Academic journal article Journal of Risk and Insurance

An Empirical Investigation of the Effect of Growth on Short-Term Changes in Loss Ratios

Academic journal article Journal of Risk and Insurance

An Empirical Investigation of the Effect of Growth on Short-Term Changes in Loss Ratios

Article excerpt


Given the use of premium growth as a risk measure in regulatory and private risk assessment models, the impact of growth on underwriting profitability is an important question. Our results show a negative relationship between premium growth and changes in loss ratios, suggesting that premium growth alone does not necessarily result in higher underwriting risk. Further, there is a positive relationship between claim count growth and changes in loss ratios, suggesting that claim count growth may be a preferred measure of underwriting risk.


The purpose of this article is to evaluate the short-term effect of premium growth on the loss ratio of property-casualty insurers. The effect of premium growth on underwriting profitability is a key consideration in the evaluation of the financial strength of insurers. For example, the A.M. Best Company's capital adequacy ratio (A.M. Best, 2003) includes a growth risk component, and several of the A.M. Best solvency studies over the years have cited premium growth as an indicator of financial impairment.

The National Association of Insurance Commissioners' (NAIC) two primary early warning systems, the Insurance Regulatory Information System (IRIS) and the Financial Analysis and Solvency Tracking System (FAST), both include premium growth ratios as early warning signals of financial impairment. The NAIC's risk-based capital formula includes two specific capital charges for excessive growth, one of which is applied to premiums to measure near-term risk, and the other is applied to reserves to address long-term effects.

In recent years, questions have been raised about the true effect of premium growth on profitability and on underwriting risk. In 2004, California's competitive workers' compensation fund, the State Compensation Insurance Fund (SCIF), sued the California Department of Insurance over the applicability of the NAIC's risk-based capital (RBC) standards to SCIE specifically questioning the accuracy of the excess growth risk component. At the time, SCIF was the largest workers' compensation insurer in California and, with nearly $8 billion in premiums, one of the largest in the country. The inclusion of an excess growth risk component in the NAIC formula was enough to trigger regulatory action under the risk-based capital statute in California. SCIF argued that the price strengthening that the company had imposed on its customers was fueling its premium growth, and that the organization was actually becoming stronger, not weaker, as a result.

A.M. Best makes a distinction between premium growth and exposure growth in its evaluation of the financial strength of insurers. In a presentation to industry CEOs, an A.M. Best vice president reported that rating analysts had begun to focus on growth risk in a different manner.

   Because of the hard market, A.M. Best is also looking at rapid
   growth, the leading cause of insolvencies, differently. While rapid
   premium growth is a cause for concern, especially when it exceeds
   20 percent, policy count is the index on which analysts focus in
   climate of rising prices, because it provides a better measure of
   exposure growth. (Horvath, 2004)

The development of the premium growth charge in the RBC formula was controversial in that the formula does not distinguish between exposure growth (an increase in the number of policyholders) and rate-level growth (an increase in the average price per exposure), although the two sources of risk are materially different (Feldblum, 1996). Premium growth attributable to rate increases can actually reduce the risk of the firm if the same customers are paying more for the same risk exposure. On the other hand, if the price increases alter the mix of customers, the new book of business can generate unexpected losses if the new mix of business is mispriced. Exposure growth would have no effect on profits if the products are properly priced, but in a competitive market, significant exposure growth may be an indication of underpricing. …

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