CIA.Territories

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Reading: “Territory Pricing Considerations in Property and Casualty Insurance,” March 2024. Official Link

Author: Canadian Institute of Actuaries

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BA Quick-Summary: Territory Pricing The following items must be given consideration when performing territory pricing: Territory Setup: Boundaries should balance granularity and data credibility. Modelling: Use residual-based models to define and adjust territories. Data Sources: 3rd-party data (weather, crime...) can enhance pricing accuracy. Fairness: Must consider fairness and regulatory expectations in rate setting.

Pop Quiz

What is a potential consequence of not having territories as a rating variable?

Study Tips

💡 Key Insight:

Territory is a cornerstone rating variable for P&C insurance. This guide explains how to balance technical considerations with business strategy and fairness concerns when defining territories and setting relativities. Remember that territorial ratemaking has two distinct phases that require different considerations.

📚 Study Strategy Summary:

Focus on understanding the two-phase approach to territorial ratemaking and how various factors influence both boundary definitions and rate relativities. Pay special attention to the technical modelling process and fairness considerations, as these are increasingly important in regulatory reviews.

Estimated study time: a few hours

Overview: The Territory Pricing Framework

Territory pricing in P&C insurance involves making strategic decisions about geographic risk differentiation. The process requires actuaries to balance multiple competing objectives while adhering to regulatory requirements and fairness principles.

The foundation of territorial ratemaking rests on basic geographic building blocks such as postal codes, forward sortation areas (FSA), and census blocks. These building blocks provide the canvas for creating territory definitions that can vary by coverage and peril, allowing insurers to capture geographic variations in risk while maintaining operational efficiency.

The Two-Phase Approach

Phase 1: Determine Territory Boundaries

Phase 2: Determine Rate Relativities

Understanding these two distinct phases is crucial for exam success. Each phase has its own considerations and challenges that must be addressed systematically.

Phase 1: Territory Boundary Considerations

When determining territory boundaries, actuaries must balance several key factors that often conflict with each other. The goal is to create territories that are both statistically credible and intuitively linked to underlying risk factors.

Size and Credibility Balance

The Fundamental Trade-off

The size-credibility balance represents one of the most fundamental challenges in territorial ratemaking. Territories must be:

• Granular enough to capture nuanced variations in expected loss costs
• Large enough to provide credible data for ratemaking

Credibility metrics commonly used include earned exposure, claim count, and gross written premium. Practical limitations such as rating system capabilities and regulatory guidelines may also constrain the total number of territories that can be implemented.

Intuitive Risk Connection

A well-designed territory structure should have an intuitive connection to risk levels. This is particularly important in auto insurance, where urban and rural areas exhibit distinctly different risk profiles. Traffic volumes, road infrastructure, and population density all contribute to these differences.

However, the document acknowledges that establishing such intuitive connections may not always be possible due to practical limitations. While desirable for explainability, an intuitive risk connection should not be considered an absolute requirement for territory definitions.

Regulatory Constraints

⚖️ Regulatory Flexibility and Limitations

Regulatory frameworks add another layer of complexity to territory design. Key regulatory considerations include:

• Territories need not be contiguous
• Different coverages/perils can have different territory definitions
• Some jurisdictions mandate contiguity or limit the number of territories

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Phase 2: Rate Relativity Considerations

Beyond expected loss costs, several business factors influence the determination of territory relativities. These considerations reflect the reality that pricing decisions must balance actuarial indications with market dynamics.

Business Strategy Factors

Competitiveness and Market Position: Insurers must evaluate how their current rates compare to competitors within each territory. Strategic decisions about target market segments and desired business mix directly impact territory relativities.

Dislocation and Customer Impact: Rate changes create dislocation that can affect both retention and new business volumes. Actuaries must carefully balance the pursuit of profitability improvements against potential negative impacts on growth and customer satisfaction.

Technical Modelling Process

🔧 The Standard Territory Modelling Approach

The technical approach to defining territory boundaries typically follows a systematic process that isolates geographic effects from other rating variables. This process assumes that all risk characteristics not captured by other rating variables are attributed to territory.

Step-by-Step Modelling Process

Step 1: Build a Non-Territory Model Create a comprehensive model including all rating variables except geographic information. This establishes the baseline expected losses before considering territorial effects.

