Congratulations; you have just been asked to serve as a board member for a captive insurance company or a risk retention group. While you may well be an expert in your chosen profession, serving as a board member for an insurance company, even a captive insurer or risk retention group, requires you to exercise your fiduciary responsibility to ensure the captive is financially sound. The following article, third in the series, is intended to provide board members with a basic grounding in the pricing of coverage. (See the first article in the series, "Key Concepts for New Captive Board Members," and the second, "Basics of Loss Development Triangles." )
Obviously, the insurance pricing fundamentals discussed below are only a starting point, and, like all good directors, you should seek to continue your education in insurance as you grow into your role.
Insurance differs from most businesses in that the price set for the product being delivered cannot be known in advance. For insurance companies, it will take months or even years to know for sure whether the price of the coverage sold was adequate to cover the costs associated with the product. In our article on loss development triangles, we followed how expenses associated with claims change or "develop" over time. Pricing, which may appear reasonable at one point in time, may look entirely inadequate at a later date. Insurance pricing then is based on predictions and not the actual cost of the product. Also, unlike most other businesses, insurance pricing is subject to regulatory constraints.
Insurance pricing or rate making is the art/science behind determining how to develop the correct premium/price to charge for the insurance being offered. To better understand this concept, it is important to define some key terms, as follows.
- Rate is the price per unit of insurance.
- Exposure unit is the unit of measurement used in insurance pricing and will vary by line of coverage. For most captives, these units will typically be $100 per unit of property coverage and $1,000 per unit of liability coverage.
- Pure premium is the portion of the rate calculated to fully pay the cost of losses and loss adjustment expenses.
- Loading is the amount above the pure premium that is added to cover expenses, a risk margin (or contingency amount in case the pure premium estimate is wrong), and a profit margin.
- Gross rate is the price per unit, including the loading costs.
- Gross premium is the gross rate times the number of exposure units.
Rate making must also satisfy two different constituencies as we noted above—regulatory authorities and policyholders. From a regulatory perspective, rates need to be adequate, not excessive, and also not considered to be discriminatory. From a policyholder perspective, rates should be simple to understand, stable over time, promote good risk behavior, and adaptive to changes in the environment.
The primary purpose of rate making is to determine the lowest premium that meets all of the objectives outlined above. Captive insurers rely on their actuaries to design and implement the rate-making model(s) used to set rates and determine premiums. These techniques will vary by line of business and due to regulatory constraints and data limitations. However, the basic goal is to reliably predict future losses, so the captive insurer sets pricing according to the inherent risk associated with the coverage and policyholder.
Actuaries rely on data to develop rate models, and for captive insurers, data can be problematic. The quality of the rate will be entirely dependent on the quantity and quality of the data that goes into the model. Most captives do not have either sufficient historical data or a large enough universe of data to allow the actuary to develop rates.
Board members need to understand where the data is coming from to populate the rate model for the captive. If the historical industry data being used is not indicative of the actual losses the captive is looking to insure against, the rates will not be set correctly. More likely than not, the actuaries will use more conservative data to ensure rates are adequate. However, especially when market conditions are soft, the rates may not be competitive, and captive policyholders will seek competing commercial quotes. While it is not important for a board member to understand the intricacies of the actual rate model, he or she should at least understand the basic inputs being used.
Rates for property and casualty insurance are determined by a class rating or an individual rating. Individual rating includes judgment rating and merit rating. Merit rating can be further subdivided into schedule rating, experience rating, and retrospective rating. Individual rates depend on the individual, whereas class rates depend on the underwriting class of the insured. It is beyond the scope of this article to cover all of these rate-making methods in detail. Below, we provide a basic synopsis so you as a board member can ask which method or methods are being used in your own captive. (For those looking for a deep dive into rate making, Basic Ratemaking, a paper published by the Casualty Actuarial Society, is recommended.)
- Class rating means exposures with similar characteristics are placed in the same category and charged the same rate. The rate reflects the average loss experience for the class as a whole. Class rating is used when factors causing losses are well known, and there are reliable analytics for predicting future losses. Class rating is used frequently by group captives.
- Individual rating, otherwise known as judgment rating, is where each exposure is individually evaluated and the rate is determined largely by the underwriter's judgment. Individual rating is used when potential losses are varied and cannot easily be quantified.
- Merit rating is based on a class rating methodology; however, the class rate is then adjusted for each individual policyholder. Merit rating is used where the factors that impact the class are more diverse and therefore likely to lead to a greater deviation from the average loss developed for the class itself.
Read the fourth article in this series: "Captive Insurance Assets and Investment Policies."
- Schedule rating uses the class rate as a starting point, and then the rate is adjusted using debits and credits according to specific details of the loss exposure.
- Experience rating uses the actual losses in previous policy periods—typically 3, 5, or 10 years—to determine the premium for the current year.
- Retrospective rating adjusts the premium charged at the beginning of the policy period retroactively based on the actual losses incurred during the period. Typically, there is a minimum and maximum retro premium amount agreed to at the beginning of the policy period.