Rate making or insurance pricing is the method of determining the rates of premiums which are to be charged to the policy holder. This rate can be gauged with the help of online premium calculator provided by most insurance companies.
There is a difference between the selling price of insurance and that of other products. This difference is that the real cost of the insurance provided is not known until the lapse of the policy period although this is somewhat easier in the case of term insurance.
This is the reason that insurance rates are based on prediction rather than actual costs. Most of the times, rates are determined with the help of statistical analysis of losses in the past on specific variables of the policy holder. Variables yielding the best forecasts are used as criteria with the help of which the premiums are decided.
However, in some cases the historical analysis is not sufficient in providing statistical justification for selling rate, for instance, in the case of insurance against earthquakes. In such cases use of catastrophe modeling is made, but even this method has limited success.
The actuaries set the insurance rates based on the specific variables, while underwriters decide which variables are to be applied to a specific insurance policy holder.
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The Purpose of Rate Making
As an insurance company is a business which is intended to make profits, the premiums charged should cover expenses and losses and also earn profits. However, in order to be competitive, the companies need to offer the lowest possible premium for an amount of coverage provided.
The main objective of rate making is to determine the lowest premium that meets all of the required objectives. The main method of determining the premiums is to identify each characteristic that can predict losses in the future reliably.
In this manner lowest premiums can be charged to the groups that are low risk and higher premiums can be charged to the high-risk groups. When an insurance provider offers lower premiums to the low risk groups, these groups get attracted to the insurance company in question.
This in turn lowers the loss and expense of the insurance company, while the other companies will suffer an increase in the loss and expense as they will retain the higher risk groups. This is the reason that most insurance companies spend a lot of resources on the actuarial studies which are aimed at identifying every characteristic that reliably predicts future losses.
The Need of Accuracy
Here you need to bear in mind that both underwriting and rate making have to be accurate. If the rate is accurate for a specific class but the underwriter ends up assigning policy holders which do not belong to that class then the rate will not be adequate to compensate for losses. At the same time, if the underwriters are competent, but inadequate samples are taken for the rate or the rate making is based on variables that do not predict losses in the future reliably then the insurance company will end up suffering significant losses.
The pure premium which is calculated by actuarial studies consists of the part of the premium which is necessary to cover the losses and expenses related to losses. Then there is loading which is part of the premium necessary to cover the expenses like sales expenses and to allow for a significant profit.
The premium calculator available online uses this information to calculate the premium for a particular policy holder. As mentioned above the calculation of premium for term insurance is relatively easy, but for other types of insurance a lot of effort has to be made in order to calculate the right premium