Rate making

Key takeaways

Rate making belongs to science; place it in that map before memorising details.
Learn the definition first, then one example that makes the definition concrete.
Connect Rate making to a quantity you can measure, compute or draw — that is where exam questions come from.
Reproduce the core statement of Rate making from memory before moving on to harder problems.

Reference excerpt

Rate making, or insurance pricing, is the determination of rates charged by insurance companies. The benefit of rate making is to ensure insurance companies are setting fair and adequate premiums given the competitive nature.

Fundamental rate-making definitions The following are fundamental terms that are commonly used in rate making. A rate "is the price per unit of insurance for each exposure unit, which is the unit of measurement used in insurance pricing". The exposure unit is used to establish insurance premiums by examining parallel groups. The pure premium "refers to that portion of that rate needed to pay losses and loss-adjustment expenses". The loading "refers to the amount of the premium necessary to cover other expenses, particularly sales expenses, and to allow for a profit". The gross rate "is the pure premium and the loading per exposure unit". Finally, the gross premium is the premium paid by the insured consisting of the gross rate multiplied by the number of exposure units.

Objectives in rate making Rate making has several objectives under regulatory requirements regulated by the states and business objectives due to the goal of profitability: The goal of insurance regulation is to protect the public and three regulatory objectives are placed to meet certain standards:

The first regulatory requirement is that rates must be adequate; meaning the rates the insurers charge should be able to cover expenses. The second regulatory requirement is that rates must not be excessive; meaning rates should not be so high that policyholders are paying more than the actual value of their protection. The third regulatory objective is the rates must not be unfairly discriminatory; meaning exposures that are similar with respect to losses and expenses should not be charged significantly different rates. The business objectives are set as a guide for insurers while designing the rating system. The rating system should meet each of the four objectives:

For producers to be able to quote premiums with a minimum amount of their time and expense, the rating system should be easy to understand. To maintain customer satisfaction, the rates should remain stable over short periods of time. The rapid change of rates could lead to customer dissatisfaction. To meet the objective of rate adequacy, the rates should be responsive over time in comparison with changing economic conditions and loss exposures. Finally, to reduce the frequency and severity of losses, the rating system should encourage loss control activities. Loss control is important in insurance because it tends to keep insurance affordable.

Rate making methods In property and casualty insurance, there are three basic rate-making methods:

Judgment Rating is used when the factors that determine potential losses are varied and cannot easily be quantified. There are no statistics regarding quantity of future losses and probability. This means an underwriter rates each exposure individually. The second rate making method is class rating, or manual rating. This rating means that exposures with similar characteristics are placed in the same underwriting class, and each is charged the same rate. The advantage of class rating lies with its easy application and ability to quickly be obtained. The third rate making method is merit rating. This rating means a plan which class rates, or manual rates are adjusted upward or downward based on individual loss experience. Merit rating is based on the assumption of loss experience will differ substantially from other loss experience

Rate making in life insurance Life insurance actuaries determine the probability of death in any given year, and based on this probability determine the expected value of the loss payment. These expected future payment are discounted back to the start of the coverage period and summed to determine the net single premium. The net single premium may be leveled to convert to installment premiums. A loading for expenses is added to determine the gross premium. With determining life expectancy, age is the most important factor, other significant factors are sex of the individual and smoking. Thus, an actuary can reasonably estimate the average age of death for a group of 25-year-old males, who don't smoke.

References

Worked examples

Example 1 — a first encounter with Rate making

Start with the simplest possible case. Write down what Rate making claims or describes in one sentence, then invent the smallest concrete situation in which that sentence is true. In science, the smallest case is usually a single object, a single equation or a single measurement. Check that every symbol or term in your sentence has a meaning in that case.

Example 2 — changing one variable

Take the situation from Example 1 and change exactly one quantity: double it, halve it, or set it to zero. Predict what should happen to Rate making before you calculate. Comparing your prediction with the result is the fastest way to find out whether you understand the idea or only the words.

Example 3 — an exam-style question

Typical questions about Rate making ask you to (a) state it precisely, (b) apply it to given data, and (c) explain a limitation. Practise writing all three answers in under five minutes; the third part is what separates a full-mark answer from an average one.

Applications of Rate making

In research: Rate making appears in science research whenever the underlying quantities have to be modelled precisely. Papers usually cite it as a starting assumption and then explore where it breaks down.
In technology and industry: Engineering practice reuses Rate making in design rules, simulations and safety margins. Knowing the idea lets you read a specification sheet and understand why the numbers look the way they do.
In the classroom: Rate making is common in secondary-school and first-year university syllabi. It links to neighbouring topics Actuarial science, Pricing, so understanding it makes those chapters shorter.
In everyday life: Look for Rate making outside the textbook — in sport, cooking, traffic, electronics or the sky above you. An example you found yourself is remembered far longer than one you were given.

How to study Rate making in 20 minutes

Read the reference excerpt below once, without taking notes.
Close the page and write down what Rate making means in your own words.
Compare your version with the excerpt and mark what you missed.
Work through the three examples above with pen and paper.
Explain Rate making out loud to somebody else — or to Teacher Smith in the lgStudy chat.

Frequently asked questions

What is Rate making in simple terms?

Rate making, or insurance pricing, is the determination of rates charged by insurance companies. The benefit of rate making is to ensure insurance companies are setting fair and adequate premiums given the competitive nature.

Why does Rate making matter?

Because it connects several science ideas at once: it gives you a definition you can apply, a quantity you can calculate, and a way to check whether a result is plausible.

How should I study Rate making?

Read the excerpt, restate it from memory, then work through the examples and applications listed on this page. The five-step study plan above takes about twenty minutes.

What does this page cover?

It gives you a compact reference excerpt plus original lgStudy explanations, examples, applications and study material on Rate making.