How Premiums Are Built and Changed

A premium is the end of a chain of decisions. Someone measures the insurer’s past losses, someone decides how much of each premium dollar can go to losses, a filing converts the result into a rate change, and the rating plan carries that change to each policy at renewal. A producer who can follow the chain can explain a renewal increase, find a legitimate discount and tell a client what a higher deductible really saves. Each link is worked below with invented figures. None of the rates, factors or credits is a filed or statutory figure.

The Two Ratios That Drive a Rate Change

A loss ratio is incurred losses divided by earned premium. Incurred losses include claims already paid plus reserves for claims still open, and they usually include the expense of adjusting those claims. A permissible loss ratio is the share of each premium dollar the insurer has priced for losses. It is what remains after the rate’s allowance for expenses and for profit and contingencies:

• Permissible loss ratio = 100% − expense provision − profit and contingency provision.

Assume the insurer’s expense provision is 31% and its profit and contingency provision is 4%. The permissible loss ratio is 100% − 31% − 4%, or 65%. If actual losses consume 65% of premium, the rate is doing what it was designed to do. If they consume more, the rate is inadequate. If they consume less, it may be excessive.

Indicating a Rate Change

The indicated change compares the loss ratio the current rates are producing with the permissible one. Because rates will apply to policies written in the future, the insurer adjusts past losses before comparing them. It trends them for inflation in repair costs, and it develops them for claims that will cost more than their current reserves. The adjustments here are shown as one combined factor.

Assume a homeowners book:

Item	Amount
Earned premium at current rates	$8,000,000
Incurred losses and adjustment expense	$5,300,000
Combined trend and development factor	1.04
Adjusted losses	$5,300,000 × 1.04 = $5,512,000
Adjusted loss ratio	$5,512,000 ÷ $8,000,000 = 68.9%
Permissible loss ratio	65%
Indicated change	68.9% ÷ 65% − 1 = +6.0%

The unadjusted loss ratio is 66.25%, and it would suggest a change of only +1.9%. The gap between the two is the reason insurers adjust. A rate that rests on last year’s costs is already out of date on the day it takes effect.

The same arithmetic can point downward. At an adjusted loss ratio of 58.5%, the indicated change would be 58.5% ÷ 65% − 1, or −10.0%.

Smaller insurers lack enough losses of their own to be statistically reliable. Michigan allows an insurer to satisfy its filing obligation by belonging to a licensed rating organization that files for it, and to file deviations from the organization’s filings (MCL 500.2108(2)). A filing must include information supporting the requirements of MCL 500.2109, which can be the insurer’s experience, an organization’s interpretation of statistics, or the experience of other insurers (MCL 500.2108(4)).

Building One Premium

Rating a homeowners policy usually starts from a base rate for the amount of insurance and then adjusts it by factors for the class of risk. Assume a base rate of $2.80 per $1,000 of Coverage A, a home insured for $300,000, and these factors:

Step	Factor	Running premium
Base: 300 units of $1,000 × $2.80		$840.00
Masonry construction	0.90	$756.00
Protection class and hydrant distance	0.95	$718.20
$1,000 deductible, against a $500 base	0.92	$660.74
Monitored alarm and smoke detectors	0.95	$627.71

The factors multiply to 0.74727, and $840.00 × 0.74727 is $627.71. The arithmetic is carried unrounded and rounded to the cent at the end, so the running figures above are shown to the cent.

Michigan restricts which factors a home classification may use. Permitted bases include the amount and types of coverage, security and safety devices, repairable structural defects, fire protection class, construction, the insured’s controllable loss experience, smoking within the structure, hydrant distance and availability of law enforcement or crime prevention services (MCL 500.2111(7)). Each factor in the table falls under one of these bases, and the deductible credit is best read as part of amount and types of coverage. An insurer may add other factors if its plan is consistent with the purposes of the Act and reflects reasonably anticipated changes in losses or expenses (MCL 500.2111(9)). Auto rating is more tightly bounded. An auto insurer must not rate on sex, marital status, home ownership, educational level, occupation, postal zone of residence or credit score (MCL 500.2111(4)), and it must apply a merit rating plan that surcharges substantially at-fault accidents and Vehicle Code violations on every coverage except comprehensive (MCL 500.2111(3)).

An Auto Premium and a Merit Surcharge

An auto premium is built the same way, from permitted factors only. Assume a base premium of $1,100 for the coverages selected, a factor of 0.95 for the driver’s years of experience, and 1.10 for the vehicle’s make and model. The premium is $1,100 × 0.95 × 1.10, or $1,149.50. Now suppose the driver was found substantially at fault in an accident, which means more than 50% responsible (MCL 500.2104(4)), and the insurer’s merit rating plan surcharges that accident by 25%. The premium becomes $1,149.50 × 1.25, which is $1,436.88, an increase of $287.38 (the $287.375 result rounded to the cent). The surcharge the statute requires is tied to substantially at-fault accidents (MCL 500.2111(3)(a)), so a driver found 50% responsible or less falls outside it.

Applying the Change at Renewal

The insurer files the indicated +6.0% as a change to its base rate. How soon the new rate can be used depends on the line:

• Home insurers may use rates as soon as they are filed (MCL 500.2106(3)).
• Auto insurers’ manuals and plans must remain on file for a 90-day waiting period before they take effect, though the Director may allow earlier use on written application (MCL 500.2108(6)).
• An insurer may not issue or renew a policy except in accordance with the filings in effect (MCL 500.2108(7)).

