CHAPTER 4

Rating and
ratemaking
Ratemaking The pricing of insurance and the calculation of
insurance premium
Rate The price per unit of insurance
Exposure unit The unit of measurement used in insurance
pricing
Actuary The person who determines rates and
premiums
Underwriting The process of selecting,classifying and pricing
applications.
Underwriter The person who decides to accept or reject an
application
Statement of *An insurer must establish an underwriting
underwriting policy policy that is consistent with company
objective
*The line underwriters are the persons who
make daily decisions concerning the
acceptance or rejection of business.
*The purpose of underwriting standards is to
reduce adverse selection against the insurer.
Basic underwriting
principles
Attain an - To produce a profitable book of business.
underwriting profit - The underwriter constantly strives to select
cretain types of applicants and to reject others
so as to obtain a profitable book of business.
Select prospective - Reduce adverse selection against the insurer - A property insurer may
insureds accprding -Adverse selection is the tendency of people wish to insure only high
to the company’s with a higher-than-average chance of loss to grade factories and
underwriting seek insurance at standard rates. If not expects that its actual loss
standard controlled by underwriting, this will result in experience will be well
higher-than-expected loss levels. below average
 Provide equity One group of policyholders should not unduly -A group of 20-year-old
among the subsidize another group persons and a group of
policyholders 80-year old persons
should not pay the same
premium rate for
individual life insurance.
Steps in - Agent as first underwriter. -E.g. in auto insurance, an
underwriting -This step is also known as field underwriting. agent may be told not to
-The agent is told of what types of applicants solicit applicants that are
are acceptable, borderline or prohibited. risk driver.
Sources of The underwriter requires certain information in
underwriting deciding whether to accept or reject an
information applicant for insurance
Application The type of information required depends on
the type of insurance requested.
Agent’s report Many insurer require the agent or broker to
give evaluation of the prospective insured.
Inspection report In property insurance, the company may
require an inspection report by some outside
agency especially if the underwriter suspects
moral hazard.
Physical inspection In property and casualty insurance, the
underwriter may require a physical inspection
before the application is approved
Physical In property and casualty insurance, the
examination underwriter may require a physical inspection
before the application is approved
Making an (i) Accept the application and recommend
underwriting that the policy be issued
application (ii) Accept the application subject to
restrictions or modifications
(iii) Reject the application
-Many insurers now use computerized
underwriting for certain personal lines of
insurance that can be standardized.
Other underwriting Other factors when underwriting
considerations
Rate adequacy and Property and casualty insurers are more willing
underwriting to underwrite new business for a specific line if
rates are considered adequate.
 Reinsurance and Availability of reinsurance may result in more
underwriting liberal underwriting
Renewal In life insurance,policies are not canceallable.
underwriting
Production The sales and marketing activities of insurers
Producers Agents who sell insurance
Agency department -Life insurers have an agency or sales
department
-Property and casualty insurers have marketing
departments.
Professionalism in -The modern agent should be a competent
selling professional who has a high degree of
technical knowledge in a particular area of
insurance and who also places the needs of his
or her clients first.
-The professional agent identifies potential
insured, analyzes their insurance needs.
Claims settlement
Basic objectives in -Verification of a covered loss
claims settlement -Fair and prompt payment of claims
-Personal asistance to the insured
 Verification Verify that a covered loss has occurred.This
of a covered step involves determining whether a specific
loss person or property is covered under the policy
and the extent of coverage.
 Fair and -If a valid claim is denied,the fundamental Some unfair claim
prompt social and contractual purpose of protecting practices probihited by
payment of the insured is defeated laws:
claims -Fair payment means that the insurer should i)Refusing to pay claims
avoid excessive claim settlement and should without conducting a
resist the payment of fraudulent claims bcs this reasonable investigation
will result in higher premiums. ii)Not attempting to
provide prompt, fair, and
equitable settlements
iii)Offering lower
settlements to compel
insureds to institute
lawsuits to recover
amounts due
  Personal Aside from any contractual obligations,the
asistance to insurer should also provide personal assistance
the insured after a loss occurs.
Claims adjustors The person who adjusts a claim.
 Insurance Often has authority to settle small first-party
agent claims up to some limit
 Company Is usually a salaried employee who will
adjustor investigate a claim, determine the amount of
loss, and arrange for payment.
 Independent Is an organization or individual that adjusts
adjustor claims for a fee
 Public Represents the insured and is paid a fee based
adjustor on the amount of the claim settlement
Steps in settlement
of a claim
Notice of loss must Notify the insurer of a loss.The notice must -Eg:- the homeowners
be given also include the name and addresses of any policy requires the
injured persons and of witnesses insured to give
immediate notice.
Investigation of the After notice is received,an adjustor must
claim determine that a covered loss has occurred
and must also determine the amount of the
loss.
Filling a proof of An adjustor may require a proof of loss before
loss the claim is paid.