Step 2: Calculate Territory Residuals At the chosen building block level (e.g., FSA), calculate residual loss costs by comparing actual losses to model-predicted losses. These residuals represent the unexplained geographic variation in risk.

Step 3: Model the Residuals Group similar residuals to define territory boundaries, balancing the credibility of individual building blocks with information from neighboring areas. This step requires significant actuarial judgment.

Step 4: Finalize Boundaries Consider practical factors including credibility thresholds, market positioning, and business input. Involving non-actuarial teams such as claims and business development can provide valuable insights during finalization.

Lifecycle Management

Territory definitions require periodic review, though typically less frequently than other rating variables. The appropriate review frequency depends on several dynamic factors.

Factors Triggering Territory Review

• Population size changes
• Portfolio size and geographic distribution shifts
• Evolution of risk profiles within territories
• Regulatory or market changes

While pricing models are commonly reviewed annually or semi-annually, territory boundaries may only need refreshing every 3-5 years unless significant changes occur.

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Third-Party Data and Models

External data sources can significantly enhance territorial analysis, particularly for certain perils and coverages. The integration of third-party data requires careful consideration of relevance and accuracy.

Common Third-Party Data Sources

Data Type	Application	Key Consideration
Topography data	Natural catastrophe perils	Model validation critical
Accident location	Auto coverages	Data quality varies
Crime statistics	Theft/comprehensive	Update frequency important
Weather data	Water/hail perils	Historical vs. forward-looking
Public transit	Auto frequency	Correlation vs. causation

Catastrophe Model Considerations

For natural catastrophe perils like flood and earthquake, relying solely on internal historical data is often inappropriate. Third-party catastrophe models can provide more accurate territory definitions, but require careful implementation.

Due Diligence Requirements:

• Understand model construction and assumptions
• Verify relevance to specific risks being priced
• Identify coverage gaps (e.g., ice jamming in flood models)

Model Validation:

• Use internal and public data where available
• Compare results to industry benchmarks
• Document validation procedures and findings

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Postal Code Considerations

📮 Understanding Postal Codes as Building Blocks

Postal codes represent the most common geographic building block for Canadian insurers. Understanding their advantages and limitations is crucial for effective territorial design.

Advantages of Postal Codes

• Completeness and Data Availability: Every Canadian address has a postal code, and Statistics Canada provides demographic and socioeconomic data at this level. This comprehensive coverage simplifies data management and analysis.

• Hierarchical Structure: The postal code system provides built-in geographic hierarchy. The first character indicates province/region, while the second indicates urban/rural classification, facilitating high-level analysis and validation.

• Appropriate Granularity: In urban areas, postal codes typically encompass small, relatively homogeneous areas suitable for risk differentiation.

Disadvantages of Postal Codes

Variable Geographic Size: Since postal codes are based on dwelling count (averaging 20 addresses), their geographic coverage varies dramatically. Rural postal codes can cover 15-20 square kilometers or more, creating challenges for perils like flood where risk can vary significantly over short distances.

Frequent Updates: Monthly updates to postal code definitions require robust systems to ensure correct premium calculation when addresses are reassigned to different postal codes.

Non-Insurance Purpose: Postal codes are designed for mail delivery efficiency, not insurance risk assessment. They may not align with natural risk boundaries like flood plains or traffic patterns.

Fairness Considerations

⚖️ The Growing Importance of Fairness in Territory Design

Territory definitions inherently intersect with sociodemographic factors, making fairness considerations increasingly critical in modern ratemaking. This area has received heightened regulatory scrutiny and will likely remain a focal point in rate filing reviews.

Three Pillars of Fairness Review

Regulatory Compliance: Fairness concerns rooted in legislation or regulations must be factored into territory definitions and relativities. Actuaries must stay current with evolving regulatory expectations in their jurisdictions.

Internal Guidelines: Company-specific fairness policies play a crucial role in shaping territory decisions. These guidelines should align territory definitions with organizational values and corporate social responsibility commitments.

Professional Standards: The CIA's 2023 publication "Bias and Fairness in Pricing and Underwriting of Property and Casualty (P&C) Risks" provides essential guidance on addressing fairness concerns in territorial ratemaking.

