Chapter 18: Rating methodologies and bases

Question 1

The rating methodology used will depend on:

Answer 1

• the class of business being priced
• the availability of relevant data
• the market in which the company is operating

Question 2

Components of the risk premium

Answer 2

• the pure risk rate based on previous years’ experience
• a loading for catastrophe and/or large loss claims (which may or may not exist in the previous data)

Question 3

Components of the office premium

Answer 3

• a loading for the net of cost reinsurance
• a loading for expenses including commission
• a capital charge to reflect the cost of capital (profit loading)
• investment income
• tax

Question 5

Other considerations when calculating the premium to charge

Answer 5

• rating factors
• practical considerations concerning policy conditions, underwriting process, competition, etc.

Question 6

Steps involved in calculating the pure risk premium

Answer 6

• collect relevant data, including past exposure data and claims arising from that exposure
• adjust the data to make it more relevant
• group data into risk groups
• select most appropriate rating model or estimation process for the specific case
• analyse the data
• set assumptions required by the model or process
• test the assumptions for goodness of fit or likelihood probability
• run the model or process to arrive at an estimate of future claims cost
• perform sensitivity and scenario testing, or apply other methods, to check the validity of the estimate

Question 7

Examples of statistical approaches that can be used to derive a risk premium

Answer 7

• simple burning cost approach to premium rating, using aggregate claims data
• frequency-severity approach, where statistical distributions are fitted to the frequency and severity of claims separately and combined to give a risk premium
• multivariate models, including GLMs
• the “original loss curve” approach to premium rating

Question 8

Data obtained from external sources, should be compared with the corresponding details for the policies the insurer intends to write, as far as possible:

Answer 8

• the terms of the policy offered
• levels of risk underwritten
• the loadings included for expense and profit in the premium
• socio-economic differences

Question 9

External data is especially useful in some circumstances:

Answer 9

• for a company writing a new or modified class of business
• where the company’s own data is sparse
• to provide confirmation of results derived from internal data

Question 10

Reasons why accurate past claims data might not be suitable for premium rating

Answer 10

May not be appropriate if future conditions are expected to be different from those in the past. Examples of possible differences are:

• past data isn’t from the classes we now wish to set premiums for
• we wish to change the premium structure and the past data isn’t credible enough to use
• the volume of past data is inadequate
• there have been sudden changes in the court treatment of certain types of claim
• policy conditions have changed, e.g. an increased excess

Past data may be useful in some cases but will need to be adjusted

Question 11

Data for pricing

Credibility Theory

Answer 11

An approach of taking a weighted average of two extreme approaches on deciding which dataset to use:

• using an estimate based on the past data of the individual insurer - based on most relevant data
• using an estimate based on market-wide data - in some senses a more reliable figure

Question 12

Things that affect the amount of data needed for full credibility

Answer 12

• the variance of the underlying process. The higher the variance, the more data is needed
• the criteria chosen (distance from the true mean and confidence level)

Question 13

Subdivision of data

Answer 13

Where possible and statistically relevant, we split the data into risk cells - homogenous subsets based on factors that contribute to higher or lower claims experience

Question 14

Why is data subdivided?

Answer 14

• Enables us to better understand the risks being handled
• Helps us avoid cross-subsidies = profit won’t depend on particular cross-section of risks

Question 15

What should we do if the experience in the base period does not appear to be typical?

Answer 15

• choose another base year that is more typical
• aggregate more years’ experience
• apply an adjustment factor to the affected base year. Such a factor will be rather subjective, although market figures may be available

Question 16

To help assess what adjustments to the base period are needed, we could:

Answer 16

• gather information on results of other insurers, to establish whether the deterioration was industry-wide or specific to the insurer
• establish whether there are any global climatic or economic factors that would explain the unexpected experience (and how they are expected to affect future experience)
• look at previous years’ results to try and identify trends or cycles

Question 17

Changes in the risk may arise because of changes in:

