Emphasis: Competitive Market Analysis in Personal Lines

By Alessandro Santoni and Jeanne M. Hollister

In the past decade, many insurers have made great advances in their ability to use advanced statistical techniques to inform their pricing strategies and structures. Yet the methods used to conduct competitive analysis have not kept pace and are largely ineffective in today’s pricing environment. As a result, companies are setting their prices in a vacuum, without a full appreciation of the marketplace dynamics that will ultimately impact their ability to write profitable business.

Advanced statistical techniques can help. They can be used to gain an understanding of the dynamics of competition, just as they are currently used to develop rating structures. A structured competitive market analysis (CMA) can significantly enhance the effectiveness of a company's pricing strategy.

The Pricing Process

Traditionally, ratemaking has relied on a cost-based analysis, whereby rates are developed to reflect the anticipated cost of claims, expenses, investment income, the cost of capital and a profit margin. If all the assumptions are correct and cross-subsidies are appropriately addressed, then the company doesn't need to be concerned with inadvertent shifts in its book of business due to pockets of underpriced business that will ultimately lead to deteriorating profitability.

Cost-based pricing remains critical, but it doesn't take into account the competitive environment or customer behavior. These are two important considerations in setting a pricing strategy that supports a company’s profitability and growth objectives.

Incorporating information about customer behavior into a pricing strategy requires detailed retention statistics that can take many years to capture. In contrast, extensive competitive information can be captured more quickly, and the companies that make good use of that information when setting their prices will have an advantage in the market.

Steps for Conducting a CMA

Despite significant technological advances in the tools used to establish rate structures, many insurers assess their competitive positioning by preparing rate comparisons for a relatively small number of representative risks. They may be preparing them by hand, using competitors' rating manuals, or they may be using rate/quote engines available on many Web sites. Increasingly, with the growing complexity of competitors' rate structures, companies are considering the purchase of comparative rating engines.

Regardless of the method of collection, many companies are using far too few price points to get an accurate read on their competitive position. They lack a comprehensive and structured process for gathering and analyzing large amounts of competitive data, and an approach for incorporating the information in a way that will enable them to evaluate pricing strategy and structure.

A comprehensive CMA can be thought of in four distinct phases:

• Rating plan analysis. Understanding the components of competitors' rating plans is an important first step to the CMA. Not only does it provide a perspective on the relative sophistication and complexity of the various plans, but it provides insights that are helpful to the data-gathering phase of the analysis.
• Data gathering. Different approaches are used in different countries to obtain competitors' rates. They include rating manuals filed with regulators, quotes from an agent or broker, third-party comparative rating systems and industry association information. Accuracy of data is a challenge regardless of the source. Reviewing data for integrity and making adjustments is a labor-intensive but critical step in ensuring the validity of the analysis.
• Univariate analysis. A univariate analysis provides perspective on which rating variables are most critical to the competitive assessment. It also provides a means for segmenting the company's book of business according to a particular variable and assessing overall competitiveness from one particular dimension.

Univariate analysis can be performed on a reference portfolio representing the existing book of business, a target portfolio or a portfolio that replicates the market mix. An average premium on the total policies in the reference portfolio can be calculated to understand the overall ranking compared to competitors. To achieve a deeper level of detail, it’s possible to analyze the company's competitive positioning by coverage and by individual rating variables. Similarly, new business can be examined separately from renewal business.

• Multivariate analysis. As a final step, all variables are considered in combination to assess the intensity of competition and company positioning. Results help the company identify market niches where prices are well below the market as well as areas where prices are well above the market.

One measure that is used in the multivariate analysis is "competitive intensity," which is defined as the amount of price differentiation that is occurring in the market for a particular segment. The closer prices are to each other in a segment, the greater the competitive intensity. Conversely, the more dispersed prices are in a given segment, the less intense the competitiveness is deemed to be.

The second measure that is used in the multivariate analysis is the difference between the company’s price and the market average. As shown in Exhibit 2, the price can be below market average, in line with it or above it.

Price-Competitiveness Clusters

Multivariate analysis uses specific classification techniques to assess an insurance company's price compared to the market average, in segments of different competitive intensity, for all rating variables at once. Results of the analysis can be used to develop different rating strategies to target specific market niches. Three combinations of intensity of competition (high, medium and low) with three levels of price difference compared to market average (in line, below and above) are used to create nine statistically computed clusters for examination. Each of the clusters suggests potential pricing strategies and rating actions. In each of the clusters resulting from the model, it's possible to assess not only an individual company's positioning against the market average but also to determine the main competitors for business within that cluster. One point of interest is that this process identifies clusters where the company’s price is far enough below the market average to allow price increases without risk of losing market share (see cluster 1 in Exhibit 3).

In clusters where the price is still below the market but the intensity of competition is decreasing (clusters 4 and 7 of the matrix), there is still an opportunity to increase prices, but by a lower magnitude. This is because the higher price dispersion increases the probability that customers who shop around will be able to find less expensive quotes and decide to switch carriers. By properly identifying risks falling in clusters 1, 4 and 7, we can establish price increases that minimize the risk of losing market share.

