Classification RatemakingFurther Discussion

Robert L. Brown
Department of Statistics and Actuarial Science
University of Waterloo

Abstract

Classification Ratemaking is one of the most important elements in the process of

Property/Casualty rate calculation. It is here that the pricing actuary moves from a rate
change that is appropriate for an entire portfolio of policyholders, to prices that attempt to
be fair and equitable for each policyholder in the portfolio.

Classification Ratemaking is so important that is has its own complete Chapter in the
textbook Foundations of Casualty Actuarial Science (Chapter 6, authored by R.
Finger). Other sources of P&C study material also present lengthy analysis of this topic
(e.g. Introduction to Ratemaking and Loss Reserving for Property and Casualty Insurance
(2nd Edition) by Brown and Gottlieb (2001).

This paper illustrates that these two important references do not arrive at consistent
answers for a Classification Ratemaking situation where some cells have less than full
credibility. The paper then goes on to attempt to isolate the reason for the differences and
in so doing, determines that one approach appears to be correct and the other in error.
I Introduction

For more than a decade now, students of the CAS syllabus have learned Classification
Ratemaking from Chapter 6, Risk Classification (authored by R. Finger) in the textbook:
Foundations of Casualty Actuarial Science.

However, this is not the only source of study material on this topic. The Society of
Actuaries also introduces their students to some P&C topics through their Part 5
examination and they use the textbook: Introduction to Ratemaking and Loss Reserving
for Property and Casualty Insurance authored by Brown and Gottlieb.

Unfortunately, it will be shown that these two text references do not arrive at the same
answer for a Risk Classification Ratemaking question where some classes in the analysis
do not have full credibility.

By analyzing the reason for the differences in the two answers, the author concludes that
the method presented by Brown and Gottlieb appears to be correct, while the answer as
presented by Finger is in error.

II The Problem by Illustration

In the text: Introduction to Ratemaking and Loss Reserving for Property and Casualty
Insurance (2nd Edition) by Brown and Gottlieb, the authors present an algebraic proof that
the two classical ways to calculate Class differentials; namely, the Loss Ratio Method
and the Loss Cost Method are equivalent. This example, however, only covers the case
where all risk classes being analyzed have credibility equal to one (see Brown and
Gottlieb (2001), Appendix A, pages 173-175).

It is also the case that for a portfolio of risks where credibility is one for every class, that
the class relativities produced by Finger are equal to the relativities produced by Brown
and Gottlieb.

This will now be illustrated with a simple example.

Example, Part I

The pricing actuary has decided upon a statewide adopted rate level increase of +6%.
Given the following data, show the new adopted rates for Classes 1, 2, and 3.

The existing base rate is $100 in Class 1.

All Classes have full credibility (Z = 1).

You also have the following data by class:

 Class Existing Exposure Earned $Loss Loss Loss
Relativity Units Premium Cost Ratio

1 1.00 500 $50,000 $30,000 $60 0.6000

2 1.25 160 20,000 10,560 66 0.5280
3 1.50 200 30,000 16,200 81 0.5400
860 100,000 56,760 66 0.5676

Method I

We will use the Loss Cost Method using Class 1 as the Base Rate for the calculation.
Remember that Z = 1 throughout.

Class Existing Relativity Loss Cost Indicated Relativity

1 1.00 60 1.000
2 1.25 66 1.100
3 1.50 81 1.350

Since Z = 1 in all cells, the Existing Relativity does not have any impact on the answer
and could be ignored (as it is in some examples below).

We have set the Class Relativity for Class 1 equal to 1.000. This means that our overall
rate change may not balance to +6%. So, we need to balance back, as follows:

Old Average Relativity = [500(1.00) + 160(1.25) + 200(1.50)]/860 = 1.1627907

New Average Relativity = [500(1.00) + 160(1.10) + 200(1.35)]/860 = 1.1000

Balance-back Factor = 1.1627907/1.1000 = 1.0570825, giving us:

Class New Rate Exposure Units Premium Income

1 $112.05 500 $56,025

2 123.26 160 19,721
3 151.27 200 30,254
106,000

So, everything is as it should be.

