Chapter 10: Establishing the Price - Pricing Factors

Question 1

How can risk premium be defined?

Answer 1

The expected ultimate cost in claims of the risk being accepted, including an allowance for the degree of uncertainty

Essentially it is the amount required to pay claims

Question 2

What is a claims run-off?

Answer 2

Changes in claims reserves or claims being re-opened due to more information becoming available or court rulings on liability

Question 3

What are latent claims?

Answer 3

Claims that takes many years to be reported. An example is mesothelioma from asbestos - some claims are being made for incidents which occurred 40-50 years ago.

Also called long tail claims

Similar to INBR but much more time has elapsed

Question 4

What is meant by INBR?

Answer 4

Incurred but not reported

Estimated reserves based on expected claims for events that have occurred but not yet been reported to the insurer

Question 5

How should claims data be adjusted to reflect exposure?

Answer 5

They should be adjusted to reflect exposures today. Claims data is historical and must be viewed within that context

For example in many industries technological advancements have automated some processes which previously would have been risky therefore it would not be accurate to price the risk based upon historical claims

Question 6

What is claims farming?

Answer 6

Where a company (eg claims management company) or person encourages another to make a claim

Question 7

What are the 4 main factors to take into consideration when setting the price?

Answer 7

1. Risk premium (claims payments)
2. Expenses
3. Profit
4. Taxes and levies

Question 8

What are the two categories of expenses?

Answer 8

Fixed and variable

Question 9

What is the difference between fixed and variable expenses?

Answer 9

Fixed expenses are the same cost for every policy, whereas variable expenses may change with the size of the risk

Question 10

What are some examples of variable expenses?

Answer 10

Underwriting
Risk management/surveys
Commission
Claims handling
Risk management funds
Low claims rebates

Question 11

What is meant by return on capital employed?

Answer 11

The profit as a percentage of the capital employed

Question 12

What is investment income?

Answer 12

Insurers control a large amount of capital in the common pool. Whilst they must retain certain levels of reserves they can also invest some capital, usually in low risk areas, which gives them another source of income

Question 13

What is meant by “underwriting result” and what measures this?

Answer 13

The actual profit or loss of the insurer without taking investment income into account, as measured by the combined operating ratio

Question 14

What is the combined operating ratio (COR)?

Answer 14

A combination of the loss ratio, commission ratio, and expense ratio

Question 15

What does the COR measure?

Answer 15

The underwriting result. Essentially the financial health of the insurer

(COR is combined operating ratio)

Question 16

What is a hard market?

Answer 16

When rates and premiums are increasing as a result of less capital in the market

Question 17

What is a soft market?

Answer 17

When rates and premiums are decreasing in order to attract business

Question 18

How do insurers tend to balance their investment portfolio?

Answer 18

By investing in a mixture of:

1. Interest-bearing investments
2. More volatile investments (equities)

Question 19

What is the main problem with taking the investment income into consideration during pricing?

Answer 19

If claims are larger than expected but the investments underperform then it may cause the insurer financial difficulty

Question 20

What are the main 3 examples of levies in the UK?

Answer 20

1. Financial Services Compensation Scheme
2. Motor Insurers’ Bureau
3. Mesothelioma Act 2014

Question 21

What did the Mesothelioma Act 2014 do?

Answer 21

Established a levy on all employers’ liability premiums to fund the Diffuse Mesothelioma Payment Scheme to support those suffering from mesothelioma related illnesses who were unable to trace their employers. They can be awarded 100% of the average claim

Question 22

What is the purpose of the FSCS levy?

Answer 22

To fund the Financial Services Compensation scheme, who pay claims when the insurer has become insolvent

Question 23

What is the purpose of the MIB levy?

Answer 23

To fund the Motor Insurers’ Bureau, who seek to pay claims relating to an uninsured or untraced driver

Question 24

Why would an insurer want a high ROCE?

Answer 24

To make them a more attractive investment and encourage more shareholders to invest, and also to provide a greater return for existing shareholders

(ROCE is Return on Capital Employed)

Question 25

What is claims inflation?

Answer 25

The increase in costs to settle claims over time

Question 26

How do equities compare to interest bearing investments?

Answer 26

Equities tend to deliver a high rate of return over the medium to long term but are more volatile in the short to medium term

Question 27

What is a work transfer arrangement?

Answer 27

The insurer pays the intermediary a percentage of the premium as commission for them taking on more work such as issuing documentation or underwriting with delegated authority

Question 28

What can work transfer arrangements make it more difficult for an insurer to achieve? Why?

Answer 28

Combined operating ratio

Their expenses are higher so they must write to a lower loss ratio

Question 29

When are incurred but not reported (INBR) claims particularly important to take into underwriting consideration?

Answer 29

At the end of the underwriting year

Question 30

Why must insurers with a high degree of volatility take care to ensure they generate higher profits?

Answer 30

To encourage investors and make them a more attractive investment despite the higher risk than less volatile insurers

Question 31

What impact did the Legal Aid, Sentencing, and Punishment Act 2012 (LASPO) have on loss ratios and why?

Answer 31

A short term reduction in loss ratios, but this has not been continued over the long term

This was due to changes in the ways claims were notified and settled

Question 32

Which line of business is particularly concerned with long-tail/latent claims?

Answer 32

Employers’ Liability

Question 33

What is the FSCS levy based on?

Answer 33

The gross direct premium of the insurer

Question 34

What is the MIB levy based on?

Answer 34

The insurer’s motor claims experience

Question 35

What are catastrophe claims?

Answer 35

A large number of claims arising from a common event

Question 36

How can investment income impact an insurer’s rates? What must they be careful of?

Answer 36

They may cut rates to increase competitiveness when returns are good, however they must take care they do not cut them too much in case their investment income decreases

Question 37

What should insurers account for when pricing risks?

Answer 37

Risk premium (expected claims)
Expenses
Premium taxes + levies

Question 38

An insurer has a ROCE of 50%. What does this mean?

Answer 38

Their return on capital employed is 50%

Their profit is equal to 50% of the capital employed

Question 39

In commercial insurance how much brokerage is typical?

Answer 39

It varies, can be 7.5% for a motor fleet up to 25% or even more for some commercial credit policies

Can also vary depending on relationship with insurer and TOBAs

Question 40

Why must an underwriter ensure their reinsurance costs are equitable?

Answer 40

To avoid higher premiums putting them at a competitive disadvantage

(If their reinsurance is expensive they must charge a higher premium to the insured, who may be discouraged by the higher price and more likely to shop around for a lower premium)