It is becoming harder to make money selling auto and home owners’ insurance, for retail property and casualty insurers, which purvey these financial products, are sacrificing profit for market share in an already saturated industry. At the same time, consumers are shopping around more, and new sales channels (such as the Internet) are further commoditizing products and increasing their price transparency.

But retail property and casualty insurers have one effective weapon: better pricing of policies. With a more sophisticated approach, a typical insurer can improve its combined ratio by 8 to 15 percent.¹ Getting the pricing right seems so obvious that it is hard to understand why many insurers have either failed in their attempts to do so or largely neglected the issue. Obstacles lie in the way, however. Most property and casualty markets, particularly in emerging economies, are tightly regulated. Even in the United States, insurers must still submit rate plans to the regulator, allowing other companies to see what they are proposing and reducing their competitive edge.

In addition, some insurers lack the data for sophisticated pricing. It takes a portfolio of at least 200,000 to a million policies per product line (assuming access to reliable data) to produce a fine and reliable risk segmentation—the prerequisite for more differentiated pricing.² Other problems include inferior risk-pricing methods and the degree of discretion agents enjoy in offering discounts to customers.

Finally, comprehensive change can take years and involve large parts of a company. The transition from one rate plan to another may be painful for the sales force as well as for the company’s reputation, since premiums might rise significantly. And the rise in lapse rates as new customers replace old ones adds to the insurer’s fear of losing volume.

Nevertheless, a closer look at the way policies are priced shows why there is so much potential for improvement. In deregulated markets, insurers often charge very different prices for similar levels of risk (Exhibit 1). Moreover, the segment-by-segment correlation between premiums paid and claims incurred is often low for individual insurers, and this discrepancy leads us to believe that the pricing of many carriers is more or less random and that they manage profitability on a total-portfolio rather than segment-by-segment basis (Exhibit 2). A sophisticated company thus has huge scope to beat the competition consistently by correctly assessing risks and leveraging the customers’ price sensitivity. Few insurers, despite their expertise in risk management, have reached this level.

The rest could emulate the more sophisticated companies in three important ways. First, they could introduce new variables to help predict the risk that a customer represents. Sophisticated insurers use up to 40 variables to price a simple auto or home owners’ policy, against the average performer’s 15 or so. Extra variables might include a driver’s credit rating; a driver’s type of home, job, and family situation; and the weight and mileage of the car. Second, insurers could limit price discounts. Finally, they could maximize profits by understanding not only how much it costs to write policies but also what customers are willing to pay. Continuous pricing pilots administered through call centers or the Internet, for instance, give insurers the ability to check the behavior of consumers and to trade off profit margins against volume. When a company has identified its most profitable segments, it can direct its sales channels to them.

Undifferentiated pricing has long created room for cherry-picking strategies in most markets. For the most part, however, it has been the strategy of new attackers, which have typically not been successful, because they lacked the data for high-quality underwriting and the brand and marketing resources to ensure significant switching. More sophisticated pricing is therefore mainly a tool for established players setting out to increase their rate of growth, their profitability, or both.

Moving first is crucial: the cost of losing the most profitable customers to cherry-picking competitors is too high (Exhibit 3), and, to make matters worse, insurers risk attracting the unprofitable customers whom competitors have intentionally priced away. Once this customer-base swap has taken place, it is hard to reverse, since people are unwilling to switch carriers unless the price difference is on the order of 10 to 30 percent, depending on the segment’s price sensitivity. And then the only way to get customers back is to offer below-cost prices.