Building a Premium Calculator

A premium calculator requires three key elements:

  1. Rate file
    A rate file will typically contain all the rating tables needed to rate a policy.

  2. Rating algorithm
    This defines the calculations needed to produce a rate using the rate file given a set of policy characteristics.

  3. Policy input file (with all key rating factors)
    This contains a list of policies that rates need to be calculated for. Generally a process will need to be applied to ensure all necessary rating variables are attached to each policy.

Commonly Used Rating Factors By Type of Insurance

The following lists common rating factors for most of the common lines of insurance offered. I didn’t create these lists. I compiled these from an alternative source for future reference. Also they only represent a subset of all the possible rating factors that can be used.

Travel insurance:
• Length of holiday – The longer the trip the longer the period of cover and hence increasing the probability policyholders making a claim
• Destination – different destinations have different exposures to risk. The cost of attaining medical attention or transport costs is also different for different areas.
• Age and gender – This rating factor impacts the likelihood and the type of medical claim the policyholder is exposed to.
• Cover type – This includes how many people are covered and the level of inclusions such as cancellations, baggage loss and medical costs.
• Length of time between purchase and travel – The longer the gap the higher the chance that a cancellation claim may occur.

Motor:
• Age of driver(s): this is seen as a proxy for experience or riskiness of driving behaviour, which will influence the size and frequency of claims
• Sum insured: a higher sum insured may lead to higher payouts if a claim occurs
• Claims history: previous claims may indicate poor driving and therefore a higher likelihood of future claims
• Type of car: factors such as make/model and age may influence the occurrence and severity of claims (for example, if it is an expensive car)
• Business vs private use: commercial vehicles are typically driven more often or for longer periods of time, which increases relative exposure
• Location: the postcode may be an indicator of various risks such as weather and theft (due to local crime rates)
• Parking location: whether it is parked in a secure garage or on the street may affect the possibility of theft

Medical malpractice insurance for doctors:
• Specialty of practice – the most important rating factor – the type of work that doctoris performing (i.e. General Practice, Obstetrics, Neurosurgery, etc.). Certain practices are riskier than others.
• Location of work – State of practice (i.e. NSW, VIC, SA, etc.), urban or rural location (rural locations can have a higher risk), private practice or in a public or private hospital (practice in public hospitals can have a higher risk and are not subject to certain government recoveries).
• Expected billings/sessions for the year, which is a proxy for how much work the doctor expects to perform. The higher the billings/sessions the greater than risk.
• Number of years being covered (i.e. claim made years) – measures/identifies how many years of historical plus current work will be covered under the claims made policy, since claims are • covered by the year in which they are reported (rather than occurred). If it is an occurrence year based policy, then this might not be a rating factor (except to maybe get a sense at how proficient the doctor may be at his/her practice).

Home property insurance:
• Sum insured – key exposure measure linked with claim size
• Location – the perils a risk is exposed (and hence its claim costs) to will depend on its location. E.g. properties in Far North Queensland are more prone to cyclone/windstorm damage, while properties in Sydney are subject to hail and earthquake damage.
• Age of property – older properties would generally be prone to more damage to newer houses, but newer houses may be more costly to repair.
• Building material – how prone a property is to damage will depend on its construction materials. E.g. a weatherboard house would sustain more damage than a brick/concrete built house.
• Policy age – tend to find that newer policies tend to have worse claims experience, possibly due to bad risks constantly churning between insurers to get best price.
• Prior claims experience – this is a contentious rating factor (on a technical level anyway) I believe. Similar to how NCB status on motor insurance is generally found to be a non-significant factor in technical analysis, claims history does not appear as a significant predictor of claim costs. However most insurers include it as part of their target price calculations.

Consumer Credit Insurance:
• Length of the loan – The longer the loan length, the larger the exposure to risk
• Type of cover, whether it is a single cover or double cover
• Occupation of the insured – Some jobs are more prone to redundancy than others
• Age of the insured – Older people will have more chance to have accident
• Exposure measure is sum insured/loan amount

Workers’ Compensation:
• Occupation of Employees
• Wages Paid to Employees
• Industry of Employer
Certain industries may often be subjected to additional safety criteria (e.g. mining)
• Claims history of Employer
• Special rates for apprentices and non permanent workers

Extended warranty product:
• Type of products (e.g. washing machine, TV, fridge)
both claim frequency and repair cost would vary by different type of product
• Cost of goods
key exposure measure links to the repair cost, hence claim size
• Manufacturer
likely to impact the claim frequency, as some brands are more reliable then others even after their original warranty
• Length of original warranty
linked to exposure measure, as don’t need to cover for the period of the original warranty
• Domestic/ imported good
likely to impact the repair cost, as there might be no part to replace for imported good
• Location
linked to the cost of transport to the repair centre

