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Chapter 9

Experience rating

0 Introduction

The rating process is the process of deciding on an

appropriate level of premium for a particular class

of insurance business.

The contents of this chapter are

The rating of general insurance business

Experience-rating systems

Denition of no claims discount systems

Steady state analysis

The eect of NCD systems on the propensity

to claim

1 THE RATING OF GENERAL INSURANCE BUSINESS 2

1 The rating of general insurance business

1.1 Basic methodology

The rating process may start with a calculation of

the pure risk premium, before loadings are added

for commission, expenses, prot and other contin-

gencies to give the oce premium.

Alternatively, where there is an established rating

structure, the process may be to identify changes

that need to be made in the relative levels of pre-

mium for dierent categories within that struc-

ture, and then to determine the overall percentage

adjustment that needs to be applied to the existing

premiums to achieve the desired nancial result.

1 THE RATING OF GENERAL INSURANCE BUSINESS 3

1.2 The risk premium

The risk premium is derived from the base data

and then projected, making allowance for any changes

in cover, ination and any expected experience

trends.

1 THE RATING OF GENERAL INSURANCE BUSINESS 4

1.3 Data required

In order to carry out an examination of the ap-

propriateness of the premium structure an insurer

needs to produce a specication of the data re-

quirements, assuming that the insurer has main-

tained appropriate records for this purpose.

1 THE RATING OF GENERAL INSURANCE BUSINESS 5

1.4 Calculation of base values

The premiums will be based on the past experience

of either the insurer or the market.

Premiums are usually quoted in relation to a unit

of exposure.

In practice it is more common to analyze the ele-

ments of claim frequency, cost per claim and ex-

posure per policy separately.

These elements are analyzed separately so that

trends in experience can be spotted and projected

into the future.

1 THE RATING OF GENERAL INSURANCE BUSINESS 6

Pure risk premium per unit of exposure

= Expected claim amount per unit of exposure

The basic elements of the pure risk premium can

be derived by expanding the claim amount per

unit of exposure as follows:

Total claim amount

Exposure

=

No. of claims

Exposure

Total claim amount

No. of claims

This gives the usual formula for the pure risk pre-

mium:

Pure risk premium

= Expected claim frequency Expected cost per

claim

1 THE RATING OF GENERAL INSURANCE BUSINESS 7

1.5 Choice of base experience statistics

Internal data

An insurer that has been writing a class of

business for some years should have a bank

of past experience from which to derive the

base values.

1 THE RATING OF GENERAL INSURANCE BUSINESS 8

External data

Where an insurer has insucient or unsuit-

able internal data, it will be necessary to

make use of external data. These may take

the form of aggregate market statistics, or

competitors rates for a similar product.

1 THE RATING OF GENERAL INSURANCE BUSINESS 9

1.6 Adjusting the base values

Many dierent situations may arise to cause the

base experience to be dierent from that expected

during the new rating period.

Suitable adjustment will need to be made for:

Unusually heavy/light experience

Large or exceptional claims

Trends in claim experience

Changes in risk

Changes in cover

Changes in the cost of reinsurance

1 THE RATING OF GENERAL INSURANCE BUSINESS 10

1.7 Projecting the base values

The total claim cost and exposure values produced

from the initial analyses will be expressed in the

money terms of the base period.

Therefore, as well as allowing for future trends and

any proposed risk or cover changes, the projections

need to allow for the expected eect of in-

ation on claims between:

the mean payment date of claims in the base

period, and

the mean payment date of claims arising during

the exposure period of the new rating series

1 THE RATING OF GENERAL INSURANCE BUSINESS 11

When revaluing base values for future premium

rates, there are two parts to the calculation:

inating base values to the present day using

(broadly) known ination rates

projecting from the present day to the future

using estimated future ination rates

1 THE RATING OF GENERAL INSURANCE BUSINESS 12

1.8 Projecting exposure values

In order to arrive at a risk premium rate, the pro-

jected claim cost must be divided by a correspond-

ing projected value of the exposure.

For example, with private motor insurance,

the premium is quoted per vehicle-year. One

vehicle-year is the unit of exposure.

1 THE RATING OF GENERAL INSURANCE BUSINESS 13

Where these exposure units are expressed in terms

of monetary units, the base exposure values need

to be projected at an appropriate rate of ination.

This may not be the same as that applied to claim

cost. Here, the projection is only to the mid-point

of the exposure period arising under the new rates.

For example, in many forms of property in-

surance, the premium is quoted per 1,000

sum insured. In these cases, high ination

does not necessarily mean that the premium

rate must be increased. If the exposure mea-

sure inates as quickly as the average claim

amounts, then premium rates might stay

constant.

