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.
