Study 7 – Pricing the Risk
1. Explain the concept of an insurer’s “bucket of premium”? (p. 2)
The money in the insurer’s bucket is the sum of the pure premium and expenses, including development factors, trend factors, acquisition costs, administrative expenses and profit. The bucket must hold enough for losses and other needs.
2. What is the difference between development factors and trend factors? (p. 3)
Development factors: are adjustments to current reserves for claims that have yet to be settled to reflect the
estimated final cost of those claims.
Trend factors: are adjustments applied to all loses to reflect what they would probably cost if they were to occur
next year rather than having occurred at some time in the past.
3. What are acquisition costs? What might these costs include? (p. 3)
Acquisition costs are the costs incurred by the insurer to conclude a contract of insurance with a policyholder. The costs typically include the commission that the insurer pays to the broker/agent that mediated the transaction between insurer and policyholder. They may also include advertising or promotional expenses and inspection or appraisal fees that arise strictly out of the process of “putting the premium on the books.”
4. What is underwriting profit? (p. 5)
Underwriting profit arises out of insurance operations. It is the amount by which earned premiums exceed the cost of incurred claims and expenses.
5. What is investment income? (p. 5)
Investment income is the income the insurer earns from investing money that the insurer has received as premium but not yet earned, as well as money it has set aside as a reserve to pay claims.
6. What is the difference between the rate and the premium for an insurance policy? (p. 6)
Rate: is the price of a unit of insurance for the policy period.
Premium: is the total cost of the insurance derived by multiplying the rate by the amount of insurance.
7. What are the major components of a rate? (p. 7)
1. The anticipated cost of settling claims;
2. The acquisition costs of the business, such as commissions; and
3. The cost of administering the process, including taxes levied on the premiums.
8. What are the two conditions for rate adequacy? (p. 7)
The rate will be adequate when the rate charged for a particular class of risk should be sufficient to cover the anticipated losses and expenses associated with that risk. The two conditions are:
1. The actuarial forecast of future losses based on past losses must be accurate for the population.
2. The sample represented by the book of business written by a particular underwriter or insurer must be representative of the population.
9. Why is the size of a rating class important? What other important characteristics should a rating class have? (p. 9)
A rating class should be large enough to allow a reasonable amount of data to be collected for it. If it is too small, then the law of large numbers will not apply to the data collected for it and the rates developed from the data will lack statistical credibility.
10. What is the exposure base of a risk? Ideally, what should it reflect? (p. 10)
The exposure base is a denomination in which the unit of exposure is expressed. An example of an exposure base is gross sales, which is used for some classes of liability insurance.
The right exposure base of a given risk depends on the nature of the risk and the kinds of loss it might incur. Ideally, the exposure base will reflect the frequency and severity of loss the risk experiences.
11. How do most insurers gather statistics about loss experience? (p. 10-11)
IBC’s Insurance Information Division collects, confirms, and analyzes insurance-related data and publishes a wide range of statistical exhibits. IBC analyzes insurance loss costs for individual models of cars, develops advisory auto insurance ratings, and provides a forum for manufacturers, consumers, and insurers to discuss automobile insurance issues.
12. Explain the law of large numbers and the theory of probability? (p. 11)
The law of large numbers is the principle that a given probability becomes more reliable the larger the number of trials or cases in the sample.
The theory of probability concerns the likelihood of an occurrence, express by the ratio of the number of actual occurrences to the number of possible occurrences.
13. How is the premium rate or unit cost of insurance calculated? (p. 13)
The premium rate or unit cost of insurance is calculated by dividing the total premium by the exposure unit.
Example. The exposure unit for property insurance is usually $100 of property. Thus, if the amount of insurance premium is $3,000 to cover total property values of $2,000,000, then the premium rate is:
($3,000 premium / $2,000,000 of property) = $0.15 premium per $100 of property.
14. Describe the general process for all ratemaking? (p. 14)
1. Classifying risk;
2. Determining rating classes;
3. Selecting proper measures of exposure;
4. Gathering statistics;
5. Predicting future losses;
6. Calculating pure premium, total premium and the premium rate.
15. What does a manual rate represent? Explain. (p. 16)
The manual rate developed by actuaries for a particular class represents the price that is deemed to be appropriate for the “average” risk in that class. Thus, the manual rate reflects the “average” risk.
16. What is class rating? When is it used? (p. 17)
For larger numbers of broadly similar risks, it is typically fastest and most efficient if underwriters do not deviate a great deal from established or manual rates. This approach may be characterized as class rating.
Class rating is used when statistics can be gathered on a large number of risks that share common characteristics. The same is true for homeowners and small business insurance.
17. What is schedule rating? When is it used? (p. 18)
Some classes of business are individually rated because of their complexity and the need for underwriting judgment. This approach may be characterized as schedule rating.
It is used when the body of statistical data is too fragmented to permit class rating. One of the best examples of such fragmented statistical data may be found in commercial property insurance, where the number of risk characteristics is so large that the “cells” in the statistical plan do not contain enough data to provide a credible basis for estimating future claims costs as there are just too many possible variations of perils and hazards.
In schedule rating, rates are based on a schedule or manual that lists a multitude of characteristics identified by underwriters over a period of many decades as important factors in measuring the degree of risk.
18. Explain the process of fixing and modifying the base rate of insurance? (p. 16)
The process of schedule rating involves the fixing of a base rate or key rate. The base rate is used as the initial charge to apply to the particular community which the object of the insurance is located and takes into consideration the degree of public fire protection. Once these rates are determined, debits and credits are applied based on factors that make the risk either better or worst than the average risk of its type.
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