Part Two: The Regulatory Environment

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Part Two: The Regulatory Environment

Let’s acknowledge right away the give and take relationship between program design and the regulatory environment. Program design for current products cannot take place without detailed knowledge of the regulatory environment in the marketplace. At the same time, the current regulatory environment has usually formed in response to past market actions and will likely change in the future based on carriers’ actions today. With this in mind, let’s take a look at how the regulatory environment influences the design of automated underwriting systems.

As stated previously, PPA is regulated at the state level. State regulation has resulted in a variety of market conditions across the country. There are several ways that these different regulatory environments influence the design of an automated underwriting system.

[edit] Limits on the degree of insurance company autonomy in rate setting and program design.

While we do not intend to provide a detailed look at the topic of automobile insurance rate regulation, we do need to discuss the direct impact of regulation on the underwriting process. Since at its most basic level underwriting is matching the correct price to a risk, any limitation on an insurer’s ability to do so is significant.

The ways in which rates are regulated vary tremendously from state to state. Some states have a “Prior Approval” system requiring insurance carriers to submit detailed (and frequently massive) statistical justifications for a new PPA program or a change to an existing one. The insurance regulatory body then studies the filing and decides whether to approve, reject, or seek modification of the program. Insurers in such an environment must work with the regulators to have their rating programs approved. Rates and underwriting rules cannot be used until they have been officially approved.

Other states operate under a “File and Use” system, in which insurance carriers are required to submit certain detailed information about their rates and underwriting rules to the regulator, but may begin using them without the approval of the regulatory agency.

Still other states utilize some sort of a Rating Bureau to establish standard rates for the state. Insurance companies must rate policies according to these Bureau rates except for policies falling into categories of allowable exceptions. Some exceptions are stated as “Objective Standards Tests”, where policies not meeting established criteria may be charged a rate above the standard rate. In other cases, “Consent to Rate” systems are used. Under “Consent to Rate”, an insurance buyer who is unable to secure insurance coverage at the standard rate may consent in writing, and with full disclosure by the insurance carrier, to pay a premium in excess of the standard rate.

The issue of rate level regulation is tightly linked to an insurer’s obligation to insure anyone who applies. Some states have “all comers” laws, under which a company cannot refuse to insure anyone. In these states, some form of “residual market mechanism” exists to insulate insurance carriers from the financial ramifications of insuring risks they would not take voluntarily. Types of residual market mechanisms include Joint Underwriting Associations (JUAs), Assigned Risk Pools, Fair Access to Insurance Requirements (FAIR) Plans, and at least one Reinsurance Facility.

Other states will allow insurers, within limits, to refuse to insure risks that do not meet their guidelines. In these states, secondary and tertiary market companies generally operate which are willing to insure these risks for a price. There is usually a residual market mechanism (frequently an Assigned Risk Pool) to provide coverage for risks deemed undesirable at any price by the voluntary marketplace.

[edit] Limitations on Information Access or Use in Underwriting and Pricing PPA

The use of credit Scores in the underwriting of PPA continues to be hotly debated by insurance carriers, regulators and legislators, and consumer advocates. The ability to use credit scores, like regulation in general varies by state:

• Some states place no restrictions on the use of credit scores.

• Some states ban the use of credit scores in insurance underwriting and pricing altogether.

• Some states place the onus on the insurance carrier to prove an actuarially valid link between credit scores and predicted loss ratios.

• Some states will allow the use of Credit Scores in risk selection or program placement, but not in pricing.

Because of these differences, an automated underwriting system needs to have a great deal of built-in flexibility in handling credit scores. States have changed their stance on credit scores abruptly in the past, sometimes based on court decisions, so the ability to fine tune the system rapidly is essential.

Although most states make Motor Vehicle Records (MVRs) available to entities with a valid reason—such as an insurance company underwriting an auto policy—there are a couple of states that still limit access. Some states make records available in real time over the Internet, others will return reports electronically on a 24 to 48 hour cycle, and a few still operate on a paper-based system. Automated underwriting systems, and particularly those running at the point of sale for new business, must be able to deal with state-specific report ordering criteria.

A large enough group of applicants will have International driver’s licenses to create the need to address how you will deal with applicants without a U.S. state driver’s license.

