Insurer Pricing

• Insurance rates, like other prices, are a

function of costs.
• In insurance, unlike other industries, the
costs are not known when the product is
sold.
• Insurance prices are based on predictions.
• A second important difference between
pricing in insurance and pricing in other
fields is that insurance rates are subject to
government control.
11-1
 Basic Concepts in Ratemaking

Rate Price charged per unit of

protection
Premium Rate multiplied by the number of
units of protection purchased
Gross Rate Composed of two parts, designed
to pay losses and expenses
Pure Premium Portion of the Gross Rate
designed to pay losses
Loading Portion of Gross Rate designed
to cover expenses of operation
11-2
 Pure Premium

Total Losses
= Pure Premium
Exposure Units

$3,000,000
= $30
100,000

11-3
Converting Pure Premium to Gross Rate

Expense part of the rate

Expense Ratio: expressed as percentage
of the final rate
Permissible
Loss Ratio: 1 minus expense ratio
Pure Premium
Gross Rate: 1 _ expense ratio

$ 30 =
30
= $50
1 - .40 .60
11-4
 Advisory Organizations

1. Formerly called “rating bureaus”

2. Operate in property and liability field
3. Gather loss statistics and publish trended
loss costs
4. Major Advisory Organizations include
ISO Insurance Services Office
AAIS American Association of Insurance
Services
NCCI National Council on Compensation
Insurance
11-5
 Types of Rates

1. Class rates

2. Individual rates
• judgment rating
• schedule rating
• experience rating
• retrospective rating

11-6
 Adjusting the Level of Rates

Actual - Expected
Loss Ratio_____Loss Ratio X
Credibility
=
Expected Loss Ratio Factor
Adjustment

.90 - .60
X .50 = +.25
.60
11-7
 Underwriting

1. Basic purpose: avoid adverse selection

2. Relationship of underwriting to adequacy

of rates

3. Exposure that is unacceptable at one rate

may be acceptable at another

11-8
Sources of Underwriting Information

1. The application

2. Information from the agent or broker

3. Investigations

4. Information bureaus

5. Physical examinations or inspections

11-9
 Postselection Underwriting

1. Postselection underwriting (or renewal

underwriting) occurs when the insurer
decides whether to continue insurance.
2. Insurer may decline to renew insurance or
may offer narrower coverage.
3. Some states limit the insurer’s right to
exercise these options.
4. When the option of postselection
underwriting is limited, insurers may be
more selective in initial underwriting.
11-10
 Competition in the Insurance Industry

Competition within insurance industry is

intense. The competition occurs in two
areas:

1. Price

2. Quality

11-11
 Price Competition

1. Price competition occurs primarily at the

company level, where prices are set.

2. Agents compete on basis of price in

selecting the companies they will represent.

3. Price of insurance is a function of costs.

4. To the extent an insurer can reduce its costs

below those of competitors, it can offer a
lower priced product.

11-12
 Costs Common to All Insurers

1. Losses and loss adjustment expense

2. Acquisition expense

3. Administrative expense (company

overhead)

4. Taxes

5. Profit and contingencies

11-13
 Product (Quality) Competition

1. Insurers compete on basis of quality by

offering broader forms of coverage and
prompt claim service.

2. Most quality competition occurs at the

agency level where the level of service can
differ significantly.

3. Service provided by the agent consists

principally of advice on coverages,
companies, costs, and claims.
11-14
 Insurance Shortages

• As in any competitive market, periodic

imbalances arise between the demand for
insurance and its supply.

• As a consequence, there are occasional

shortages of insurance, which are referred
to as “availability problems.”

11-15
 Insurance Shortages

Insurance shortages or availability problems

arise for three reasons.
• The absolute supply of insurance is limited.
• Some lines of insurance are unprofitable.
• The insurance market is highly cyclical.

11-16
 Insurance Shortages

Absolute Limits in the amount of insurance

• Insurers are limited in the aggregate amount
of insurance they may write by regulations
that dictate the relationship between
premiums written and insurers' surplus.
• An underwriter who must accept some risks
and reject others will accept those that have
the greatest likelihood of yielding a profit.

11-17
 Insurance Shortages

Unprofitability of some lines of insurance.

• Availability problems arise when the price
at which insurance may be sold is less
than the costs incurred by selling it.
• There are some lines of insurance that are
demonstrably unprofitable for insurers.
This usually occurs in markets where rates
are rigidly regulated but it can also arise
from the intensive competition.

11-18
 Insurance Shortages

Cyclical Nature of the Market

• the cyclical nature of the insurance industry
creates periodic shortages of insurance.
• The insurance cycle results in changes in
insurers' surplus and profit. When surplus
falls, the supply of insurance is reduced and
insurers become more restrictive in their
underwriting, limiting availability.

