What is Ratemaking?
Ratemaking is a process of deciding the amount of the premium for insurance. Thus, it is also known as insurance pricing. As an insurance company is a profitable business, the rate of premium charged for insurance must be sufficient enough to provide for losses and expenses while at the same time earning profit for the company.
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The main objectives of determining the rate of premium are to:
- Ensure the profitability of an insurer
- Maintain competitive prices concerning other insurers
- Create a corpus that allows the insurer to pay claims and expenses as they occur
However, the rate of premium differs across insurance companies depending on the laws of the state in which it operates and various other factors related to the proposer. Rates and premiums in insurance are determined by an actuary. An actuary is a skilled mathematician who is a part of the different phases of an insurance company, such as operations planning, research, and pricing.
Apart from deciding the rate of premium, an actuary also helps in determining annuities and legal reserves, which are needed by an insurance company for the payment of future obligations. This is achieved by studying vital statistical data related to birth, marriages, deaths, disease, retirement, employment, and accidents.
In the insurance sector, underwriters or actuaries use various methods to determine the rates of premiums. However, it must not be forgotten that calculation of an insurance rate can never be an absolute or a completely scientific process in nature. Partly scientific methods used in insurance help in narrowing the areas of ambiguity. Some of the commonly used methods are listed.
- Class or manual method
- Loss ratio method
- Merit rating/individual method
- Schedule rating
- Experience rating
- Retrospective rating
Class or manual method
In this method, rates set apply uniformly to each exposure unit that belongs to the same class or group. In simple words, the same rate of premium is charged to individuals under the same situation. Such groups are usually predetermined to collect and manage claims data in an organized manner.
This method is commonly used in determining the rate of premium for life insurance, workers’ compensation insurance, automobile insurance, health insurance, etc. For example, in the case of motor insurance, the rate of premium is decided based on the type of vehicle, age of driver, gender of the driver, and category of the vehicle used like commercial, personal, etc.
Loss ratio method
The loss ratio is calculated by adding losses and loss-adjusted expenses over the premium charged from the insured. Thus, this method is applied to adjust the premium based on the actual loss that happened rather than deciding the rate of the premium.
Merit rating/individual method
This method identifies the unique features of a particular risk and a rate that reflects the severity of the risk. Moreover, in this method, actuaries develop special rating classes based on the individual attributes of proposers.
In a nutshell, the merit rating method is based on a class rating; however, the rate of premium is calculated as per the individual customers and the actual losses suffered by them.
This method is used frequently by commercial fire insurance companies. A building proposed to be covered under the insurance is considered to be a unique identity, and a rate is established for it. The representative of the insurer does an infrastructure audit, and the building is rated. Rate credits are given based on the good features of the structure.
This method takes into consideration the amount of actual loss in previous policy periods, generally in the past 3 years, for deciding the rate of premium in the next policy period. In situations wherein the exposure that affects the policy administration of the insurer is reasonably within the span of control of the policyholder, the individual risk may be given special consideration through experience rating. In such situations, one can expect a reduction of losses through special interventions.
Often, once a loss reduction is demonstrated through experience, the policyholder may be passed on the benefit of reduced cost of insurance on the pretext that the policyholder promises to demonstrate his/her ability to keep the loss low.
In the retrospective rating method, the premium is adjusted according to the losses suffered by the insurance company instead of the whole insurance industry itself. It helps an insurance company to keep control of its losses due to limiting the risk exposure of the insured. Moreover, the values of the insurance premium can be adjusted within a certain range of minimum and maximum values.