1 THE RATING OF GENERAL INSURANCE BUSINESS 14

For example, a premium rate of 2 per 1,000

sum insured set in 1956 might still be ap-

propriate in 2005. But we very much doubt

whether a, premium of 15 per vehicle year

set in 1956 would still be acceptable in 2005!

1 THE RATING OF GENERAL INSURANCE BUSINESS 15

1.9 Allowing for investment income

Insurers will be able to invest part of the premiums

for a period of time.

This can be particularly signicant for the longer-

tailed classes of business.

For long-tail classes, premiums may be invested for

many years before being needed to settle claims.

The assumption regarding investment returns is

then signicant.

Note also that the ination assumptions are far

more signicant for long-tail classes.

1 THE RATING OF GENERAL INSURANCE BUSINESS 16

1.10 Adjustments for commission, expenses and other load-

ings

Insurers adopt many dierent ways of loading the

risk premium for commissions, expenses, the cost

of reinsurance and other margins, and may allow

for the investment income likely to be generated

by holding the premium until claims are paid.

Those who start by calculating pure risk premi-

ums will load those premiums, either by applying

a simple overall percentage addition or by allowing

for expenses in a more detailed way, having regard

to their xed or variable nature.

Those who estimate the overall percentage change

required in the existing premium rates should make

due allowance for expected changes in expense lev-

els.

1 THE RATING OF GENERAL INSURANCE BUSINESS 17

1.11 Example of premium rating and premium rating formula

An example of premium rating

A sample premium rating formula

2 DEFINITION OF NO CLAIMS DISCOUNT SYSTEMS 18

2 Denition of no claims discount systems

2.0 Experience-rating systems

An experience-rating system is one in which the

premium for each individual risk depends, at least

in part, on the actual claims experience of that

risk.

Concept underlying experience-rating system: HIGH

RISK tends to remain HIGH RISK.

Experience-rating system and SELECTION RISK

Number-based / cost-based SYSTEM

Prospective / retrospective BASIS

2 DEFINITION OF NO CLAIMS DISCOUNT SYSTEMS 19

2.0.1 Prospective vs retrospective basis

With prospective rating, the premium at the re-

newal date depends on the experience of the risk

prior to that renewal.

The insurer takes on all underwriting risk in such

and arrangement.

NCD in private motor is a prospective system of

experience-rating system.

With retrospective rating, the premium for the

current policy period is adjusted, based on the ex-

perience of that period of risk.

A deposit premium, paid at the inception of the

policy, will usually be followed by an adjustment

premium, or refund, at the end of the period.

The underwriting risk to the insurer is reduced

with retrospective rating.

2 DEFINITION OF NO CLAIMS DISCOUNT SYSTEMS 20

2.0.2 Number-based systems

With number-based system, the premium adjust-

ments (whether prospective or retrospective) are

based on the number of claims paid in respect of

the policyholder, and the amounts of the claims

are ignored.

NCD system / bonus-malus system (BMS system)

2 DEFINITION OF NO CLAIMS DISCOUNT SYSTEMS 21

2.0.3 Cost-based systems

With cost-based system, the premium adjustments

(whether prospective or retrospective) are based

on the total amounts of claims incurred in respect

of the policyholder over a dened period.

System based on the cost of claims tend to be

used for larger risks or group of risks where the

aggregate cost of claims experienced within a year

may be a more suitable indicator of the relative

level of the underlying risk.

Motor eet (for larger eets) / employers liability

2 DEFINITION OF NO CLAIMS DISCOUNT SYSTEMS 22

Prot sharing, where the insurer charges a higher

initial premium, and returns some prot to poli-

cyholders whose claims are lower than expected.

This is a typical retrospective arrangement based

on claim amount.

2 DEFINITION OF NO CLAIMS DISCOUNT SYSTEMS 23

The policyholder pays an end of year adjustment

premium to reect the amount of exposure during

the year (e.g. as in employers liability).

This is not the example of experience-rating.

2 DEFINITION OF NO CLAIMS DISCOUNT SYSTEMS 24

2.1 Discount categories

There are two parts to a NCD system:

the discount categories which are often referred

to as the number of claim free years.

a set of rules for moving between these cate-

gories.

In addition, in order to investigate the properties

of a NCD system the chance that a policyholder

makes a claim each year also needs to be known.

2 DEFINITION OF NO CLAIMS DISCOUNT SYSTEMS 25

Question 9.3 on page 12.

A motor insurer operates an NCD sys-

tem with discount levels of 0%, 30%, 40%,

50% and 60%. The rules are as follows:

1. At the end of a claim free year, a poli-

cyholder moves up one level (or remains on

maximum discount).

2. At the end of a year in which exactly one

claim was made, a policyholder drops back

two levels (or moves to zero discount).

