Rate Development and Underwriting Results
Underwriting decides which risks an insurer accepts and how each one is classified. Rate development decides what each accepted risk is charged. The two are judged together: an insurer learns whether it selected and priced its risks well by comparing the premium it collected with the losses and expenses it paid. This chapter explains how an insurer measures those results, how a rate is built, and how the physical features of a property find their way into its rate.
Underwriting results
An insurer measures its underwriting results with three ratios. Each one compares money going out with premium coming in, and each is stated as a percentage.
Three terms come first. Written premium is the total premium on the policies an insurer issues during a period. Earned premium is the part of the premium for which coverage has already been provided. Incurred losses are the losses sustained during a period, whether or not they have been paid yet, so they include claims the insurer has reserved for but not finished paying.
- The loss ratio is incurred losses divided by earned premium. It shows how much of each premium dollar goes to pay claims. The cost of adjusting claims, called loss adjustment expense, is commonly counted with the losses.
- The expense ratio is the insurer’s underwriting expenses divided by premium, most often written premium. Underwriting expenses are the costs of acquiring, writing and servicing policies: commissions, other acquisition costs, general administrative expenses, and taxes (other than federal income tax), licenses and fees.
- The combined ratio is the loss ratio plus the expense ratio. It is a primary measure of whether a book of business was profitable to underwrite.
An underwriting profit is what is left of the premium after losses, loss adjustment expenses and underwriting expenses are paid. It does not count the income the insurer earns by investing premium. A combined ratio below 100% means an underwriting profit. A combined ratio above 100% means an underwriting loss: the insurer’s losses and expenses were more than the premium it earned.
Here is an example with invented figures. An insurer earns $10,000,000 of premium in a year on its property business. (To keep the arithmetic simple, assume its written premium is the same amount.)
| Year 1 (example) | Year 2 (example) | |
|---|---|---|
| Earned premium | $10,000,000 | $10,000,000 |
| Incurred losses and loss adjustment expenses | $6,500,000 | $7,500,000 |
| Underwriting expenses | $3,000,000 | $3,000,000 |
| Loss ratio | 65% | 75% |
| Expense ratio | 30% | 30% |
| Combined ratio | 95% | 105% |
| Underwriting result | $500,000 profit | $500,000 loss |
In Year 1 the insurer keeps 5 cents of every premium dollar as underwriting profit. In Year 2, a worse loss year, its losses and expenses come to 5 cents more than each premium dollar it earned. An insurer with an underwriting loss can still earn an overall profit if its investment income is large enough, but investment income is not part of the underwriting result.
Underwriters use these results. The loss ratio is tracked for the whole company and for each segment of its business, such as a class of business or a territory. A segment whose loss ratio stays high tells the insurer that its rates are too low, that its underwriting standards are too loose, or both. The insurer can respond by tightening its underwriting, by raising its rates, or by doing both.
Rate development
A rate is the price of insurance for one unit of exposure. A premium is the total amount an insured pays for a policy. Developing a rate is a matter of estimating the future, because the insurer must set its price before it knows what its losses will be. A rate is therefore an estimate of the expected cost of the coverage, and a sound rate is adequate to pay those costs without being excessive or unfairly discriminatory.
Types
Rating methods fall into the types below. They differ in how much the rate depends on the group a risk belongs to and how much it depends on the individual risk.
Judgment rating. Under judgment rating, the rate is set by the judgment of an underwriter. It is used where there are not enough similar exposures to produce reliable statistics, so each risk is evaluated on its own.
Class (manual) rating. Under class rating, risks with similar characteristics are placed in the same class and every risk in the class is charged the same rate. The rate reflects the average loss experience of the class. Class rates are published in a rating manual, which is why class rating is also called manual rating. In commercial property insurance, a building whose occupancy falls into one of the rating classes, and which meets the eligibility rules, is class rated. A building that does not qualify, generally because it is large, specially protected or put to a high-risk or unusual use, is specifically rated: its rate applies to that one property and is set after a physical inspection.
Merit rating. Under merit rating, as individual risk rating is commonly called, the insurer starts with the class rate and modifies it up or down for the individual risk. Merit rating recognizes that risks in the same class are not identical. Its main forms are:
| Form of merit rating | What the modification is based on | When the modification is set |
|---|---|---|
| Schedule rating | Characteristics of the risk that are expected to affect its losses. The underwriter applies credits for features that reduce the chance of loss and debits for features that increase it. | Before the policy period |
| Experience rating | The insured’s own loss experience in past periods, compared with the loss experience expected for its class. Better experience than expected lowers the premium and worse experience raises it. | Before the policy period |
| Retrospective rating | The insured’s actual losses during the policy period itself. The final premium is adjusted after the period ends, within a minimum and a maximum. | After the policy period |
Schedule rating is the only one of these that does not use the insured’s claim history. Experience rating and retrospective rating are used mainly for larger commercial insureds, whose own losses are numerous enough to be a reliable guide.
Loss costs and final rates. An insurer does not have to develop every rate from its own data alone. Advisory organizations collect loss statistics from many insurers and publish loss costs. A loss cost is the amount needed to pay expected losses and loss adjustment expenses for one unit of exposure. It includes nothing for the insurer’s other expenses or profit. Each insurer turns a loss cost into its own final rate by adding its expense and profit loadings, usually by multiplying the loss cost by a loss cost multiplier.