Method II

We will use the Loss Cost Method but the Base Class will be the State (Loss Cost).

Class Loss Cost Indicated Relativity Relativity with Class 1 = 1.000

1 60 0.90909 1.000
2 66 1.00000 1.100
3 81 1.22727 1.350
State 66

So, this gives us the same relativities as does Method I and there is no reason to go
further (i.e. there is no reason to do the balance back calculation).

Method III

This method follows the Loss Ratio approach with the base class being Class 1.

Class Loss Ratio Existing Relativity Indicated Change Indicated Relativity

[LRi/LR1]

1 0.6000 1.00 1.000 1.000

2 0.5280 1.25 0.880 1.100
3 0.5400 1.50 0.900 1.350

Again, the same answer. Thus, it has been shown that under the set conditions, the Loss
Ratio method and the Loss Cost method do provide the same answer (as proven
algebraically by Brown and Gottlieb).

Method IV

We will follow the Loss Ratio approach again, but now the base class will be the State
(Loss Ratio).

Class Loss Ratio Existing Indicated Change Indicated Indicated Rel

Relativity [LRi/LRS] Relativity with Class 1 = 1.000

1 0.6000 1.00 1.0570825 1.0570825 1.000

2 0.5280 1.25 0.9302325 1.1627906 1.100
3 0.5400 1.50 0.9513742 1.4270613 1.350
State 0.5676

Again, the same answer.

Method V

Finally, we follow the template presented in Chapter 5 of the Foundations textbook

(Finger). Remember that the overall rate change is +6%.

Class Existing Adjusted Adjusted Indicated Extension Adopted

Relativity Exposures Loss Costs Adjustment Relativity*
(1) (2) (3) (4) (5) (6) (7)
[(2)*Given Exp] [$Loss/(3)] [(4)/(4) Total] [(5)*Old Rate *1.06]

1 1.00 500 60.00 1.0570825 112.05 1.000

2 1.25 200 52.80 0.9302325 123.26 1.100
3 1.50 300 54.00 0.9513742 151.27 1.350
1000 56.76

* This is not produced by Finger, but is clearly consistent.

Obviously, we got identical answers for the Adopted Relativities and the New Rates from
all the approaches attempted. This should be gratifying and should create a level of
comfort among users.

Example, Part II

We now stir the pot somewhat by stipulating credibility factors for the different classes
where only Class 1 has full credibility.

We will use the following data in this illustration:

Class Existing Exposure Earned $Loss Loss Loss Credibility

Relativity Units Premium Cost Ratio Z

1 1.00 500 $50,000 $30,000 60 0.6000 1.000

2 1.25 160 20,000 10,560 66 0.5280 0.500
3 1.50 200 30,000 16,200 81 0.5400 0.600
State 860 100,000 56,760 66 0.5676 1.000

Again, we will find the new Class 1, 2, and 3 (base) rates with an overall +6% rate
increase.
Method I*

Remember that this is the Loss Cost method with the Base Class being Class 1.

Class Existing Relativity Loss Cost Indicated Relativity Z Adopted Relativity

(1) (2) (3) (4) (5) [Z(4) + (1-Z)(2)]

1 1.00 60 1.000 1.000 1.000

2 1.25 66 1.100 0.500 1.175
3 1.50 81 1.350 0.600 1.410

Now, again we have created off-balance, so we balance back:

Old Average Relativity = [500(1.00) + 160(1.25) + 200(1.50)]/860 = 1.1627907

New Average Relativity = [500(1.00) + 160(1.175) + 200(1.410)] = 1.27907

Balance Back Factor = 1.1627907/1.127907 = 1.0309278

This produces the following new base rates:

Class New Rate Exposure Units Premium Income

1 $109.28 500 $54,639.18

2 128.40 160 20,544.33
3 154.08 200 30,816.49
106,000.00

We will now repeat the original five methods of calculation to see if they again produce
identical answers.