3. At the end of a year in which more than

one claim was made, a policyholder drops

back to zero discount.

What premium does a motorist who rst

took out a policy on 1 January 1989 pay for

insurance cover in the year 2000, if the pol-

icyholder made claims on 15 August 1990,

3 February 1994, 17 September 1994 and 14

November 1999, and the full premium for

the year 2000 is 750pa?

2 DEFINITION OF NO CLAIMS DISCOUNT SYSTEMS 26

2.2 The transition matrix

The probability that a policyholder in category i

moves to category j from one year to the next can

be written as a matrix of transition probabilities.

_

_

_

_

_

_

p

00

p

01

p

02

p

10

p

11

p

12

p

20

p

21

p

22

_

_

_

_

_

_

where p

ij

is the probability that a policyholder

moves from category i to category j.

Question 9.4 on page 13.

Given the transition matrix

_

_

0.2 0.8 0

0.2 0 0.8

0 0.2 0.8

_

_

for the system with States 0, 1 and 2, us-

ing the convention given above, what is the

probability that a policyholder who starts in

State 0 is in State 0 again 2 years later?

2 DEFINITION OF NO CLAIMS DISCOUNT SYSTEMS 27

2.3 Distribution of policyholders

The transition matrix can be used to estimate how

many policyholders are expected to be in each dis-

count category each year.

The expected proportion of policyholders in cate-

gory i is denoted by

i

.

Note that

i

= 1.

Also, the proportions in the discount categories

can be represented as a vector, = (

0

,

1

,

2

, . . . ,

n

).

Then we can write

(n+1)

=

(n)

P.

Example on page 14.

3 STEADY STATE ANALYSIS 28

3 Steady state analysis

3.1 The equilibrium distribution

It is possible to continue nding

(n)

for larger

values of n.

Under reasonable conditions,

(n)

will tend to a

limit as n .

When this happens, the system has reached equi-

librium or its steady state.

This limit is denoted .

Letting n gives = P.

This is a set of equations which can be solved to

nd noting that

i

= 1.

An example on pages 16-17.

3 STEADY STATE ANALYSIS 29

3.2 Heterogeneity in the portfolio

One of the reasons which is used to justify NCD

systems is that they result in automatic premium

rating. In other words, policyholders who make

fewer claims pay less than those who make more

claims.

While this is obviously true, most do not work as

well as is hoped and the premiums policyholders

ultimately pay are not proportional to their likeli-

hood of making a claim.

This is partly because of the small number of cat-

egories of discount and the relatively low levels of

discount that are oered.

But it is also due to the relatively low probabilities

of claims occurring and hence the high probabil-

ities of all policyholders reaching the maximum

discount level at some stage.

Another reason why NCD systems do not work as

well as might be hoped is because of noise in

the system. Peoples actual claim rates dier from

those that might be expected.

3 STEADY STATE ANALYSIS 30

Given the probabilities of claiming for all policy-

holders, it would in fact be possible, mathemati-

cally, to determine a NCD system that would re-

sult, over the long term, in all policyholders paying

a pure premium that was directly proportional to

their probability of claiming.

However, this would be an extremely complex sys-

tem to administer and understand.

The following example takes the situation to the

opposite extreme, by assuming that there are only

two possible types of policyholder and there are

only three categories of discount. However, even

in this simple situation it is not easy to produce a

system that matches premiums to the probabilities

of claiming.

An example on pages 18-19.

4 THE EFFECT OF NCD SYSTEMS ON THE PROPENSITY TO CLAIM 31

4 The eect of NCD systems on the propensity to

claim

4.1 Reassessment of transition probabilities

In what has been done so far, it has been assumed

that the probability that a driver makes a claim

is the same, no matter which discount category he

or she is in.

The policyholder may take into account the in-

creases in future premiums when deciding whether

to make a claim or not.

This can be considered by comparing the change

in premiums when a claim is made.

The number of future years considered is called

the policyholders horizon, and the propensity to

claim will also depend on this horizon.

Example on page 21.

4 THE EFFECT OF NCD SYSTEMS ON THE PROPENSITY TO CLAIM 32

4.2 Calculating the transition probabilities

It can be seen from this that the probability that

a policyholder incurs a loss (eg has an accident)

is not the same as the probability that a claim is

made.

If the distribution of the loss is known, the prob-

ability that a claim is made following an accident

can be calculated.

For example, considering the policyholder in the

previous example, who has an innite horizon, is

at present in the 25% discount category and has

just had an accident. A claim will only be made if

the cost of the accident is greater than 275.

If X is the random variable which represents the

cost of an accident, then:

P(Claim| Accident) = P(X > 275)

Since it is assumed that the distribution of X is

known, this probability can be evaluated.

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