11-19
 The Insurance Cycle

• The property and liability industry is highly

cyclical, and goes through periods of
underwriting profit, followed by periods of
losses.

• The insurance market is characterized as

“hard” or “soft,” depending on the phase
of the cycle.

11-20
 The “Soft” Market

• During periods when insurers are earning

underwriting profits, the market is said to
be “soft,” as insurers engage in price
cutting to increase their market share.

• The price cutting includes not only

reduction in the absolute level of rates, but
the loosening of underwriting standards.

11-21
 The “Hard” Market

• This has the natural result of generating

losses and reducing surplus.
• The reduction in surplus and decline in
profitability results in a “hard” market,
during which insurers increase prices and
tighten underwriting standards.
• Insurance becomes more expensive and
more difficult to obtain.

11-22
 Responsibility for the Cycle

• The suggestion that the underwriting cycle

results from mismanagement in the
insurance industry ignores the fact that in a
competitive market, competitors do not set
the market price.
• Insurers cut prices not because they want
to, but because they are required to by the
pressure of market forces. Often, these
pressures stem from forces outside the
industry itself

11-23
 Cash-Flow Underwriting

• Dependence on premiums for investable

funds led to phenomenon called cash-flow
underwriting.

• In cash-flow underwriting, insurers price

insurance to compete for investable funds.

• Cash-flow underwriting is a form of

leveraged investment that has benefited
insurers.

11-24
 Access to the Insurance Market

Risk managers who decide to transfer part of the

organization’s risks to a commercial insurer will
generally access the insurance market through an
insurance agent or broker.
1. Most states require that insurance be placed
through a licensed agent or broker.
2. Even if this requirement did not exist, risk
managers would still access insurers through
agents or brokers to access the market
knowledge of the agency or brokerage firm.

11-25
 Selecting an Agent or Broker

• It is easy to inventory the characteristics

one should look for in an agent or broker.

• It is more difficult to guarantee that the

agent or broker selected will have these
characteristics.

11-26
 Selecting an Agent or Broker

Desirable Characteristics
• The most important qualities an agency or
brokerage firm can offer are a competent
staff and access to insurance markets.
• In many cases, the selection is made on the
basis of the agency’s reputation.
• A prudent buyer will investigate the agent’s
or broker’s qualifications before making a
commitment. One logical step is to ask for
references.
11-27
 Selecting an Agent or Broker

• The main service the agency or broker can

provide is technical competence and advice.
• Given the importance of technical
competence and knowledge, many buyers
focus on the education and training of the
agency’s staff.
• Professional designations as CPCU, CLU, or
ARM.

11-28
 Selecting an Agent or Broker

• Another indicator of the agency’s technical

competence is the types of accounts that the
agency currently handles.
• An agency with many large accounts is more
likely to have the technical expertise, market
channels, and services that are required to
provide the level of service required.
• Another consideration is familiarity of the
agency staff with the buyer’s particular
industry.

11-29
 The Selection Process

• Usually, relationships between buyers and

agents or brokers develop over time and
continue uninterrupted as long as both
parties are satisfied with the arrangement.
• Some firms solicit bids for their insurance
and select the agent as a byproduct in the
selection of the insurance.
• Most authorities suggest that the selection of
the agent or broker is sufficiently important
to warrant separate consideration.
11-30
 Compensating the Agent or Broker

• Traditionally, virtually all compensation to

agents and brokers was in the form of the
commission payable by the insurer.

• This was logical, since the agent or broker

was viewed primarily as a salesperson for
the insurer, and like other sales personnel
was compensated on the basis of
performance.

11-31
 The Selection Process

• One approach to selecting an agent or

broker is a “beauty contest,” in which a
number of agencies and brokers are invited
to make proposals to the organization.
• In some cases, the bidders are asked to
submit an insurance program. In other
cases, the focus in on the selection of the
intermediary, and the structure of the
program is addressed separately, after the
agent or broker has been selected.

11-32
 Fees Versus Commissions

• Buyers argued that the commission system

was flawed for several reasons.
• Under the commission system, the agent’s
compensation varies with the insured’s
hazard, not with the work that is required of
the agency.
• Dissatisfaction with the commission system
and changes in the rate regulation led first, to
negotiated commissions, and then to a fee
system for some larger accounts.
11-33
 Fees Versus Commissions

• While fixed commissions remain the rule on

small accounts, for larger accounts fixed
commissions are the exception rather than
the rule.