Method II*

This is the Loss Cost method, but with the base being the State (Loss Cost).

Class Existing Loss Indicated Ind. Rel. Z Adopted

Relativity Cost Relativity Class 1 = 1.00 Relativity
(1) (2) (3) (4) (5) (6)
[(3)/(3)Total] [(4)/(4)1] [Z*(5) + (1-
Z)*(2)]

1 1.00 60 0.90909 1.000 1.000 1.000

2 1.25 66 1.00000 1.100 0.500 1.175
3 1.50 81 1.22727 1.350 0.600 1.410
66
This is the same answer as Method I*.
However, it is possible for a poorly trained analyst to get an incorrect answer by changing
the order of the arithmetic operations.

For example, one might do the following erroneous calculation:

Class Existing Loss Indicated Z Adopted Rate Manual

Relativity Cost Relativity Relativity Relativity
(1) (2) (3) (4) (6) (7) (8)
[(3)/(3)Total] [Z*(4) + (1-Z)*(2)] (Class 1 =
1.00)

1 1.00 60 0.90909 1.000 0.90909 1.0000

2 1.25 66 1.00000 0.500 1.125 1.2375
3 1.50 81 1.22727 0.600 1.33636 1.4700
66

This answer is different than those found in the previous two calculations, and it is
wrong.
It is wrong, because in the formula for the Adopted Relativity [Z*(4) + (1-Z)*(2)], you do
not have the relativities on the same basis. Column (2) has the relativities normalized
such that the relativity for Class 1 equals 1.000, but in Column (4) the data have not been
normalized. Thus, in the formula for the Adopted Relativity, we are taking the
weighted average of apples from Column (2) and oranges from Column (4).
Obviously, this leads to an incorrect result.

Another way to picture the problem is to return to Vector Analysis. Remember problems
where a sailboat has a wind from the west at x mph and a current from the south at y
mph, and you are asked to find the resultant velocity and direction of the boat. The
analysis above would be like combining the wind which is defined in one Cartesian co-
ordinate system with a current defined by a completely different Cartesian co-ordinate
system. Obviously, you can not take the weighted average of these two vectors and draw
any results. It is just wrong.

Lets continue, because we do have a point to prove.

Method III*

This is the classical Loss Ratio method with Class 1 being the base.

Class Loss Existing Indicated Change Indicated Z Adopted

Ratio Relativity [LRi/LR1] Relativity Relativity
(1) (2) (3) (4) (5) (6) (7)
[Z*(5) + (1-Z)*(3)]
1 0.6000 1.00 1.000 1.000 1.000 1.000
2 0.5280 1.25 0.880 1.100 0.500 1.175
 3 0.5400 1.50 0.900 1.350 0.600 1.410

This agrees nicely with all of our previous work.

Method IV*

Again, this is the Loss Ratio Method with the base class being the State (Loss Ratio).

Class Loss Existing Indicated Change Indicated Indicated Rel. Z Adopted++

Ratio Relativity [LRi/LRS] Relativity Class 1 = 1.00 (7) Relativity
(1) (2) (3) (4) (5)[(4) * (3)] (6)

1 0.6000 1.00 1.0570825 1.0570825 1.000 1.000 1.000

2 0.5280 1.25 0.9302326 1.1627907 1.100 0.500 1.175
3 0.5400 1.50 0.9513742 1.4270613 1.350 0.600 1.410
State 0.5676

++ [Z*(6) + (1-Z)*(3)]

Obviously, this is an acceptable answer. But, again, the order of calculation, and the use
of factors that are normalized to the same base, is of the essence. For example, we
could erroneously do the following:

Class Loss Existing Indicated Change Indicated Z Adopted Rate Manual

Ratio Relativity [LRi/LRS] Relativity Relativity Relativity
(1) (2) (3) (4) (5)[(4) * (3)] (6) [Z(5)+(1-Z)*(3)] (Class 1 =
1.000)