The quality of MVRs varies widely from state to state. Some states simply do not have a good record for completeness or accuracy of MVRs. Moving violations from different jurisdictions within the state appear with differing degrees of accuracy/frequency. Reciprocity agreements with other states may influence whether moving violations occurring outside the license state will appear on a given state’s MVR. There are several publications which monitor and report on the quality of MVRs by state, the methods of ordering and retrieval supported, and interpretation of MVRs.

The area in which MVRs are most frequently lacking is accident reporting. Even states with high accuracy ratings for moving violations may score poorly when it comes to accidents. Many, many accidents will never appear on an MVR. When they do appear, it is usually impossible to determine fault for an accident where the driver was not convicted of a moving violation. MVRs also lack important information about the types and amounts of insurer payments for property damage and injury. Third-party claims databases generally provide more accurate accident information, including data on the types of payments made and the nature of the accident.

[edit] Insurer Responses to Regulatory Limitations

Insurance companies have responded to regulatory restrictions on their pricing and underwriting latitude in a variety of creative ways. These responses are usually reflected in the design of an automated underwriting system, as we will discuss in the design section.

There are several primary ways companies deal with regulatory restrictions:

Design proxies for prohibited items

Some states preclude insurers from rating based on age, sex or marital status.

• Instead of asking the prohibited question of driver age, companies will ask for “years licensed” or “years of driving experience”. Adding this number to the minimum license age will give a good—although admittedly imperfect-- idea of a driver’s age.

• As a proxy for marital status, companies compare the number of vehicles and number of drivers on a policy to arrive at a reasonable assumption about the marital status of applicants.

The example for Acme Insurance given in Part One was developed by a company looking for married couples without children of driving age. It was used in a state where the company could not ask for drivers’ age, sex, or marital status. The series of qualifications combine to produce a result similar to that achieved by asking the prohibited questions.

Modify payment options based on risk characteristics

Regulations may cap the premium that can be charged for certain risks, or may require that a company accept a policy it otherwise would not. Because purchasers of PPA have proven to be extremely sensitive to price and payment terms, a company might…

Require that these less than desirable risks pay the premium in full.

For risks the company wishes to attract, payment plans with low down payments can be used. Modification of down payment requirements and installment plans, especially relative to the terms offered by competitors, is an effective way of dealing with regulatory restrictions on pricing and underwriting.

Use of multiple underwriting tiers

Companies may offer multiple programs within a state, with different rate levels and underwriting qualifications. A risk that meets the most stringent guidelines may be written at a preferred (discounted) rate, offered the most attractive payment options, and issued higher limits than other risks.

As a risk fails successive underwriting rules, it is moved down a tier of underwriting levels, with increasing prices, lower liability limits, increased physical damage deductibles, and less attractive payment terms. In some states these tiers may exist within a single insurance entity; in other states the insurer may need multiple legal entities under common ownership in order to do so.

Tiering logic is a fundamental part of most automated underwriting systems.

Splitting the Policy

This term refers to the practice of voluntarily writing only certain coverages for a particular risk and placing the remaining coverages in a residual market (or declining them altogether).

As an example, a company may be able to charge a high enough premium to make the physical damage coverage for a driver with a bad driving record profitable. Because of regulatory caps on liability premiums, the company is unwilling to write those coverages and therefore places the liability policy in a residual market.

The ability to split policies varies by state. In some areas it is commonplace, while in others it is prohibited altogether.

Modify the coverages offered

After underwriting a policy, the carrier may be unwilling to insure the risk on the terms applied for. As an example, the applicant may have requested liability limits of 100/250. The company is unwilling to offer those limits for the premium it is allowed to charge, but would insure the risk with 50/100 limits. Automated underwriting systems can make these determinations and present only the limits a company is comfortable with for any specific risk.

Similarly, a company may offer modified deductibles for physical damage coverage to make a risk acceptable. Because there is an inverse relationship between deductible amount and premium charged, companies might offer only lower-deductible plans to drivers with bad records. The higher premiums that result more than offset the increased potential claim payment that accompanies a lower deductible. A good automated underwriting system will make these determinations based on company rules.