Decision The adjustor must make a decision concerning

concerning payment
payment
Reinsurance An arrangement by which the primary insurer
that initially writes the insurance transfers to
another insurer (reinsurer) part of all of the
potential losses associated with such insurance.
Ceding company The primary insurer that initially writes the
insurance.
Reinsurer The insurer that accepts part or all of the
insurance from the ceding company.
Retention limit or The amount of insurance retained by the
net retention ceding company for its own account.
 Cession The amount of insurance ceded to the
reinsurer.
Retrocession The reinsuer in turn may reinsure part or all of
the risk with another insurer.
Retrocessionaire The second reinsurer.
Reasons for
reinsurance
Increase -Used to increase the insurance company’s
underwriting underwriting capacity to write new business
capacity -Without reinsurance , the agent would have to
place large amounts of insurance with several
companies or not accept the risk.
Stabilize profits -An insurer may wish to avoid large
fluctuations in annual financial results.
-Can be used to stabilize the effect of poor loss
experience
Reduce the Unearned premium reserve is the fund that
unearned premium contains the portion of the premium that has
reserve been paid in advance for insurance that has
not yet been provided
Provide protection Reinsurance can provide considerable
against protection to the ceding company that
catastrophic loss experiences a catastrophic loss.
Type of reinsurance -Facultative reinsurance
-Treaty reinsurance
Facultative -An optional case-by-case method that is used Advantage :
reinsurance when the ceding company receives an -it can be tailored to fit
application for insurance that exceeds its any type of case
retention limit. -It can increase the
-The primary insurer is under no obligation to capacity of the primary
cede insurance and vice versa. insurer to write large
amounts of insurance.
-It can help stabilize the
financial operations of
the primary insurer by
shifting part of a large
loss to the reinsurer.
Disadvantages :
-the primary insurer does
not know in advance
 whether a reinsurer will
accept any part of the
insurance.
Treaty reinsurance -The primary insurer has agreed to cede Advantages :
insurance to the reinsurer and the reinsurer has - it is automatic
agreed to accept the business -no uncertainty or delay
-All business that falls within the scope of the is involved
agreement is automatically reinsured Disadvantages :
according to the terms of treaty. -unprofitable to the
reinsurer
-the premium received by
the reinsurer may be
inadequate

Methods for 2 basic method:

sharing losses (1)Pro-rata:- The ceding company and
reinsurer agree to share losses and premiums
based on some proportion
(2)Excess-of-loss:- The reinsurer pays only
when covered losses exceed a certain level.
Quota-share treaty -The ceding company and reinsurer agree to Advantage:
share premiums and losses based on some The primary insurer’s
proportion. premium reserve is
-The ceding company’s is stated as a percentage reduced
rather than as a dollar amount Disadvantage:
A large share of
potentially profitable
business is ceded to the
reinsurer.
Surplus-share The reinsurer agrees to accept insurance in Advantage:
treaty excess of the ceding insurer’s retention limit,up The primary insurer’s
to some maximum amount underwriting capacity on
-The retention limit is refered to as a line and is any single exposure is
stated in a dollar amount. increased.
-Each party pays its respective share of any Disadvantage:
loss regardless of its size. The increase in
administrative expenses.
Excess-of-loss -Designed largely for protection against a Can be written to cover:
Reinsurance catasthrophic loss 1)A single exposure
 -The reinsurer pays part or all of the loss 2)A single occurrence of
exceeds the ceding company’s retention limit catasthrophic loss
up to some maximum level 3)Excess losses when the
primary insurer’s
cumulative losses exceed
a certain amount.
Reinsurance pool An organization of insurers that underwrites Pools work in 2 ways:
insurance on a joint basis i)Each pool member
-A single insurer simply cannot cover a large agrees to pay a certain
amount of insurance but insurers as a group percentage of every loss
can combine their financial resources to obtain ii)Each pool member pays
the necessary capacity. for its share of losses
below a certain amount
Alternative to
traditional
reinsurance
Securitization of An insurable risk is transferred to the capital
risk markets through the creation of a financial
instrument, such as a catastrophe bond or
futures contract,options contract or other
financial instrument.
Catastrophe bonds Corporate bonds that permit the issuer of the
bond to skip or reduce the interest payments if
a catastrophic loss occurs
Investments The investment function is extremely important
in the overall operations of insurance
companies because premiums are paid in
advance,the can be invested until needed to
pay claims and expenses.