furthermore does not apply any underwriting rules, such as risk requirements and endorsements.

While the underwriting must be sound and reasonable, it must also be balanced with what is practically possible and will assist all stakeholders. Proper information enables the underwriter to apply more accurate pricing techniques, which result in fairer premiums and less cross-subsidies. Proper underwriting will naturally also yield more sustainable and healthier loss ratios.

Further considerations

Other elements the broker considers when choosing between potential risk carriers include service, scope of cover, claims handling ability and credit rating. Good service will be of benefit to the broker and policyholder, but may not influence the loss ratio as such. Scope of cover will definitely influence the claims being paid or rejected – but we should assume that the broker advises the policyholder of the appropriate cover. Credit ratings give an indication of the insurer’s financial strength and ability to withstand adverse conditions.

In practice

Ultimately, the broker needs to ensure that the loss ratio is maintained at a healthy level over time.

To summarise this in a nutshell, the broker needs to:
1. Define the “healthy” loss ratio, possibly per portfolio;
2. Balance the desire for cheaper premiums against sustainable underwriting results;
3. Support proper risk selection and underwriting processes;
4. Look after the client’s interests by considering service, credit rating and scope of cover;
5. Achieve all the above with economies of scale and low levels of churn.

Competitive market

Churn is another challenge the broker faces. While the policyholder may be advised of the optimal quote, which is based on the appropriate cover, with proper financial strength and backed up by good service, at a market-related premium, the broker may still lose the policy to another broker or direct insurer if the policyholder can “save a few Rand” or is convinced that another offer is superior.

The direct insurers and unsustainable premium levels thus present further challenges to the broker’s quest to maintain a healthy loss ratio while maintaining a good client base. Policyholders only interested in the cheapest premium may thus inevitably be less attractive to the broker, since they will always be on the prowl for a better deal.

All brokers have their work cut out to maintain healthy loss ratios. Given the plethora of things to consider, the regulatory pressures and the offering of bigger brokerages based on economies of scale, our market may yet see a consolidation of those who can “score many tries”.