Page 47 - Insurance Times December 2020

The following are some items that may necessitate a For example, in workers compensation insurance an
restatement of the historical experience: employee working in a high-risk environment (e.g., a steel
1. Rate changes worker on high-rise buildings) is expected to have a higher
2. Operational changes propensity for insurance losses than one in a low-risk
environment (e.g., a clerical office employee). Typically,
3. Inflationary pressures insurance companies recognize this difference in risk and
4. Changes in the mix of business written vary premium accordingly. Failure to recognize differences
5. Law changes in risk will lead to rates that are not equitable.

The key to using historical information as a starting point Rate making is the determination of what rates, or
for estimating future costs is to make adjustments as premiums, to charge for insurance. A rate is the price per
necessary to project the various components to the level unit of insurance for each exposure unit, which is a unit of
expected during the period the rates will be in effect. There liability or property with similar characteristics. For instance,
should be a reasonable expectation that the premium will in property and casualty insurance, the exposure unit is
cover the expected losses and expenses and provide the typically equal to Rs. 100 of property value, and liability is
targeted profit for the entity assuming the risk. measured in Rs. 1,000 units. Life insurance also has Rs. 1000
exposure units. The insurance premium is the rate multiplied
When considering the adequacy or redundancy of rates, it by the number of units of protection purchased.
is important to ensure that the fundamental insurance
equation is in balance at both an overall level as well as at Insurance Premium = Rate X Number of Exposure Units
an individual or segment level. Equilibrium at the aggregate Purchased.
level ensures that the total premium for all policies written
is sufficient to cover the total expected losses and expenses The difference between the selling price for insurance and
and to provide for the targeted profit. If the proposed rates the selling price for other products is that the actual cost of
are either too high or too low to achieve the targeted profit, providing the insurance is unknown until the policy period
the company can consider decreasing or increasing rates has lapsed. Therefore, insurance rates must be based on
uniformly. predictions rather than actual costs. Most rates are
determined by statistical analysis of past losses based on
In addition to achieving the desired equilibrium at the specific variables of the insured. Variables that yield the best
aggregate level, it is important to consider the equation at forecasts are the criteria by which premiums are set.
the individual risk or segment level. Principle 3 of the CAS
"Statement of Principles Regarding Property and Casualty However, in some cases, historical analysis does not provide
Insurance Ratemaking" states "A rate provides for the costs sufficient statistical justification for selling a rate, such as
associated with an individual risk transfer" (CAS Committee for earthquake insurance. In these cases, catastrophe
on Ratemaking Principles, p. 6). A policy that presents modeling is sometimes used, but with less success. Actuaries
significantly higher risk of loss should have a higher premium set the insurance rate based on specific variables, while
than a policy that represents a significantly lower risk of loss. underwriters decide which variables apply to a specific
insurance applicant.

Because an insurance company is a business, it is obvious
that the rate charged must cover losses and expenses, and
earn some profit. But to be competitive, insurance
companies must also offer the lowest premium for a given
coverage. Moreover, all states have laws that regulate
what insurance companies can charge, and thus, both
business and regulatory objectives must be met.

The primary purpose of ratemaking is to determine the lowest
premium that meets all of the required objectives. A major part
of ratemaking is identifying every characteristic that can
reliably predict future losses, so that lower premiums can be
The Insurance Times, December 2020