For example, with invented figures, if the published loss cost for a class of building is $0.50 per $100 of insurance and an insurer’s loss cost multiplier is 1.60, that insurer’s final rate is $0.80 per $100 of insurance ($0.50 × 1.60).
Components
A rate is made up of the following components.
- The pure premium, or loss cost. This is the part of the rate needed to pay expected losses, and usually the expense of adjusting them. It is the average loss per unit of exposure.
- The expense loading. This is the part of the rate that pays the insurer’s cost of doing business: commissions to producers, other costs of acquiring business, general administrative expenses, and taxes (other than federal income tax), licenses and fees.
- The allowance for profit and contingencies. This is the part of the rate that provides the insurer’s underwriting profit and a margin in case losses turn out worse than expected.
The pure premium plus the two loadings equals the rate. To continue the example above, with its invented figures, the insurer’s rate of $0.80 per $100 of insurance is made up as follows:
| Component (example) | Amount per $100 of insurance | Share of the rate |
|---|---|---|
| Pure premium (loss cost) | $0.50 | 62.5% |
| Expense loading | $0.26 | 32.5% |
| Profit and contingencies | $0.04 | 5% |
| Rate | $0.80 | 100% |
The components of a rate line up with the ratios used to measure underwriting results. If losses come in at the 62.5% the rate provided for and expenses at 32.5%, the combined ratio is 95% and the insurer earns the 5% it planned. If losses are heavier than the pure premium assumed, the combined ratio rises and the profit allowance is the first thing to disappear.
Basis
A rate is always stated for a basis, also called the premium basis or exposure base: the measure of exposure to which the rate is applied, such as the amount of insurance or the payroll. One unit of that measure is an exposure unit, the basic unit of risk that underlies the premium. In rating, an exposure unit is a unit of measurement, so one policy can have many. (The same term is also used for each person or property in an insured group.) A good exposure unit rises and falls with the expected loss and is practical to measure and verify.
The premium is the rate multiplied by the number of exposure units:
In property insurance, the basis is generally the amount of insurance. The exposure unit is commonly each $100 of insurance, and some property rates are stated for each $1,000 of insurance. The more insurance a property owner buys, the more exposure units the policy has and the higher the premium.
For example, with invented figures, a building is insured for $400,000 and the rate is $0.80 per $100 of insurance.
- Number of exposure units: $400,000 ÷ $100 = 4,000
- Premium: 4,000 × $0.80 = $3,200
Other lines use other bases. Workers compensation rates apply to each $100 of payroll, and general liability rates often apply to sales or payroll. Whatever the basis, the calculation is the same.
Physical hazards in property rating
A hazard is a condition that increases the probability or the severity of a loss. A physical hazard is a material, structural or operational feature of the property or its surroundings that creates or increases the chance of loss. Faulty wiring, a long distance to the nearest fire hydrant and a fireworks factory next door are all physical hazards. Physical hazards can be found by inspecting the property, and they are the characteristics a property underwriter reviews.
Property underwriters sort physical hazards under four headings, remembered as COPE:
| What it means | What the underwriter looks at | |
|---|---|---|
| Construction | The main materials and method used to build the structure | Whether the building is frame, masonry or another type of construction |
| Occupancy | How the building is used | The business carried on in a commercial building, or whether the owner or a tenant lives in a home |
| Protection | The level of fire protection for the property | The quality of the fire department, the water supply, and the distance to the nearest fire station and hydrant |
| Exposure | The risk of loss posed by neighboring property or the surrounding area | What is located nearby, such as an office building or a fireworks factory |
These features enter the rate at each step described above. Class rates vary with characteristics such as the type of construction. A specifically rated building is inspected and rated on its own physical features. Schedule rating gives a debit for a characteristic that increases the chance of loss and a credit for one that reduces it.
Insurers also consider moral and morale hazards, which arise from the honesty and the care of the people involved rather than from the property. Those are covered in the chapter on transferring losses.
Lesson summary
- Underwriting results are measured by the loss ratio (incurred losses divided by earned premium), the expense ratio (underwriting expenses divided by premium) and the combined ratio (the two added together).
- A combined ratio below 100% is an underwriting profit and one above 100% is an underwriting loss. Investment income is not part of the underwriting result.
- A rate is the price for one unit of exposure, and it is an estimate of future costs. A premium is the total price of the policy.
- The types of rating are judgment rating, class (manual) rating and merit rating. Merit rating modifies the class rate for the individual risk.
- The main forms of merit rating are schedule rating (credits and debits for characteristics of the risk), experience rating (the insured’s past losses) and retrospective rating (the insured’s losses during the policy period, adjusted afterward).
- A loss cost provides for expected losses and loss adjustment expenses only. An insurer adds its own expense and profit loadings to reach its final rate.
- The components of a rate are the pure premium (loss cost), the expense loading and the allowance for profit and contingencies.
- The basis of a rate is the measure of exposure it is applied to, counted in exposure units. Rate × exposure units = premium, and in property insurance the exposure unit is commonly each $100 of insurance.
- A physical hazard is a material, structural or operational feature of the property or its surroundings that increases the chance of loss. Property underwriters group physical hazards as construction, occupancy, protection and exposure (COPE).