Introduction Pricing I Pricing II

STAT 3058/6058 - Risk Modelling 2

Ratemaking (1)

Garry Khemka

S2, 2024

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Introduction

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What is Ratemaking?

Price: payment for goods or services

Usually dictated by supply and demand
Usually delivery is immediate or at a pre-specified time

Premium: payment for protection

Unknown future payments from an insured contingent event
Timing can be unknown (and can take years)
Usually expressed as standardised units, and hence the term rates

Technical Prices vs True Prices

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Key Considerations

Ratemaking is prospective
Balance needs to be acheive both at the aggregate and individual risk
levels

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Objectives of ratemaking

Main objectives are:

1 Cover Expected Losses and Expenses
2 Make Adequate Provision for Contingencies
3 Encourage Loss Control
4 Satisfy Rate Regulators
Desired Objectives are:
a. Generate Rates that are Reasonably Stable
b. Generate Rates that are Reasonably Responsive to Changes
c. Be Simple and Easy to Understand

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Company Level Records

Typically required information is organised into the following databases:
Policy database
Information regarding the underlying risk, the policyholder, and the
contract provisions

Claims database
Information about each claim
Linked to the policy database
Payment database
Information on each claim(s) transaction
May include changes to case reserves
Linked to the claims database
The information can be aggregated as required to suit the purpose of the
actuary.
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Exposures - Timeline and crossovers

Financial reporting period

Fixed in the calendar
Financial Year
Calender Year (we use this)
Other
Policies can begin anytime!
Policies (likely) have same contract period, say one year
They will end at different time points in the financial reporting period
Following slide provides illustration of four such policies

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Exposures - Timeline and crossovers

Figure 1: Timeline of Exposures for Four 12-Month Policies

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Exposures - measures

Written exposures: exposure on policies written in the FRP

Earned exposures: exposure actually exposed to loss in the FRP
Unearned exposures: exposure yet to be exposed to loss at a given
point in time
In force exposures: exposure units exposed to loss at a given point in
time
Illustration:
In-Force
Effective Written Exposure Earned Exposure Unearned Exposure Exposure
Policy Date 1/1/2019 1/1/2020 1/1/2019 1/1/2020 1/1/2019 1/1/2020 1/1/2020
A 1 Jan 2019 1.00 0.00 1.00 0.00 0.00 0.00 0.00
B 1 April 2019 1.00 0.00 0.75 0.25 0.25 0.00 1.00
C 1 July 2019 1.00 0.00 0.50 0.50 0.50 0.00 1.00
D 1 Oct 2019 1.00 0.00 0.25 0.75 0.75 0.00 1.00
Total 4.00 0.00 2.50 1.50 1.50 0.00 3.00

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Premiums

Summarized exactly the same way as exposures. Premiums can be:

written premiums
earned premiums
unearned premiums
in force premiums

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Example

Example
A 12-month policy is written on March 1, 2002 for a premium of $900. As
of December 31, 2002, which of the following is true?

Calendar Year Calendar Year

2002 Written 2002 Earned Inforce
Premium Premium Premium
A. 900 900 900
B. 750 750 900
C. 900 750 750
D. 750 750 750
E. 900 750 900

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Example
Example
A 12-month policy is written on March 1, 2002 for a premium of $900. As
of December 31, 2002, which of the following is true?

Calendar Year Calendar Year

2002 Written 2002 Earned Inforce
Premium Premium Premium
A. 900 900 900
B. 750 750 900
C. 900 750 750
D. 750 750 750
E. 900 750 900

Only earned premium differs from written premium and inforce premium
and therefore needs to be computed. Thus, earned premium at Dec 31,
2002, equals $900 × 10/12 = $750. Answer E.
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Losses, Claims and Payments - Terminology

Loss is the amount of damage sustained in an insured event
Claim is the amount paid
Claim = Loss - Deductibles and policy limits

IBNR claims - incurred but not reported claims

Accident Date is the date of loss or the occurence date
Report Date is the date the insurer receives notice of the claim
IBNR claims arise when there is a lag between the two dates
Reported losses = Paid losses + Case reserves
Paid losses are losses paid
Case reserves are expected future payments on claims
Ultimate Losses is the amount required to close all claims on a risk
Ultimate Losses = Reported losses + IBNR reserves + IBNER reserves
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Loss Adjustment Expense

