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Insurance Pricing

Intro. to Risk
Management
& Insurance
Samuel
Njoroge

Revised: 12/22/09

Topic Objectives
Insurance pricing
objectives
Property-liability pricing
methods
Life insurance pricing
concepts
Reserves for future
claims/benefits

Insurance Pricing Objectives


Regulatory

Business

Adequate
Not Excessive
Not Unfairly
Discriminatory
Reasonable Relative
to Coverage (Life)

Simplicity
Stability
Responsiveness
Encourage Loss
Control

Pricing Components
Rate: price per unit of insurance
Exposure: unit on which rate is based
Pure Premium: expected loss cost and
loss adjustment expense
Loading: amount added for other
expenses, profit, contingencies
Gross Rate: pure premium + loading
Gross Premium: gross rate x exposure
units

Example 1: Auto Insurance


Exposure: one car-year
Pure Premium: $300
Loading: 40%

Gross Rate = $300 + .4 x $300 =


$420
Gross Premium = $420 x 1 = $420

Example 2: Workers Comp


Exposure Unit: $100 payroll
Total Payroll: $1 million
No. Exposure Units: $1m $100
= 10,000
Pure Premium: $2.00
Loading: 30%
Gross Rate = $2.00 + .3 x $2.00 =
$2.60
Gross Premium = 10,000 x $2.60
= $26,000

Property-Liability Rating
Judgment Rating
Each risk individually evaluated based on
underwriters judgment.

Class Rating
Risks placed in similar class and each
receives the same rate.

Class Rating Adjustments


Retrospective Rating
Insureds loss experience during policy period
affects premium paid for the period.

Class Rating
Best suited for types of insurance where
exposures can be readily distinguished by
certain characteristics.
Examples include auto insurance, home
insurance, and workers compensation.
In auto insurance, factors include location,
type of use, miles driven, years of driving
experience, etc.
Issues can arise as to the factors used,
e.g., credit scores.

Issues in Class Rating


Insurers choose rating factors based on:

Historical association with claims experience


Verifiability
Cost of accessing information on factor
Simplicity
Regulatory and social acceptance

Issues
Should there be causal relationship between factor and
claim frequency (and severity)?
Should some factors be prohibited because they are
considered unfair or socially unacceptable?

Class Rating Adjustments


Schedule Rating
Basic rate modified by credits and debits
for physical features.
Schedule credits sometimes used for
competitive purposes.

Experience Rating
Class rate modified based on past loss
experience.
Typically found in commercial insurance.
Not suited for small insureds.

Experience Rating Explained


Class rates reflect the average claims experience
of every one in the class.
However, the risk of loss is likely to differ among
different people within the class.
Experience rating is one method to adjust the
class rate for these differences.
Class rate is modified according to past claims
experience.
Higher than average experience results in
modification >1.0.
Lower than average experience results in
modification <1.0.

From Cost to Premium


Territory
Midtown

Historical Loss Data


Sex of Driver(s)
Males
Females
Losses Car-Years Losses Car-Years

Losses
Totals

Car-Years
Totals

$3,600,000

3,000 $2,000,000

2,000 $5,600,000

5,000

Dunwoody $1,500,000

2,000 $1,000,000

2,500 $2,500,000

4,500

Totals

5,000 $3,000,000

4,500 $8,100,000

9,500

$5,100,000

Expected Loss Cost = Historical Losses Exposure Units


Expected Loss Costs per Car
Sex of Driver(s)
Territory
Male
Females
Midtown
Dunwoody

$1,200.00 $1,000.00
$750.00

$400.00

Premium for 2 Dunwoody


Females
ELC: $400
Loading: 40%
Gross Rate: $400 x 1.4 = $560
Premium: $560 x 2 = $1,120

Life Insurance: Level Pricing


Premiums collected during early portion of
policy period will exceed benefit payments
and vice versa.
Under level premium approach, insurer
determines the monthly premium necessary
to pay benefits and expenses throughout the
policy.
$

Increasing Benefit Payments

P> B
Build Reserve
P< B
Draw Reserve

Constant Premiums
Time

Property-Liability Reserves
Purpose of Reserves
Recognition of financial liability or
obligation to insureds.

Unearned Premium Reserve


Provision for premiums not yet earned to
pay losses, policy refunds, reinsurance.

Loss Reserves
Provision for estimated unpaid claims.

Loss Reserve Components


Claims reported and adjusted but
not yet paid (Case reserves)
Claims reported and filed but not
yet adjusted
Claims incurred but not yet
reported (IBNR)

Reserves and Pricing


Insurers base future prices on historical
loss experience.
Reserves are part of estimates of
historical losses.
If reserves are inaccurate, then future
prices more likely to be wrong.
Underestimated reserves can lead to
inadequate prices.
Overestimated reserves can lead to
excessive prices.

Life Insurance Policy Reserve


Difference between
present value of
future benefits and
present value of
future net
premiums.
The policy reserve
increases over the
life of the policy.

PVFB

Reserve
PVFP
Life of policy