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Insurance companies use a variety of rate-making methods to determine the premiums charged for their products. One such method is the pure premium method, which calculates the pure premium by summing the losses and loss-adjusted expenses over a given period and dividing that by the number of exposure units. The loading charge is then added to the pure premium to determine the gross premium charged to the customer. The pure premium formula is calculated as follows: pure prem + fixed expenses per exposure unit 1 – (variable expense %) – (profit & contingencies %). This formula ensures that insurance companies set fair and adequate premiums, taking into account the competitive nature of the industry.
| Characteristics | Values |
|---|---|
| Pure premium calculation | Sum of losses and loss-adjusted expenses over a given period, divided by the number of exposure units |
| Pure premium | Part of the premium necessary to pay for losses and loss-related expenses |
| Loading | Part of the premium covering other expenses, especially sales expenses, and allowing for a profit |
| Gross rate | Pure premium plus loading per exposure unit |
| Gross premium | Premium charged to the insurance applicant, equals the gross rate multiplied by the number of exposure units to be insured |
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What You'll Learn
Pure premium
Mathematically, the pure premium formula can be expressed as:
For example, if the amount of loss impact due to crop failure risk is Rp 29,918.034, and there are 280 hectares of exposure units, the pure premium would be Rp 106,850.12 per hectare.
The pure premium method is one way to determine insurance rates. In this method, the pure premium is first calculated by summing the losses and loss-adjusted expenses over a given period and then dividing that sum by the number of exposure units. This calculation provides insight into the basic loss ratio, which represents the portion of the premium attributed solely to covering losses without considering additional expenses or profits.
The pure premium rate deviations reflect insurers' expectations of losses relative to the average of all insurers. It is important for insurers to accurately determine the pure premium to ensure they can cover claims while remaining competitive and financially stable.
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Gross rate
The gross rate in insurance is a crucial concept in rate-making, which is the process of determining insurance premiums. It is the sum of the pure premium and the loading per exposure unit. The pure premium, as determined by actuarial studies, covers losses and loss-related expenses, while the loading covers other expenses, especially sales expenses, and allows for a profit. The gross rate multiplied by the number of exposure units to be insured gives the gross premium, which is the premium charged to the insurance applicant.
Gross premium, also known as gross rate, is the total amount an insured individual pays for an insurance policy. It includes amounts to cover commissions for brokers, selling expenses, and other insurer expenses. Insurance companies rely on gross premiums to understand their revenue generation from policies, and it is often the basis for taxation. Gross premiums are adjusted upwards to account for various expenses and can be calculated using different rate-making methods.
Rate-making in insurance involves setting premiums based on risk assessment and other factors. There are two primary rate-making systems: the manual or class-rating method and the individual or merit-rating method. The former applies uniformly to predetermined classes based on factors like age or residence, while the latter recognises individual characteristics. The pure premium method, a variation of rate-making, calculates the pure premium by summing losses and loss-adjusted expenses over a period and dividing by exposure units, before adding a loading charge to determine the gross premium.
Retrospective rating, or retro plans, use actual loss experience to determine premiums within a set range. A portion is paid initially, and the remaining retrospective premium is paid at the end of the period, factoring in actual losses. This method is often used for burglary insurance, where past losses may not indicate future trends. Rating bureaus are also used to calculate rates based on industry-wide experience, ensuring fairness and adequacy.
In conclusion, the gross rate in insurance is a fundamental concept in rate-making, encompassing the pure premium and loading per exposure unit. The gross premium, or gross rate, is the total amount paid by the insured and is pivotal for insurers in understanding revenue and taxation. Rate-making methods, such as pure premium and retrospective rating, involve intricate calculations to determine premiums, reflecting the dynamic nature of insurance pricing.
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Loss ratio
Pure premium is the part of an insurance premium necessary to pay for losses and loss-related expenses. It is calculated by summing the losses and loss-adjusted expenses over a given period and dividing that by the number of exposure units.
A high loss ratio can be an indicator of financial distress, especially for property or casualty insurance companies. For instance, if an insurance company earned $100 million in premiums from clients in 2020, and paid out a total of $65 million in claims, the loss ratio would be 65%. This high loss ratio could indicate that the company is in financial distress, although it is not a definitive indicator as other expenses such as salaries and marketing are not included in the ratio.
The loss ratio is used by both insurers and external parties such as regulators, lenders and consumer advocates to monitor and assess performance. Regulators may set minimum loss ratio requirements to prevent excessive profits, and if an insurer breaches this minimum, they may be required to refund policyholders. A high loss ratio may also indicate that an insurance company is returning most of the premium in claim payouts and not overcharging customers.
The loss ratio is also used to adjust insurance premiums. If the actual loss ratio differs from the expected loss ratio, the premium may be adjusted accordingly. For example, if an insurance company is experiencing financial distress due to a high loss ratio, they may raise premiums to improve profitability.
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Retrospective rating
Pure premium is a term used in insurance to describe the part of the premium necessary to pay for losses and loss-related expenses. It is calculated by summing the losses and loss-adjusted expenses over a given period and dividing that by the number of exposure units. The loading charge is then added to the pure premium to determine the gross premium charged to the customer.
The retrospective premium is based on a base insurance rate, modified by the actual losses incurred in the period, a charge for the loss adjustment, and state premium taxes. The premium is subject to a minimum and maximum amount that can be charged, and it is paid in two parts. The first part is paid at the beginning of the period, and the second part, the retrospective premium, is paid at the end of the period and is determined by the actual losses for that period.
The formula for calculating the retrospective premium for workers' compensation is provided in one source, but it does not include the pure rate formula. The formula for the pure premium is, however, provided in the sources:
> Pure prem + fixed expenses per exposure unit 1 – (variable expense %) – (profit & contingencies %)
This formula can be used to calculate the pure premium, which is then used in the retrospective rating formula.
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Rate adequacy
Several methods are employed to determine rate adequacy, including experience rating, manual rating, and judgment rating. Experience rating involves analyzing the claims history of the policyholder to assess the likelihood of future claims. Manual rating utilizes predetermined rates based on factors such as the size and location of the risk. Judgment rating draws on the insurer's experience and expertise to set a rate that matches the specific risk.
Insurers face the challenge of balancing profitability, affordability, and protection. They must consider competition, regulatory requirements, and economic conditions when setting premiums. For instance, economic inflation impacts the value of both premiums and claims, while social inflation, such as the civil litigation environment in the US, increases loss costs across the industry.
To maintain rate adequacy, insurers must continually monitor and adjust their rates over time. This includes addressing the impact of macroeconomic factors, such as inflation, and managing increased loss trends and volatility. Ultimately, achieving rate adequacy is essential for insurers to remain in business and provide customers with the products they need.
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Frequently asked questions
The formula for pure rate in insurance is: pure prem + fixed expenses per exposure unit 1 – (variable expense %) – (profit & contingencies %).
The pure rate, also known as the pure premium, refers to the portion of the rate needed to pay for losses and loss-adjustment expenses.
The pure rate is calculated by summing the losses and loss-adjusted expenses over a given period and dividing that by the number of exposure units.
