The insurance industry’s law of large numbers is broken eight ways from Sunday. And it is broken due to a lack of critical thinking skills combined with minimal accountability.
I’ll use Florida as a starting point. If the law of large numbers is applicable, then the way loss ratios should be reviewed is over a long period of time. This is an especially important statistical approach because according to Wikipedia, about 121 hurricanes have hit Florida since 1851 (per the NOAA Hurricane Research Division, aoml.noaa.gov/hrd/hurdat/All_U.S._Hurricanes.html).
121 hurricanes in 173 years equals 0.7 hurricanes per year. Because not even one hurricane strikes Florida annually and because in that 173-year span, on multiple occasions Florida was not struck by a hurricane for two or more years at a time, the law of large numbers must include a long time span. Last year’s hurricanes, on a frequency basis, are simply catching up to the average and yet carriers and markets act like the sky is falling.
I analyzed Florida’s homeowners loss ratios over the last 11 years (all the years I could access). The average adjusted loss ratio is 60.3% with a median of 54.1%. What is the national average over the last ten years? The net loss and LAE ratio is 73.3%! (All numbers are per A.M. Best).
Better not write in Florida! A carrier might make more money than normal!
While that’s an overstatement because underwriting expenses in Florida are higher offsetting some of the profits, my point is that over time, i.e., application of the law of large numbers, Florida is not a bad place to write. It might not be great, but it’s better than average.
The law of large numbers is also broken because the concept presumes all accounts, good and bad, are placed in the same pool with limited underwriting ability to predict which accounts will have claims. Therefore, rather than spending too much time and money underwriting, price the entire pool adequately, and everything will work out fine. And if one loses a little, raise rates spreading the pain just enough to make a profit but not causing too much pain clients will shop.
But predictive modeling, if you believe it works, ruins that model quickly.
And a carrier does not need predictive modeling if the carrier is willing to do the real work of underwriting. The parties that do this are moving huge portions of the commercial premiums into various forms of captives. The results there are far more profitable and as the pool of the best clients placed in alternative markets grows (the last estimate I saw from Aon showed more than 50% of all commercial premiums are now in the alternative space), the regular market becomes concentrated with poorer accounts. And one of the most important underwriting rules is, “You can’t charge enough for a bad risk.”
With 50% plus of premiums moved to alternative risk transfer markets, the law of large numbers in the regular insurance pool is dwindling.
This means that markets and brokers capable and willing to spend the calories required to critically think have more opportunity than ever. This is the kind of market that can reward true intelligence and effort. This industry is a fairly lazy thinking industry, or at least that is what I’ve experienced over the last 35 years. Most carriers and brokers will never realize what is happening until it is too late.
As evidence of this trend even in the standard market, 10 carriers now have 52% of all premiums out of approximately 1,000 P&C carriers. The top 20% or so of carriers are averaging profit margins 14 full percentage points better than average on a CONSISTENT basis. That means the other carriers are inadequately profitable to survive. And my latest analytics clearly show who the winners and losers will be in case you’re interested in being a winner.
The law of large numbers model rewards lazy thinking and if the law of large numbers is dead, not much hope exists for lazy thinking.
NOTE: The information provided herein is intended for educational and informational purposes only and it represents only the views of the authors. It is not a recommendation that a particular course of action be followed. Burand & Associates, LLC and Chris Burand assume, and will have, no responsibility for liability or damage which may result from the use of any of this information.
None of the materials in this article should be construed as offering legal advice, and the specific advice of legal counsel is recommended before acting on any matter discussed in this article. Regulated individuals/entities should also ensure that they comply with all applicable laws, rules, and regulations.
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