Answer 17

• the mix of underlying risks
• cover/policy conditions
• claims handling/underwriting strategy
• method of distribution
• level of reinsurance coverage

Question 18

Matters in which significant inconsistencies may arise:

Answer 18

• policy acceptance
• policy coverage
• method of distribution
• claims settlement procedures

Question 19

Major changes in policy conditions are likely to be in:

Answer 19

• the perils covered
• limits or excesses applied to any claim

Question 20

Examples of environmental factors that affect claims experience

Answer 20

• legislative factors
• advances in technology
• medical advances
• changes in construction of property

Question 21

Time delays that may result in adjustment to the data may occur because of:

Answer 21

• time take for sufficient claims experience to develop from the historical data
• time taken to analyse the claims experience
• time taken to reach and agree on the new premium rates and premium structure
• time taken to administer and implement the new rates
• time delay between the risk period and the payment of claims due to reporting and settlement delays
• time taken for any approval needed from a regulatory body to introduce rates

Question 22

We need to allow for the expected effect of inflation on claims between:

Answer 22

• the mean payment date of claims in the base period and
• the mean payment date of claims arising during the new exposure period

Question 23

When revaluing base values for future premium rates, there are two parts to the calculation:

Answer 23

• inflating base values to the present day using (broadly) known inflation rates
• projecting from the present day to the future using estimated future inflation rates

Question 24

Approaches for adjusting for large individual (non-catastrophic) losses:

Answer 24

• omit them from the analysis and allow for them seperately in the risk premium
• truncate large claims at a set point and spread any cost above this level across the larger portfolio of risks
• leave large claims in the data, although we rarely do this because this would implicitly assume future occurences will replicate those seen in the past

Question 25

Ways of allowing for the cost of reinsurance in a premium rate

Answer 25

- as the net cost of reinsurance (reinsurance less recoveries) in a premium rate based on a gross risk premium (not considering reinsurance recoveries) - as the gross cost of reinsurance (reinsurance premium) in a premium rate based on a net risk premium (considering reinsurance recoveries)

Question 26

For most insurers, the expenses, in roughly decending order might be:

Answer 26

- staff salaries, pensions costs, national insurance contributions, etc - commission payments - office rent and related costs - office equipment (e.g. computers) - office consumables (e.g. stationary)

Question 27

Stages involved in determining the required expense loadings

Answer 27

- allocate the expenses by class or product and, possibly, by major rating factor groups - allocate expenses by function - decide on how to allow for each expense type in the rating formula

Question 28

Theoretically, we can divide expenses into:

Answer 28

- underwriting and brokers' commission - policy administration - claims handling - overheads - levies to state insurance schemes, e.g. to SASRIA

Question 29

Ways of charging for commissions, expenses and other margins:

Answer 29

- add an overall percentage to the risk premium, based on evidence of previous year's underwriting results - take into account the split between fixed and variable expenses and likely volumes of business in the future

Question 30

Factors to consider when selecting an assumed rate of investment return

Answer 30

- likely investment conditions at the time when the premiums are receivable - assets likely to be held (which should be matched to the nature of the liabilities) - consistency with the inflation assumption used to project expected claims and expenses

Question 31

Pricing with limited data

Answer 31

- use of other data - margins - use of ILFs or exposure curves - qualitative methods

Question 32

Using a mixture of quantitative and qualitive data is used when quantitive data is:

Answer 32

- incomplete - inaccurate - sparse - where risk perception plays an important element in price determination

Question 33

Inadequate data may distort calculations of actual projections of the new rating requirements. This may be due to errors in:

Answer 33

- the apparent size of business in force, and its value expressed in exposure units and premium - the apparent claims experience and its trends, on which the projected future costs are being based

Question 34

If we adopt a deficient set of rates as a result of faulty data, the insurer might:

Answer 34

- suffer underwriting losses if rates are too low - suffer loss of market share if rates are too high - attract undesirable risks, causing deterioration in underwriting experience if rates for such risks are too low