[[Actuarial Notes Wiki|Wiki]] / [[Exam 5 (CAS)]] / **Four Principles of Ratemaking** ## Definition ==Four Principles of Ratemaking== The Four Principles of Ratemaking are fundamental guidelines established by the Casualty Actuarial Society for developing insurance rates that are actuarially sound and equitable. ## The Four Principles ### 1. A rate is an estimate of the expected value of future costs **Key Points:** - Rates are prospective (forward-looking) - Based on probabilistic estimates - Include all costs: losses, expenses, profit - Reflect uncertainty and variability **Application:** - Use statistical methods - Consider loss development - Apply appropriate trends - Include risk load for uncertainty ### 2. A rate provides for all costs associated with the transfer of risk **Components to Include:** - **Losses** - Expected claim payments - **Loss Adjustment Expenses (LAE)** - ALAE and ULAE - **Underwriting Expenses** - Acquisition and general expenses - **Profit and Contingencies** - Return on capital, risk margin - **Premium Taxes and Fees** - Regulatory assessments **Formula:** ``` Rate = (Losses + LAE) / (1 - UW Expenses - Profit - Taxes) ``` ### 3. A rate provides for the costs associated with an individual risk transfer **Risk Classification:** - Rates should reflect individual risk characteristics - Group similar risks together (homogeneity) - Differentiate when actuarially justified - Balance equity and practicality **Considerations:** - Statistical significance - Operational feasibility - Regulatory constraints - Social acceptability ### 4. A rate is reasonable and not excessive, inadequate, or unfairly discriminatory **Reasonableness Tests:** **Not Excessive:** - Returns reasonable profit - Competitive with market - Justified by costs - Not exploitative **Not Inadequate:** - Covers expected costs - Maintains solvency - Sustainable long-term - Protects policyholders **Not Unfairly Discriminatory:** - Reflects actual differences in risk - Based on objective criteria - Statistically supported - Applied consistently ## Application in Practice ### Rate Review Process 1. Estimate expected costs (Principle 1) 2. Include all cost components (Principle 2) 3. Develop classification structure (Principle 3) 4. Ensure reasonableness (Principle 4) ### Regulatory Compliance Most states require rates to be: - Adequate (not inadequate) - Not excessive - Not unfairly discriminatory These directly correspond to Principle 4. ### Documentation Rate filings should demonstrate: - Methods used (Principle 1) - Cost allocations (Principle 2) - Classification rationale (Principle 3) - Reasonableness testing (Principle 4) ## Examples ### Principle 1 Application ``` Developing auto liability rates: - Project future losses from historical data - Develop to ultimate - Trend to rating period - Account for uncertainty ``` ### Principle 2 Application ``` Premium calculation includes: Pure Premium: $250 (losses + LAE) Variable expenses: 20% Fixed expenses: 10% Profit & contingency: 5% Rate = $250 / (1 - 0.20 - 0.10 - 0.05) = $250 / 0.65 = $385 per exposure ``` ### Principle 3 Application ``` Auto insurance territories: - Urban high-density: Higher rate (more accidents) - Rural low-density: Lower rate (fewer accidents) - Suburban: Medium rate Each reflects actual risk differences ``` ### Principle 4 Application ``` Testing reasonableness: - Compare to industry benchmarks - Verify profit margin is competitive - Check for anti-selection - Ensure sufficient solvency margin ``` ## Conflicts and Trade-offs ### Precision vs. Practicality - More classes = more precise (Principle 3) - But may reduce credibility (Principle 1) - Balance needed ### Cost Recovery vs. Competitiveness - Full cost recovery (Principle 2) - But must remain competitive (Principle 4) - Market considerations apply ### Individual Equity vs. Social Goals - Actuarial fairness (Principles 3, 4) - But societal concerns - Regulatory intervention may occur ## Related Concepts - [[Rate Adequacy]] - [[Rate Equity]] - [[Rate Not Excessive]] - [[Rate Not Unfairly Discriminatory]] - [[Classification Ratemaking]] - [[Homogeneity]] ## References - CAS Statement of Principles Regarding Property and Casualty Insurance Ratemaking (1988) - Werner & Modlin, Chapter 1 - ASOP 12 (Risk Classification)