1 0.6000 1.00 1.0570825 1.0570825 1.000 1.0570825 1.000

2 0.5280 1.25 0.9302326 1.1627907 0.500 1.2063953 1.141
3 0.5400 1.50 0.9513742 1.4270613 0.600 1.4562638 1.378
State 0.5676

This is an incorrect answer because in our Adopted Relativity calculation, Column (3)
has been normalized so that Class 1 has a relativity equal to 1.00, but Column (5) has
not. Thus, we are attempting to do a weighted average of apples and oranges.

Method V

This uses the template found in Chapter 5 of the Foundations text as authored by
Finger (2001).

Class Existing Exposure Adjusted Adjusted Indicated Z

Relativities Units Exposures Loss Costs Adjustment
(1) (2) (3) (4) (5) (6) (7)
[(3)*(2)] [$Loss/(4)] [(5)/(5) Total]
1 1.00 500 500 60.00 1.0570825 1.000
 2 1.25 160 200 52.80 0.9302326 0.500
3 1.50 200 300 54.00 0.9513742 0.600
860 1000 56.76
Continuing with the template:

Class Credibility Weighted Extension Balanced New Extension

Adjustment Adjustment Rates
(8) (9) (10) (11) (12)
[Z*(6) + (1-Z)] [(8) * (4)] [(8)/(8) Total] [(10)*Old*1.06] [(11)*(3)]

1 1.0570825 528.54 1.0437107 110.63 55,316.66

2 0.9651163 193.02 0.9529077 126.26 20,201.64
3 0.9708245 291.25 0.9585438 152.41 30,481.69
1.0128118 1012.81 106,000.00

This all seems to check out just fine. The final answer is a +6% rate increase as
requested. However, the New Rates are different than what we got in the other four
Methods. Why?

One can see why when one determines the new Class Relativities created by Finger (but
never actually displayed). They are as follows:

Class Relativity with

Class 1 = 1.00

1 1.000
2 1.141
3 1.378

What we have found is that the result of the Finger template is equivalent to the
incorrect Loss Ratio methodincorrect because it does a credibility weighting of
apples and oranges.

The fact that the Finger approach resembles a Loss Ratio methodology rather than a
Loss Cost methodology should not be a surprise. Fingers Adjusted Exposures
effectively mean that the resultant Adjusted Loss Costs work exactly like Loss Ratios.

But how is it that Fingers template gives us incorrect indications for the Class
Relativities? It is for the same reason as stated twice above.

In Fingers template, Column (8) equals [Z*(6) + (1-Z)]. Then Column (8) is multiplied
by Column (4) to give us Column (9). But Column (6) has not been normalized so that
Class 1 equals 1.00, whereas Column (4) effectively comes from (2) where Class 1 does
equal 1.00. So just as in our manufactured erroneous example, Fingers template mixes
apples and oranges in the credibility weighted average. Once this is understood, it is
clear that this will give us an incorrect answer.
It is this authors opinion that while this is very subtle (and does not create huge errors) it
is critically important.

III Conclusion

As stated in the Introduction, classification ratemaking is one of the most important steps
in arriving at a new rate manual.

This topic has been presented in a variety of forms, templates and methodologies over the
years. Unfortunately, the method now being used in the basic education for CAS
students has been found to be erroneous.

Clearly, this matter can be quickly corrected. However, it is the position of this author,
that leaving the old template as part of the educational material, and explaining clearly its
deficiencies, might lead to a superior ultimate education.

Bibliography

Brown, R. L. and L. R. Gottlieb (2001) Introduction to Ratemaking and Loss Reserving

for Property and Casualty Insurance. (2nd Edition). ACTEX Publications Inc., Winsted,
CT.

Finger, R.J., "Risk Classification," Foundations of Casualty Actuarial Science (Fourth

Edition), Casualty Actuarial Society, 2001, Chapter 6, pp. 287-342.