Boat Insurance:
• Age of Boat. Newer boats attract a higher premium, while older boats attract a lower premium. The repair costs for newer boats are higher in general.
• Boat Value. The higher the boat’s value at the commencement of the policy, the higher the premium due to our increased exposure to risk.
• Type of boat. Small powerboats or sailing boats attract lower premiums than high speed powerboats or yachts.
• Hull construction material. Boats constructed of fibreglass tend to attract lower premiums than boats constructed of timber.
• Optional covers (eg. Waters Skiers Liability, Racing Cover, Additional Boat Contents Cover). The more optional covers you choose the higher your premium will be.
• Level of basic excess. If you choose a higher basic excess this will attract a lower premium, due to a lower claim cost retained by the insurer.
• Payment frequency. If you pay by the month your premium will be higher than if you chose to pay in one annual payment because insurer charges a monthly fee.

Lenders Mortgage Insurance (LMI):
• Region: different areas are subject to different property market forces, for example prices in Sydney continue to trend upwards, while those in Hobart have been going sideways.
• Type of property (i.e. free-standing house, apartment, etc) and its value
• Loan to valuation ratio: the more that is being borrowed the higher the risk
• Loan term: shorter term loans are riskier due to higher monthly repayments
• Rating variables using the borrower’s information include:
• Credit score
• Employment history, for example, if the borrower is self-employed or have had unexplained periods out of the workforce they’de be considered higher risk
• Income and details on any existing loans
• Whether they’re a first home buyer or not

Business insurance (SME):
• Location for each of the business(e.g. franchise)
• Then for each of the business:
• Liability sum insured (there is usually a minimum sum insured requirement)
• Building sum insured
• Stock & content sum insured which may contain regular stock and seasonal stocks
• Turnover
• Occupation
• Number of employees

Business Interruption:
• Business type – different businesses have different suppliers and may be more susceptible to disruption and thus have differing claim frequencies;
• How long the business has been running – more established businesses may have contingency plans in place which may reduce the frequency of claims;
• Annual gross revenue – the greater the revenue, the larger the average claim size;
• Number of employees – indicator of the size of the business where a greater number of employees suggests a larger business and a greater than average claim size;
• Past claims history – businesses which have had claims in the past may be more likely to claim in the future.

Sound Rating

A sound premium is the amount required to return an appropriate profit after allowing for claims, expenses and earnings from investments.

Sound premium combines:
– the pure risk premium (or risk cost)
– expense loading
– profit loading

A basic formulaic approach to sound premium can be written as follows:

       Discounted Risk Premium * (1 + Claim Expense Rate) * (1 + Profit Loading)
      ————————————————————————————————————————
       1 – Commission Rate – Net Reinsurance Cost – Underwriting Expense Rate

Expense loadings:
– Underwriting expenses
    commissions, sales & marketing, selection, policy administration
– Policy alteration
    administrative details, risks covered, terms of cover, cancellations, lapses
– Claim handling
– Reinsurance
– Government charges
– General overheads

Profit loading:
Loading required to meet required RORBC. Capital required is the amount of capital held from the time a risk comes on the book to the time it fully expires. It can be calculated on the basis of the difference between the present value of notional transfers at the earned interest rate and the required rate of return.

Pricing Methods

There are four main approaches to pricing insurance products:
– Market rate pricing
– Target pricing
– Cost-plus pricing
– Demand-adjusted pricing

Additional methods include:
– Reinsurance driven pricing
– Sound rating

Insurance market deregulation: Pricing

Insurance is one of those industries that tend to be heavily constrained by regulation in most jurisdictions. Certain classes such as CTP and Workers Compensation tend to have more than others. The four key areas that are impacted by regulations include:

  • Product coverage
  • Premium setting
  • Distribution
  • Licensing requirements

Insurance market deregulation can result in a lot of benefits to the market as a whole. Although as with any major change there are going to be negative effects as well. I’ve listed a few of these below from the view points of the consumer and the insurer.

 

Consumer Insurer
Advantages –   More product choices

–   Risk based pricing

–   Increased access to insurance

–   Lower premium due to less legal requirements for Insurer

 

–   Ability to compete on product offering

–   Differentiate risks

–   More avenues of distribution

–   Lower requirements – reducing capital/compliance costs

Disadvantages –   Products harder to compare

–   Less cross subsidization

–   Insurers may pass on distribution costs

–   Higher insolvency risk

–   Cost of product development

–   Cost of pricing and technology

–   Cost of distribution

–   Increased competition

 

The common regulated pricing structures include:

–          Reference Premium Rates

–          Elastic caps and floors

–          Restrictions on rating variables

–          Fixed loading structure