• For very large accounts, the insurer may

quote coverage on a net basis, without an
allowance for the agent’s commission. The
agent then negotiates directly with the
client, usually for a fixed annual fee for
handling the account.
11-34
 The Excess and Surplus Lines Market

• Under certain specified conditions defined

by state instance laws, nonadmitted
insurers are allowed to write insurance in a
state where they are not licensed.

• When a buyer cannot obtain needed

coverage from a licensed insurer, such
coverage may be placed in the
nonadmitted market under laws relating to
Excess and Surplus Line Laws.

11-35
 The Excess and Surplus Lines Market

• Coverage may be placed only with

nonadmitted insurers approved by the state
(or not “black-listed.”),

• All states require the payment of an excess

and surplus lines tax, which is collected by
the agent and paid to the state.
• Agents must usually hold a special “excess
and surplus lines license” to place business
in nonadmitted insurers.
11-36
 Access to the Non-Admitted Market

The non-admitted market abroad can be

approached in several ways.
• A buyer can go directly to a London broker
or a non-admitted insurer and buy coverage.
• The insurance may be placed with any agent
or broker holding an E&S license.
• Insurance may be placed with a managing
general agent (MGA), who acts as a
wholesaler in the E&S market.

11-37
 Access to the Non-Admitted Market

• Normally, a buyer accesses the E&S market

through an agent that is specifically licensed
to place business in the E&S market.
• An excess and surplus lines license is
required for placement in the nonadmitted
market.
• Specialty agents and brokers known as
managing general agents (MGA) serve as
wholesalers for the E&S market.

11-38
 Consent to Rate Laws

• One reason nonadmitted insurers are willing

to write business that admitted insurers
reject is that the nonadmitted insurers’ rates
are not subject to filing and approval.
• To create equity, many states have enacted
“consent to rate laws,” under which an
admitted insurer can charge a higher rate
than the filed rate at the request of the
insured.

11-39
 Selecting the Insurer

• The insured may receive assistance from the

agent in selecting an insurer if the agent
represents several companies.
• In choosing an insurer, the major
consideration should be financial stability.
• In addition, the company’s product line and
ancillary services (claims, loss
prevention)are important.
• Finally, cost is a consideration.

11-40
 Insurer Rating Services

• Alfred M. Best Company

• Standard and Poor's Corporation
• Moody's Investors Service, Inc.
• Duff & Phelps/MCM Investment Research
Company
• Weiss Ratings, Inc.

11-41
 Insurer Rating Services

• Each of the rating services uses a slightly

different classification system, and the
categories have slightly different
designations.

• All rating services, however, distinguish

between insurers whose financial
condition is deemed adequate and those
insurers that are classified as vulnerable
or weak.

11-42
 Insurer Rating Services

• When properly used, the ratings assigned

by rating services can be effective tools
for avoiding delinquent insurance
companies.
• The ratings should be checked for a period
of years.
• If there has been a downward trend in the
rating, further investigation into the cause
of the change is warranted.

11-43
 Competitive Price Quotations

• Usually, the agent or broker who handles an

account will shop the market and obtain
quotes from insurers the agency represents.
• Occasionally, a buyer wants to seek bids more
widely, either for a particular line of insurance
or for its entire account.
• Obtaining bids is a reasonable way of
fostering price competition among insurance
agencies, but attempting to obtain bids
whenever a policy comes up for renewal is
impractical.

11-44
 Competitive Price Quotations

• A company that requests bids annually is

likely to find that after the first few years,
few insurers are willing to prepare serious
proposals.

• As a general rule, requests for bids should

not be undertaken more often that every
three to five years.

11-45
 Approaches to the Bidding Process

Two basic approaches in a bidding process.

• Selected agencies are asked to propose a
program, and are given flexibility in the
design of coverages they recommend.
• Under the second approach, the agencies
are asked to quote a specific package of
coverage, in which the coverage
specifications are tightly defined.

11-46
 Agent of Record Letter

• Insurers decided long ago that they did not

want to be put in the middle of two of their
agents, both of which want to bid on a
particular account.
• To eliminate the dilemma they might face in
choosing one of their agents over another,
insurers devised the Agent Letter of Record,
a letter from a prospective buyer instructing
an insurer to recognize a particular agent as
its agent “of record.”

11-47
 Agent of Record Letter

Once a particular agent has been so

designated, the insurer will not entertain
applications for the account from other
agencies unless and until the insurance
buyer has changed the agent of record.

11-48
 Agent of Record Letter

• In a bidding process, the organization

seeking bids must name each of the bidders
through an agent of record letter for the
insurers they propose to use.

• Usually, each agent or broker submits a list

of insurers he or she plans to use, listed in
order of preference. The risk manager then
gives letters of authorization to each broker
for those companies he or she appears best
able to represent.
11-49