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Key Takeaways for Exam

🎯 Essential Concepts to Master

1. Two-Phase Process: Understand the distinction between boundary definition and relativity determination
   
2. Balance of Factors: Know how to balance credibility, granularity, and business needs
   
3. Technical Process: Master the four-step modelling approach
   
4. Third-Party Data: Understand when and how to incorporate external data
   
5. Fairness Framework: Be prepared to discuss regulatory and ethical considerations

Practice Questions

Conceptual Questions:

• What are the two distinct phases of territorial ratemaking?
• How do urban and rural postal codes differ in their suitability as territory building blocks?
• Why might territories differ between coverages for the same insurer?

Application Questions:

• An insurer wants to use flood model output for territory definitions. What validation steps should they take?
• How would you balance credibility and granularity when combining FSAs into territories?
• What factors would trigger a review of existing territory boundaries?

CIA Territory Pricing Considerations - Practice Questions Answer Key

Practice Questions Answer Key

Conceptual Questions

Q: What are the two distinct phases of territorial ratemaking?

Answer: The Two Phases of Territorial Ratemaking

Phase 1: Determining Territory Boundaries

This phase focuses on defining the geographic boundaries of each territory. Key activities include:

• Deciding which geographic building blocks to use (postal codes, FSAs, census blocks)
• Grouping these building blocks into territories
• Balancing granularity with credibility
• Ensuring intuitive connection to risk where possible
• Adhering to regulatory requirements (contiguity, maximum number of territories)

Phase 2: Determining Territory Rate Relativities

This phase involves setting the relative rates for each defined territory. Considerations include:

• Calculating expected loss costs for each territory
• Evaluating competitive positioning
• Assessing business strategy and target markets
• Considering customer impact and rate dislocation
• Balancing actuarial indications with business needs

💡 Key Insight: These phases are distinct but interconnected - boundary decisions directly impact the ability to set appropriate relativities

Q: How do urban and rural postal codes differ in their suitability as territory building blocks?

Characteristic	Urban Postal Codes	Rural Postal Codes
Geographic Size	Small area coverage	Can cover 15-20+ square km
Risk Homogeneity	Generally homogeneous risks	Risk can vary significantly within postal code
Suitability	Well-suited for most perils	Challenging for location-specific perils (e.g., flood)
Granularity	Appropriate granularity	May be too large for precise risk differentiation

Detailed Explanation:

Postal codes are defined based on dwelling count (average 20 addresses), not geographic area. This creates fundamental differences:

Urban Areas: Postal codes cover small, densely populated areas where risks tend to be relatively homogeneous. This makes them excellent building blocks for territory definition in cities.

Rural Areas: The same 20-address average can span vast geographic areas with potentially diverse risk characteristics. A single rural postal code might include:

• Valley bottoms prone to flooding
• Hillsides with different exposure
• Areas near and far from fire services
• Varying road conditions and wildlife collision exposure

This variability makes rural postal codes less suitable as building blocks, particularly for perils where risk changes significantly over short distances (flood, wildfire, etc.).

Q: Why might territories differ between coverages for the same insurer?

Answer: Coverage-Specific Territory Design

Territories can and should differ between coverages because different perils have different geographic risk patterns. Key reasons include:

1. Different Risk Drivers by Coverage:

• Collision: Traffic density, road infrastructure, commuting patterns
• Comprehensive: Crime rates, hail exposure, wildlife density
• Property damage: Construction costs, catastrophe exposure
• Bodily injury: Legal environment, medical costs, jury attitudes

2. Credibility Requirements Vary:

• High-frequency coverages (collision) can support more granular territories
• Low-frequency coverages (comprehensive) may need larger territories for credibility

3. Regulatory Flexibility:

• Regulations typically allow different territory definitions by coverage
• This flexibility enables better risk differentiation

4. Competitive Considerations:

• Different competitors may be strong in different coverages
• Territory design can be optimized for each coverage's competitive landscape

📊 Example: An insurer might use 50 territories for collision (high frequency) but only 20 for comprehensive (lower frequency)

Application Questions

Q: An insurer wants to use flood model output for territory definitions. What validation steps should they take?