A policy already in force keeps the premium it was issued with for its term, and the new rates reach it at renewal. Applying the filed +6.0% to the base rate in the example:

	Before	After
Base rate per $1,000	$2.80	$2.968
Base premium (300 units)	$840.00	$890.40
Same factors (0.74727)	$627.71	$665.37
Change		+$37.66, or +6.0%

Because every factor multiplies the base, a uniform base rate increase passes through at the same percentage. Increases differ among policyholders when the filing changes factors differently, for example a larger surcharge for a class that performed badly.

At least once a year, in conjunction with a renewal notice or bill, the insurer must tell the policyholder that a description of the rating classifications and a general explanation of how rates vary among policyholders is available on request, with the rights to appeal the application of the rating plan (MCL 500.2112(1)). A producer who can recompute the premium from the rating factors is the person best placed to explain a renewal change.

Territories and Classes

Risks may be grouped by territory for both home and auto insurance in Michigan (MCL 500.2111(5), (8)). Territory relativities are set from each territory’s loss experience, but a small territory’s experience is not fully reliable. Insurers weight the indicated relativity by credibility, a number between 0 and 1 that reflects how much weight the data deserves. The new relativity is credibility times the indicated figure plus one minus credibility times the current figure.

Suppose the statewide permissible loss ratio is 65%, Territory A has a loss ratio of 52% and Territory B 78%, and credibility is 0.50 for each:

	Territory A	Territory B
Loss ratio	52%	78%
Indicated relativity	52 ÷ 65 = 0.80	78 ÷ 65 = 1.20
Credibility-weighted, from a current relativity of 1.00	0.5 × 0.80 + 0.5 × 1.00 = 0.90	0.5 × 1.20 + 0.5 × 1.00 = 1.10

If Territory A produces 60% of the premium and B produces 40%, the weighted average of the new relativities is 0.6 × 0.90 + 0.4 × 1.10, or 0.98. Dividing each by 0.98 keeps the overall premium level unchanged. Territory A becomes 0.918 and Territory B 1.122.

An insurer must still put these steps into rates that are not excessive, inadequate or unfairly discriminatory. A rate is unfairly discriminatory if the difference between rates is not reasonably justified by differences in losses, expenses or uncertainty of loss (MCL 500.2109(1)(c)). Michigan also treats refusing to insure or limiting coverage because of the location of the risk as redlining (MCL 500.2108(8)). The permitted way to price a territory is through its filed rate and not through exclusion.

Deductible and Limit Credits

A deductible lowers the premium because the insured keeps the first part of every loss. Assume the same home, with the $500 deductible rated at a factor of 1.00, $1,000 at 0.92 and $2,500 at 0.85. The premium with the other factors is $682.29 at $500, $627.71 at $1,000 and $579.95 at $2,500.

• Moving from $500 to $1,000 saves $54.58 a year and exposes the insured to $500 more on each loss. The saving covers the extra retention if the insured has a loss less often than $54.58 ÷ $500, which is 0.109 a year, or about once in 9 years.
• Moving from $1,000 to $2,500 saves $47.76 and exposes the insured to $1,500 more. The break-even is $47.76 ÷ $1,500, or 0.032 a year, about once in 31 years.

The first step buys much more saving per dollar of retention than the second. That comparison is how a producer should present deductible choices: as what the client risks in a bad year against what the client earns in all the others.

Liability limits are priced the other way. Assume Coverage E of $100,000 is included, $300,000 adds $18 a year and $500,000 adds $31. Raising the limit from $100,000 to $300,000 buys $200,000 of added protection for $18, which is $9 per $100,000. Going on to $500,000 adds another $200,000 for $13, or $6.50 per $100,000. The price per dollar of protection falls as the limit rises, because most claims are small and the added layers are less likely to be reached.

What Michigan Forbids in Ratemaking

Michigan makes it an unfair method of competition and an unfair or deceptive act for a property and casualty insurer to use price optimization in ratemaking (MCL 500.2027a(1)). Price optimization is charging based on an insured’s price tolerance, producing adjustments that are not actuarially justified and rest on factors unrelated to risk of loss or expense. The statute lists the likelihood of shopping, canceling or not renewing, estimating willingness to pay a higher premium, and measuring price elasticity of demand (MCL 500.2027a(2)(b)). Under this rule, a premium may rise because losses rose and may not rise because the insured is unlikely to shop around.

Lesson summary

• A rate change begins with a loss ratio compared with a permissible loss ratio, which is 100% less the expense and the profit and contingency provisions.
• Losses are trended and developed before comparison, because rates apply to future policies. The indicated change equals the adjusted loss ratio divided by the permissible loss ratio, minus 1.
• A premium is built from a base rate on the amount of insurance, multiplied by factors for construction, protection, deductible and protective devices. Michigan lists the bases that may be used in home classifications.
• A uniform base rate increase passes through to each policy at the same percentage when the factors multiply the base.
• Home rates may be used on filing in Michigan, auto filings wait 90 days, and the new rate reaches an in-force policy at renewal.
• Territory relativities are weighted by credibility, and Michigan treats refusing a risk because of its location as redlining.
• A higher deductible lowers the premium, and the break-even is the saving divided by the added retention. Michigan makes price optimization an unfair method of competition.