Page 46 - Insurance Times December 2020

a given rate per unit of risk exposed. Insurance premium
can vary significantly for risks with different characteristics.
The rating manual is the document that contains the
information necessary to appropriately classify each risk and
calculate the premium associated with that risk. The final
output of the ratemaking process is the information
necessary to modify existing rating manuals or create new
ones.

The earliest rating manuals were very basic in nature and
provided general guidelines to the person responsible for
determining the premium to be charged. Over time, rating
manuals have increased in complexity. For some lines, the
manuals are now extremely complex and contain very Ratemaking is the current prospective:
detailed information necessary to calculate premium. As stated earlier, insurance is a promise to provide
Furthermore, many companies are creating manuals compensation in the event a specific loss event occurs during
electronically in lieu of paper copies. Before, understanding a defined time period in the future. Therefore, unlike most
the complex process of insurance pricing and ratemaking, non-insurance products, the costs associated with an
it is important to be familiar with some basic insurance insurance product are not known at the point of sale and as
terminology used in the pricing process for better a result need to be estimated. The ratemaking process
understanding. involves estimating the various components of the
fundamental insurance equation to determine whether or
The basic economic relationship for the price of any product not the estimated premium is likely to achieve the target
was given as follows: profit during the period the rates will be in effect.
Price = Cost + Profit.
It is common ratemaking practice to use relevant historical
This general economic formula can be tailored to the experience to estimate the future expected costs that will
insurance industry using the basic insurance terminology be used in the fundamental insurance equation; this does
outlined in the preceding section. Premium is the "price" of not mean actuaries are setting premium to recoup past
an insurance product. The "cost" of an insurance product is losses. As per the principle in the CAS Statement of Principles
the sum of the losses, claim-related expenses, and other Regarding Property and Casualty Insurance Ratemaking"
expenses incurred in the acquisition and servicing of policies. states that "A rate is an estimate of the expected value of
Underwriting profit is the difference between income and future costs". Historic costs are only used to the extent that
outgo from underwriting policies, and this is analogous to they provide valuable information for estimating future
the "profit" earned in most other industries. Insurance expected costs.
companies also derive profit from investment income,
although at this juncture this aspect of profit for the insurers When using historic loss experience, it is important to
is relatively drab. recognize that adjustments will be necessary to convert this
experience into that which will be expected in the future
The goal of ratemaking is to assure that the fundamental when the rates will be in effect. For example, if there are
insurance equation is appropriately balanced. In other inflationary pressures that impact losses, the future losses
words, the rates should be set so that the premium is will be higher than the losses incurred during the historical
expected to cover all costs and achieve the target period. Failure to recognize the increase in losses can lead
underwriting profit. Thus, a rate provides for all costs to an understatement of the premium needed to achieve
associated with the transfer of risk. There are two key points the target profit.
to consider in regards to achieving the appropriate balance
in the fundamental equation: There are many factors that can impact the different
1. Ratemaking is the current prospective. components of the fundamental insurance equation and that

2. Balance should be attained at the aggregate and should be considered when using historical experience to
individual levels. assess the adequacy of the current rates.

The Insurance Times, December 2020