Loss Adjustment Expense (LAE) is the expense associated with

settling claims

LAE = ALAE + ULAE

Allocated Loss Adjustment Expenses (ALAE) are claim-related

expenses that are directly attributable to a specific claim
Unallocated Loss Adjustment Expenses (ULAE) are claim-related
expenses that cannot be directly assigned to a specific claim

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Underwriting Expenses

These are expenses associated with acquisition of business and comprises

of:
Commissions and brokerage
Other acquisition costs
General expenses
Taxes, licenses, and fees

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Underwriting Profit

Insurance companies are assuming an unknown loss

This requires capital
The rate of return to service the capital is called the Underwriting
Profit
Also known as loading for contingencies and profit
Note, the other source of income for insurance companies, Investment
income, is ignored in this course.

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Insurance Ratios
Frequency: The rate at which claims occur
Number of Claims
Frequency = .
Exposure (number)

The numerator is, usually, the number of reported claims and the
denominator is the number of earned exposures
Changes in claims frequency can identify general industry trends
Help measure the effectiveness of specific underwriting actions

Severity: The average cost of claims

Losses
Severity = .
Number of Claims

Paid vs Reported Severity

Treatment of LAE
Changes in severity provides information about loss trends and impact
of changes in claims handling procedures.
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Insurance Ratios
Pure premium or Loss Cost: The average loss per exposure
Losses
Pure premium = = Frequency × Severity.
Exposure (number)

‘Pure Premium’ is a unique term for insurance

Losses are either reported or ultimate losses and usually include LAE
(unless specified)
Changes in pure premium highlight industry trends in overall loss costs
due to changes in both frequency and severity
Loss Ratio: The portion of each premium dollar used to pay losses
Losses
Loss ratio = .
Premium
Both losses and premium share typically the totals for a line of
business
The loss and LAE ratio (later) are a primary measure of the adequacy
of the rates overall and for various key segments of the portfolio
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Insurance Ratios
Loss Adjustment Expense Ratio: Compares the amount of claim-related
expense to total losses
Loss Adjustment Expenses
LAE Ratio = .
Losses
The loss and LAE ratio is the loss ratio multiplied by the sum of one
plus the LAE ratio.
This ratio over time indicates stability of claim settlemt procedures
Can be used against competitor ratios for benchmarking
Underwriting Expense Ratio: The portion of each premium dollar used to
pay for underwriting expenses
UW Expenses
UW Expense Ratio = .
Earned Premium
Can be subdivided into those that happen at the outset and that that
occur during the policy
This ratio over time can be used to compare actual changes vs
expected changes (from general inflation)
Can be used against competitor ratios for benchmarking
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Insurance Ratios

Operating Expense Ratio (OER): The portion of each premium

dollar used to pay for loss adjustment and underwriting expenses

Loss Adjustment Expenses

OER = UW Expense Ratio + .
Earned Premium
Used to monitor operational expenditures
Key to determining overall profitability
Note, expenses are usually subdivided into Fixed and Variable expenses
for premium calculation purposes in this course (more on this later).

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Pricing I

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Premium Principles

Pricing only based on losses

Does not depend on expenses and profit (these are introduced later)
Developed on a probabilistic basis
Here we provide a basic introduction

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Premium Principles

Let a random loss X has cdf FX (x )

Let H be a rule that transform FX (x ) to the positive real line
For example, H could be the expectation operator
Note, for simplicity we write H(FX (x )) as H(X )

This rule H is called the Premium Principle

Provides a guide as to how much an insurer will charge for accepting a
risk X

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Premium Principles

Description Definition (H(X ))

Net (pure) premium E [X ]
Expected value (1 + α)E [X ]
Standard deviation E [X ] + αSD(X )
Variance E [X ] + αVar (X )
Zero utility solution of u(w ) = E [u(w + P − X )]
1 αX
Exponential α log E [e ]
Table 1: Common Premium Principles

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Properties

Description Definition
Nonnegative loading H(X ) ≥ E (X )
Additivity H(X1 + X2 ) = H(X1 ) + H(X2 ), for independent X1 , X2
Scale invariance H(cX ) = cH(X ), for c ≥ 0
Consistency H(c + X ) = c + H(X )
No rip-off H(X ) ≤ max{X }
Table 2: Common Properties of Premium Principles