Answer: Comprehensive Flood Model Validation Process

Step 1: Due Diligence on Model Construction

• Understand the model's methodology and assumptions
• Verify the model includes all relevant flood sources (riverine, pluvial, coastal)
• Check if model gaps exist (e.g., ice jamming) that affect your coverage
• Review model resolution and its appropriateness for territory definition

Step 2: Data Validation

• Compare model outputs to:

 * Internal historical loss data (where credible)
 * Public flood maps and historical flood events
 * Industry loss data (IBC, CatIQ)
 * Government flood studies

• Look for systematic biases or missing flood zones

Step 3: Sensitivity Testing

• Test how sensitive territory boundaries are to model assumptions
• Evaluate different return periods (1-in-20, 1-in-100, etc.)
• Consider climate change scenarios if available

Step 4: Practical Validation

• Review proposed territories with:

 * Claims personnel familiar with flood losses
 * Underwriters with local market knowledge
 * External flood experts if needed

• Ensure territories align with known flood-prone areas

Step 5: Documentation

• Document all validation steps and findings
• Note any model limitations and how they're addressed
• Establish periodic review process as models update

⚠️ Critical Point: Using only internal data for flood is often inappropriate due to its low frequency and high severity nature

Q: How would you balance credibility and granularity when combining FSAs into territories?

Answer: Balancing Framework for FSA Combination

Step 1: Establish Credibility Standards

Define minimum credibility thresholds:

Earned exposure (e.g., minimum 500 vehicle-years) Claim count (e.g., minimum 30 claims) Premium volume (e.g., minimum $500,000 GWP)

Set different standards by coverage if appropriate

Step 2: Calculate Initial Relativities

Compute raw relativities for each FSA Identify FSAs failing credibility standards Create credibility-weighted estimates

Step 3: Apply Grouping Logic

Geographic Proximity: Start with neighboring FSAs Risk Similarity: Group FSAs with similar:

Raw relativities (within 10-15%) Demographic characteristics Loss patterns

Business Logic: Consider:

Marketing areas Distribution channels Competitive landscape

Step 4: Iterative Refinement

Test different grouping scenarios Measure:

Credibility improvement Homogeneity within territories Differentiation between territories

Use statistical tests (e.g., chi-square) to validate groupings

Step 5: Practical Constraints

Respect maximum number of territories allowed Ensure territories are explainable to stakeholders Consider implementation system limitations

💡 Best Practice: Document the trade-offs made between credibility and granularity for regulatory review

Q: What factors would trigger a review of existing territory boundaries?

Answer: Territory Review Triggers

1. Portfolio Changes

Significant geographic shift in business distribution Entry into new geographic markets Material changes in market share by region Changes exceeding 20% in any territory's exposure

2. External Environmental Changes

Major infrastructure developments:

New highways or public transit Hospital closures/openings Major employer relocations

Urban expansion into previously rural areas Natural disaster impacts (permanent changes)

3. Risk Profile Evolution

Emerging trends in loss patterns Significant changes in frequency or severity by territory New perils becoming material (e.g., cyber, autonomous vehicles)

4. Competitive/Strategic Triggers

Competitor territory restructuring New business strategy requiring different geographic focus Distribution channel changes Product redesign

5. Regulatory/Compliance Factors

New regulations on territory definitions Fairness concerns raised by regulators Changes to allowable rating factors Public policy shifts (e.g., flood insurance changes)

6. Technical/Analytical Triggers

Model updates showing current territories are suboptimal Availability of new third-party data System upgrades enabling more territories Credibility falling below thresholds

📅 Typical Review Cycle: Every 3-5 years for routine review, with ad-hoc reviews triggered by material changes

🎯 Study Tips Summary

Key Takeaways for Exam Success

Two-Phase Process: Always distinguish between boundary definition and relativity setting
Postal Code Limitations: Understand urban vs. rural challenges
Coverage Differentiation: Know why territories should vary by coverage
Model Validation: Be able to outline a complete validation process
Balancing Act: Credibility vs. granularity requires systematic approach
Review Triggers: Both internal and external factors matter

Remember that territory pricing is described as a "holistic and adaptive approach" - be prepared to discuss how technical, business, regulatory, and fairness considerations all interact in territorial ratemaking decisions.

POP QUIZ ANSWERS

Could lead to policies in certain FSAs/Postal codes being classified as onerous contracts