Study 7 - Pricing the Risk

Question 1

Define pure premium

Answer 1

Portion of the total premium that is needed to pay expected losses. It does not take into account money needed for company expenses

Question 2

Define premium

Answer 2

The price of insurance protection for a specified risk for a specified period of time

Question 3

Define acquisition cost

Answer 3

The cost of putting a business on the books and acquiring the premium. The items involved are not standard with all insurers, but generally may include items such as commissions, field representative costs, premium tax, and perhaps some of the relevant head office acquisition costs of operation

Question 4

Define commission

Answer 4

Compensation based on the amount of production; for example, independent insurance agents are compensated on the basis of a percentage of the premium. The percentage varies with different lines of insurance

Question 5

What are development factors?

Answer 5

Adjustments to current reserves for claims that have yet to be settled

Question 6

What are trend factors?

Answer 6

Adjustments applied to all losses to reflect what they would probably cost if they were to occur next year rather than having occurred at some time in the past

Question 7

What are administrative expenses?

Answer 7

General expenses incurred to operate the

ie. Buying/leasing equipment, purchasing office supplies, paying salaries and benefits for staff, and covering interest costs on debt

Question 8

What are six common items go into allocating premium?

Answer 8

Pure premium, development factors, trend factors, acquisition costs, administration expenses, profit

Question 9

What are ULAEs?

Answer 9

Unallocated loss adjustment expenses

Cannot be attached or attributed to a single claim

Question 10

Define underwriting profit

Answer 10

The amount of money an insurance company gains as a result of its insurance operations. Excess of earned premiums collected over loss payments and expenses

Question 11

Define underwriting loss

Answer 11

The amount of money that an insurance company loses as a result of its insurance operations, it excludes investment transactions and income taxes

Question 12

What is often used to offset underwriting losses?

Answer 12

Investment income

Question 13

Define actuary

Answer 13

One who specializes in the mathematics of insurance, mortality rates and the like

Question 14

Define ratemaking

Answer 14

The process of compiling and analyzing data to establish rates that accurately reflect the level of risk. Usually performed by actuaries

Question 15

Define rate

Answer 15

Amount charged to an insured that reflects the expectation of loss for a covered risk, insurance company expenses, and profit. In other words, it is the basis of premium calculation for the insurance provided for the exposure

Question 16

What are the three major components of any rate?

Answer 16

• Anticipated cost of settling claims
• Acquisition costs of the business, such as commissions
• Cost of administering the process, including taxes levied on the premiums

Question 17

What two conditions ensure rate adequacy?

Answer 17

• Actuarial forecast of future losses based on past losses is accurate for the population
• Sample represented by the book of business written by a particular underwriter or insurer is representative of the population

Question 18

What is the 8-step process is establishing rate adequacy?

Answer 18

1) Classify risks based on the types of objects of insurance, hazards of exposure, or both
2) Determine the number and nature of the rating classes
3) Select the proper measure of exposure
4) Gather loss statistics
5) Predict future losses based on past losses
6) Calculate the pure premium from the predicted losses
7) Calculate the total premium
8) Calculate the premium rate or unit cost

Question 19

What is the exposure base?

Answer 19

The denomination in which the unit of exposure is express

Question 20

What is the exposure unit?

Answer 20

A specified amount of the exposure base

Question 21

What is ASP?

Answer 21

Automobile Statistical Plan

A collection of statistical information that all automobile insurers who write business in Canada must record and file as prescribed by the Superintendent of Insurance. Commonly known as the Green Book.

Question 22

What is GISA?

Answer 22

General Insurance Statistical Agency

Question 23

What three plans are administered by GISA?

Answer 23

Automobile Statistical Plan
Ontario Statutory Accident Benefits Statistical Plan
Ontario Commercial Liability Statistical Plan

Question 24

Define law of large numbers

Answer 24

The mathematical premise that states that the degree of uncertainty is reduced as the number of events increases

Question 25

What two things are used to predict future losses?

Answer 25

The law of large numbers

Theory of probability

Question 26

What three major aspects of statistics are also considered?

Answer 26

Size of the sample
Time period over which the sample was taken
Past and future conditions

Question 27

What are the two basic approaches to rating?

Answer 27

Class rating

Schedule rating

Question 28

When is class rating used?

Answer 28

When statistics can be gathered on a large number of risks that share common characteristics

Question 29

What three categories can losses be subdivided into under class rating?

Answer 29

Territory
Type of unit insured
Value of the unit insured

Question 30

How can class rating be summarized?

Answer 30

Virtually eliminates the element of judgment in rating and streamlines the policy-issuing process, also reducing production costs

Question 31

Define schedule rating

Answer 31

A method of rating risks by measuring them against fixed standards of construction and protection. Risks below standards earn a charge that increases the rate, risks above earn a credit that reduces the rate

Question 32

When is schedule rating used?

Answer 32

When the body of statistical data is too fragmented to permit class rating

Such as commercial insurance

Question 33

What are the factors that allow for an underwriter to have some degree of flexibility when it comes to rating a risk?

Answer 33

The type of insurance and the size of the risk

Question 34

What are the general processes described for all ratemaking?

Answer 34

• Classifying risk
• Determining rating classes
• Selecting proper measures of exposure
• Gathering statistics
• Predicting future losses
• Calculating pure premium, total premium, and finally the premium rate

Question 35

When is class rating used?

Answer 35

• When statistics can be gathered on a large number of risks that share common characteristics (for example, the same basic risk factors are either present or absent for most automobile insurance risks)
• Same is true for homeowners and small business insurance
• This makes it possible to statistically measure the claims experience for each risk factor,
something that is not possible for more complex risks
• The record of losses for the period under review can be subdivided into categories such
as territory, type of unit insured, and value of the unit insured
• When the total losses in dollars are calculated and divided by the number of units to be
insured, the result will be an average class cost per unit insured

Question 36

Why is schedule rating used in some instances by underwriters?

Answer 36

• Some classes of business are individually rated because of their complexity and the need for underwriting judgment—schedule rating is used when the body of statistical data is too fragmented to permit class 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
• The process of schedule rating involves the fixing of a base rate or key rate
• Base rate is used as the initial charge to apply to the particular community in which the object of the insurance is located and takes into consideration the degree of public fire protection
• After these rates are determined, debits and credits are applied based on factors that make the risk either better or worse than the average risk of its type

Question 37

How are future losses predicted?

Answer 37

• Apply the law of large numbers
• Statistics are only useful in predicting future loss depending on how much loss information is collected, when it is collected, and under what conditions it is collected
• Examine the size of the sample
• Examine the time period over which the sample was taken
• Look at past and future conditions

Question 38

Explain the concept of proper measure of exposure

Answer 38

• Proper measure of exposure for a given class of risks is the exposure base
• Exposure base is the 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 exposure unit is expressed as a specified amount of the exposure base
• For example, gross sales are often expressed in units of $1,000 so that rating for the liability exposure of a certain risk might be expressed as so much per $1,000 of gross sales
• The right exposure base for 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 that the risk experiences
• Exposure bases vary between lines of insurance
• In property insurance, for example, the exposure is the value of the property and the exposure unit is each $100 of property
• Selecting the right exposure base to measure the susceptibility or vulnerability of the insured to loss is probably one of the most important steps in the initial determination of a rate for a new coverage