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Example

Example


Let X ∼ N µ, σ 2 and the insurer has an exponential utility function,

u(x ) = −αe −αx , α > 0

Show whether the zero utility premium principle satisfies the scale
invariance property, i.e.,

H(cX ) = cH(X ), for c ≥ 0

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Example

Example
1 2 2
We know MX (t) = e µt+ 2 σ t
. Then

log(MX (α)) 1
P= = µ + ασ 2
α 2
Hence,
1 1
H(cX ) = cµ + αc 2 σ 2 ̸= cH(X ) = cµ + αcσ 2 (when c > 0)
2 2
Thus, the scale invariance property is not satisfied.

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Exam Style Question

Question
The mean value principle states that the premium, H(X ), for a risk X is
given by:
g(H(X )) = E (g(X ))
where g(x ) is a function such that g ′ (x ) > 0 and g ′′ (x ) ≥ 0 for x > 0.
(a) You are given that X follows a compound Poisson distribution with
λ = 8 and the individual claim amount distribution is a lognormal
distribution with µ = 2 and σ = 2. Calculate H(X ) when g(x ) = x 2 .
(b) Let Y = X + 1000 and X is defined in (a) above. Find H(Y ) and
hence check if the mean value premium principle is or is not consistent.

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Exam Style Question

Solution
(a) g(H(X )) = H(X )2 = E (X 2 ). Therefore, H(X ) = [E (X 2 )]0.5

E (X ) = λ exp(µ + σ 2 /2) = 8 exp(2 + 22 /2) = 8 exp(4) = 436.79

V (X ) = λ exp(2µ + 2σ 2 ) = 8 exp(12) = 1, 302, 038

E (X 2 ) = V (X ) + [E (X )]2 = 1, 492, 820

p
H(X ) = [E (X 2 )]0.5 = 1, 492, 820 = 1221.8

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Exam Style Question

Solution
(b) H(Y ) = [E (Y 2 )]0.5 .

H(Y )2 = E (Y 2 ) = E ((X + c)2 ) = E (X 2 ) + 2cE (X ) + c 2 .

If c = 1000,

H(Y )2 = E (X 2 ) + 2000E (X ) + 1, 000, 000

= 1, 492, 820 + 2000(436.79) + 1, 000, 000 = 3, 366, 400.
p
H(Y ) = 3, 366, 400 = 1, 834.78.

H(X ) + c = 2221.8 ̸= H(Y ).

Therefore, not consistent.

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Pricing II

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Fundamental Insurance Equation

The fundamental insurance equation is

Premium = Losses + LAE + UW Expenses + UW Profit

It is also commonly written as

Premium = Losses + Expenses + UW Profit

where the LAE term is either incorporated within Losses or within
Expenses depending on the company’s policy.

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Pure Premium Method

Consider a collection of n contracts with losses X1 , . . . , Xn .

n is large
X1 , . . . , Xn are iid, i.e., homogeneous risks
Pn
i=1 Xi Loss
E(X ) ≈ = = Pure Premium.
n Exposure

Or from before

claim count Loss

Pure Premium = × = frequency×severity.
Exposure (number) claim count

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Pure Premium and FIE

Decompose ‘Expenses’ into those that vary by premium, ‘Variable’,

and those that do not, ‘Fixed’.
Consider Variable and profit as fractions of premium

Variable UW Profit
V = and Q = .
Premium Premium
Then from FIE

Losses + Fixed
Premium = .
1−V −Q

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Pure Premium Rate

Divide by exposure to get rate

Premium Losses/Exposure + Fixed/Exposure

Rate = Exposure = 1−V −Q
Pure Premium + Fixed/Exposure
= 1−V −Q .

pure premium + fixed expense per exposure

Rate = .
1 - variable expense factor - profit and contingencies factor

These rates are called indicated rates

We ignore investment income in all calculations for GI

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Example

Example
Determine the indicated rate per exposure unit, given the following
information:
Frequency per exposure unit = 0.25
Severity = $100
Fixed expense per exposure unit = $10
Variable expense factor = 20%
Profit and contingencies factor = 5%

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Example

Solution
Under the pure premium method, the indicated rate is
pure premium + fixed expense per exposure
Rate = 1 - variable expense factor - profit and contingencies factor
frequency×severity + 10
= 1−0.20−0.05 = 0.25×100+10
1−0.20−0.05 = 46.67.