From a strict methodological point of view, this analysis does not necessarily require an assessment of the level of profitability since pricing is being increased. However, other considerations must be taken into account, particularly when increasing prices in already profitable segments. Depending on the magnitude of the price increase, one strategy might be to increase revenues and profit while minimizing the risk of losing market share. However, in order to determine the optimal price level for these segments, an elasticity-of-demand analysis is necessary to quantify how much business might be lost.

Where rates are particularly high (i.e., clusters 3, 6 and 9 in Exhibit 3), it might be possible to decrease rates in order to increase market share. As in the case of clusters 1, 4 and 7, pricing decisions for clusters 3, 6 and 9 must consider both competitive intensity and profitability. It is especially important to consider profitability because high rates may be resulting from high loss costs, and large rate reductions might erode profitability to unacceptable levels. Again, an elasticity-of-demand analysis could be used to maximize new customers' conversion rates.

Illustrative output from the multivariate analysis is shown in Exhibit 4, which depicts the variance from market averages (in circles) and the percentage of risk profiles falling into each cluster (rectangles). The number of risk profiles falling into each cluster depends on the overall market positioning of the company. (For example, a company with rates at the high end of the competitive range will have most of its risks on the right side of the matrix.) But the results will also depend on the complexity of the company’s rating structure and its ability to target specific segments. For example, a company with a highly refined target marketing strategy might find its business concentrated in the very high- and very low-priced segments.

Line-Of-Business Considerations

CMA techniques have, until now, been applied predominantly to motor insurance, reflecting the fact that in many countries this is the most significant line of business. However, the same concept can be applied to other personal lines products, such as health or homeowners insurance.

More broadly, CMA analysis is particularly effective under the following conditions:

• The product is treated as a commodity, with no significant coverage differences, guarantees or perceived quality of service differences compared to other products
• .Rating structures are publicly available, and the actual premium charged by agents or brokers does not differ substantially from the rate manual. In some markets, however, this situation does not apply. In Europe, for example, it is common for agents and company underwriters to grant discounts or surcharges of 30% or more for certain coverages. While it is possible to estimate surcharges and discounts, the level of accuracy achieved is reduced.
• Competitor rating plans are based on known rating factors applied multiplicatively, and there aren’t variables that depend on information that is unique to a specific company, such as the number of customers who have requested quotes, the time of day of the quote or the timing of the quote vis-E0-vis television advertising.

Using CMA to Help Manage the Underwriting Cycle

Monitoring a company's competitive position needs to be done with a fair degree of regularity to keep pace with changes in the market. Ideally, a CMA would be conducted each time a company is about to introduce new rates. Additionally, it might be conducted when major competitors make a significant change to their rating plans. But, even without rate structure changes, the impact on profitability may vary with changes in consumer behavior and individual company risk portfolios. Ultimately, practicality will be a consideration, because conducting a CMA is a time-intensive process. In reality, we have seen companies conduct CMAs as frequently as quarterly.

One significant advantage of conducting CMAs regularly is that the analysis can help a company navigate its way through underwriting cycles with more knowledge and forethought. Understanding signs of changes in the insurance cycle and how particular competitors are positioned to weather the next stage of the cycle can inform your own company's pricing strategy. For example, a competitor with a relatively unsophisticated rating structure that has low prices is likely to face significant challenges in a softening market. This company faces the choice of lowering its prices to grow its book of business at the expense of profits, or making no change to prices and losing business to competitors. The information available through the CMA will make it clear in which market segments that competitor is most vulnerable. This in turn can inform your own company’s pricing strategy and allow you to be more judicious about where, and to what degree, you modify your own prices in anticipation of a softening market.

First Movers' Advantage

CMA and an integrated approach to pricing have been adopted by a number of insurance companies to grow market share without compromising profitability. Given the competitive intensity of the automobile market globally, we expect to see more companies adopting this approach. Similar analysis in other lines lending themselves to this type of approach is likely to follow. Those that move first will have a considerable advantage over those that do not make the investment.

Implementing changes to a company's rating plan and its rate structure that appropriately reflect competitive dynamics isn’t easy. For a discussion of implementation challenges associated with new pricing structures, see "Managing Change to Complex Pricing" on page 18.

Ultimately, the true winners in the pricing of property/casualty products will be those that conduct a comprehensive CMA and factor it into their pricing. These companies will also be able to reflect price elasticity considerations in their rating approach.

Advanced statistical techniques and enhanced computing power make it possible to develop an integrated approach to pricing that simultaneously considers costs, competition and price elasticity. These capabilities will in turn enable a company to determine the optimal prices that support its strategic objectives. It is only a matter of time before most companies adopt this approach. The value of what can be gained is too great to be ignored.

For comments or questions, call or e-mail Alessandro Santoni at 39 06 3280 3445, alessandro.santoni@towersperrin.com or Jeanne Hollister at 1-860-843-7055, jeanne.hollister@towersperrin.com.