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Rate making (aka insurance pricing) is the determination of what rates, or premiums, to charge for insurance. A rate is the price per unit of insurance for each exposure unit, which is a unit of liability or property with similar characteristics. For instance, in property and casualty insurance the exposure unit is typically equal to $100 of property value, and liability is measured in $1,000 units.
Because an insurance company is a business, it is obvious that the rate charged must cover losses and expenses, and earn some profit. However, all states also have laws that regulate what insurance companies can charge, and thus, both business and regulatory objectives must be met.
The main business objective is to charge an adequate premium to cover losses, expenses, and allow for a profit; otherwise the insurance company would not be successful. The pure premium, which is what is determined by actuarial studies, consists of that part of the premium that is necessary to pay for losses and loss related expenses. Loading is the part of the premium necessary to cover other expenses, particularly sales expenses, and to allow for a profit. The gross rate is the pure premium and the loading per exposure unit and the gross premium is the premium charged to the insurance applicant, and is equal to the gross rate multiplied by the number of exposures units to be insured. The ratio of the loading charge over the gross rate is the expense ratio.
Gross Rate = Pure Premium + Load
Gross Premium = Gross Rate x Number of Exposure Units
Expense Ratio = Load / Gross Rate
Other business objectives are simplicity in the rate structure, so that it can be more easily understood by the customer, and sold by the agent; responsiveness to changing conditions and to actual losses and expenses; and encouraging practices among the insured that will minimize losses.
The main regulatory objective is to protect the customer. A corollary of this is that the insurer must maintain solvency in order to pay claims. Thus, the 3 main regulatory requirements regarding rates is that they be fair compared to the risk; premiums must be adequate to maintain insurer solvency; and not discriminatory—the same rates should be charged for all members of an underwriting class with a similar risk profile. Although competition would compel businesses to meet these objectives anyway, the states want to regulate the industry enough so that fewer insurers would go bankrupt than would otherwise be the case if competition was the main factor in determining the viability of a company so as to protect the many customers dependent on insurance companies.
The main problem that many insurers face in setting fair and adequate premiums is that actual losses and expenses are not known when the premium is collected, since the premium pays for insurance coverage in the immediate future. Only after the premium period has elapsed, will the insurer know what its true costs are. Larger insurance companies maintain their own databases to estimate frequency and the dollar amount of losses for each underwriting class, but smaller companies rely on rating bureaus for loss information. A rating bureau is a company that collects loss information to sell to insurance companies, and may even suggest the rates to charge. A major rating bureau in the United States is the Insurance Services Office (ISO). Although the suggestion of rates to charge is generally against antitrust laws, rating bureaus are exempt under the McCarran-Ferguson Act of 1945, which states that federal antitrust laws only apply to the extent that insurance is not regulated by state law. Nonetheless, ISO, for instance, does not suggest what rates to charge, but only sells the loss data, letting the companies determine what rates to charge.
There are 3 methods for determining rates in property and liability insurance: judgment rating, class rating, and merit rating. Merit rating can be further classified as schedule rating, experience rating, and retrospective rating.
Judgment ratings are used when the factors that determine potential losses are varied and cannot easily be quantified. Because of the complexity of these factors, there are no statistics that can be used reliably to assess the probability and quantity of future losses. Hence, an underwriter must evaluate each exposure individually, and use intuition based on past experience. This rating method is predominant in determining rates for ocean marine insurance, for instance.
Class rating is used when the factors causing losses can either be easily quantified or there are reliable statistics that can predict future losses. These rates are published in a manual, and so the class rating method is sometimes called a manual rating. Class ratings are often used in pricing insurance products sold to the consumer because there are copious statistics and a large enough population of similar situations that make class ratings effective. It also allows agents to give an insurance quote quickly.
There are 2 methods to determine a class rated premium or to adjust it.
In the pure premium method, the pure premium is 1st calculated by summing the losses and loss-adjusted expenses over a given period, and dividing that by the number of exposure units. Then the loading charge is added to the pure premium to determine the gross premium that is charged to the customer.
| Pure Premium Formula | ||
|---|---|---|
| Pure Premium | = | Actual Losses + Loss-Adjusted Expenses ──────────────────────── Number of Exposure Units |
Gross Premium = Pure Premium + Load
The loss ratio method is used more to adjust the premium based on the actual loss experience rather than setting the premium. The loss ratio is the sum of losses and loss-adjusted expenses over the premiums charged.
If the actual loss ratio differs from the expected loss ratio, then the premium is adjusted according to the following formula:
| Loss Ratio Method for Adjusting Premiums for a Class Rating | ||
|---|---|---|
| Rate Change | = | Actual Loss Ratio - Expected Loss Ratio ──────────────────────── Expected Loss Ratio |
Merit rating is based on a class rating, but the premium is adjusted according to the individual customer, depending on the actual losses of that customer. Merit rating often determines the premiums for commercial insurance, and, in most of these cases, the customer has some control over losses—hence, the name. Merit rating is usually used when a class rating can give a good approximation, but the factors are diverse enough to yield a greater spread of losses than if the composition of the class were more uniform. Thus, merit rating is used to vary the premium from what the class rating would yield based on individual factors or actual losses experienced by the customer. There are 3 methods to determine merit rating.
Schedule rating uses a class rating as an average base, then the premium is adjusted according to specific details of the loss exposure. Some factors may increase the premium and some may decrease it—the final premium is determined by adding these credits and debits to the average premium for the class.
For example, schedule rating is used to determine premiums for commercial property insurance, where such factors as the size and location of the building, the number of people in the building and how it is used, and how well is it maintained are considered.
Experience rating uses the actual loss amounts in previous policy periods, typically the prior 3 years, as compared to the class average to determine the premium for the next policy period. If losses were less than the class average, then the premium is lowered, and if losses were higher, then the premium is raised.
The adjustment to the premium is determined by the loss ratio method, but is multiplied by a credibility factor to determine the actual adjustment. The credibility factor is the reliability that the actual loss experience is predictive of future losses. In statistics, the larger the sample, the more reliable the statistics based on that sample. Hence, the credibility factor is largely determined by the size of the business—the larger the business, the greater the credibility factor, and the larger the adjustment of the premium up or down. Because the credibility factor for small businesses is small, they are not generally eligible for experience rated adjustments to their premiums.
Experience rating is typically used for general liability insurance, workers compensation and group insurance. It is also extensively used for auto insurance, including personal auto insurance, because losses obviously depend on how well and how safely the individual drives.
Retrospective rating uses the actual loss experience for the period to determine the premium for that period, limited by a minimum and a maximum amount that can be charged. Part of the premium is paid at the beginning, and the other part is paid at the end of the period, the amount of which is determined by the actual losses for that period.
Retrospective rating is often used when schedule rating cannot accurately determine the premium and where past losses are not necessarily indicative of future losses, such as for burglary insurance.
Rate making for life insurance is much simpler, since there are mortality tables that tabulate the number of deaths for each age, which includes a population of many people. Also, there are well known factors that have a significant effect on life expectancy, such as the sex of the individual, and smoking. Thus, an actuary can reasonably estimate the average age of death for a group of 25-year old males, who don’t smoke.
The simplest case is determining the net single premium, which is the premium that would need to be charged to cover the death claim, but does not cover expenses or profit. Although most people don’t pay a single premium because of the cost, all life insurance premiums are based on it. Annual level premiums can easily be calculated from the net single premium. The net single premium is simply the present value of the death benefit. The net single premium is less than the death benefit because interest can be earned on the premium until the death benefit is paid. The gross premium includes the premium to cover the death claim plus all expenses, a reserve for contingencies, and profit.
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