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Loss Ratio

The loss ratio is the ratio of the sum of losses to the premium (as we
saw earlier)

Loss
Loss Ratio = .
Premium
Note, premium is built into the denominator and hence this is
counter-intuitive in setting premiums
Ratio used for rate changes rater than raw rates

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Loss ratio
Let Q be the profit loading, then

Loss+Fixed
Q =1− − V = 1 − Loss Ratio − Fixed Expense Ratio − V
Premium

Now if a new profit target Qtarget is required, then company changes the
Premium by the ICF (‘Indicated Change Factor’)

Loss + Fixed
Qtarget = 1 − − V.
Premium × ICF

Thus,

Loss Ratio + Fixed Expense Ratio

ICF = .
1 − V − Qtarget
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Example

Example
Assume the following information:
Projected ultimate loss and LAE ratio = 65%
Projected fixed expense ratio = 6.5%
Variable expense = 25%
Target UW profit = 10%
Calculate the Indicated Change Factor (ICF ).

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Example

Solution
The ICF is
(Losses + Fixed)/Premium 0.65 + 0.065
ICF = = = 1.10.
1 − V − Qtarget 1 − 0.25 − 0.10

This means that overall average rate level should be increased by 10%.
(Note, in this example losses and loss adjustment expense are grouped
together into losses. This is a common treatment, and hence the absence
of LAE in the discussion above.)

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Loss Ratio - Alternative Approach

Define experience loss ratio

experience losses
LRexperience = .
experience period earned exposure × current rate

From the FIE, we can write

Losses 1−V −Q 1−V −Q

LR = = = ,
Premium (Losses + Fixed)/Losses 1+G
where, G = Fixed/Losses, the ratio of fixed expenses to losses, and the
term 1 − V − Q is also known as permissible loss ratio

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Loss Ratio - Alternative Approach

Thus,
1−V −Q Permissible loss ratio
LRtarget = = .
1+G 1 + ratio of non-premium related expenses to losses
and,
LRexperience
ICF =
LRtarget

The new expression provides far more flexibility to explicitly incorporate

trended experience.

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Pure Premium vs Loss Ratio

Pure Premium Method Loss Ratio Method

Based on exposures Based on premiums
Does not require existing rates Requires existing rates
Does not use on-level premiums Uses on-level premiums
Produces indicated rates Produces indicated rate changes

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Pure Premium vs Loss Ratio

1 The pure premium method requires well-defined, responsive exposures

2 The loss ratio method cannot be used for new business
3 The pure premium method is preferable where on-level premium is
difficult to calculate.

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Example

Example
You are given the following information:
Experience period on-level earned premium = $500,000
Experience period trended and developed losses = $300,000
Experience period earned exposure = 10,000
Premium-related expenses factor = 23%
Non-premium related expenses = $21,000
Profit and contingency factor = 5%
(a) Calculate the indicated rate level change using the loss ratio method.
(b) Calculate the indicated rate level change using the pure premium
method.

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Example
Solution (a)
We will calculate the experience and target loss ratios, then take the ratio to get
the indicated rate change. The experience loss ratio is
experience losses 300, 000
LRexperience = = = 0.60.
experience period premium 500, 000
The target loss ratio is:

1−V −Q
LRtarget = 1+G
= 1−premium related expense factor - profit and contingencies factor
1+ratio of non-premium related expenses to losses
1−0.23−0.05
= 1+0.07
= 0.673.
21,000
Here, the ratio of non-premium related expenses to losses is G = 300,000
= 0.07.
Thus, the (new) indicated rate level change is

LRexperience 0.60
ICF = −1= − 1 = −10.8%.
LRtarget 0.673

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Example

Solution (b)
Using the pure premium method
Losses + Fixed
Premiumexperience = 1−Q−V
300,000+21,000
= 1−0.23−0.05
= 445, 833.33.
445,833.33
Thus, the indicated rate level change is 500,000 − 1 = −10.8%.

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