Wrecks & Fires

Chapter 9

Premium Rates

Setting Premium Rates

  There are multiple insurance companies selling property and casualty home and auto insurance in the United States.  While the type of insurance company may vary, they all sell in two basic ways:

1. directly to the general population through the mail or

2. indirectly using a middleman (insurance agent).

Estimating Loss Exposures To Determine Rates

  Locating and measuring loss exposures requires detailed information searches which must be done in an organized manner.  Many sources are utilized.  Financial records are one important source.  The balance sheet of a business is always an excellent source of information as well.  A systematic study of each asset will often help to locate loss exposures.  Such things as asset location, replacement costs, utility values, and the perils and hazards to which they are exposed are all considered.

  The process of setting premium rates is part of estimating the risk faced by the insurer.  An insurance rate is the cost for one unit of insurance.  The premium is basically the rate multiplied by the number of units purchased.  It is similar in concept to unit pricing at the local grocery store.  A box of food may be priced at $4.25 for the total package, but the unit price is what the cost is for a given measure whether that unit of measure happens to be an ounce or a pound or whatever.  By comparing the "unit price," the consumer may determine the best buy.  A box of rice costing $4.25 may actually be the best buy over a box costing $3.00 if the unit price is less per pound.  In other words, $1.50 per pound is always less than $1.75 per pound no matter what size or shape the package may be.

  A unit of insurance is generally $1,000 of coverage.  As with the package of rice, the cost of one's insurance is based upon the rate, not the size of the policy.  Rates are given for every type of car and driver and for each geographical area of each state.

  The rate for any given policyholder depends upon numerous rates.  Surcharges and discounts may be considered penalties and rewards given by the insurance company to their policyholders.  These penalties and rewards are based upon the kind of risk that the policyholder represents.

Basic Rate Guidelines

  Typically, rates are set along three basic guidelines:

1. To make enough money to cover all their policyholders claims and pay the company's overhead expenses.  If a company is publicly held, they must also pay a profit (hopefully) to their shareholders.

2. To charge higher rates to drivers who file more costly claims and lower rates to drivers whose claims occur less often and/or who have smaller claims. 

3. To stay competitive with other insurers in the markets which they think will be the most profitable.

  The state of the insured has a bearing on the rates they will pay for their insurance.  The insurer must follow the regulations of each individual state.  The rate for a particular car and driver could change from state to state.

  When determining a driver's rate, one of the first things which will be considered is the amount of risk the driver represents.  Such things as age is considered as well as factors such as the type of car driven, the number of miles driven and so forth.  Although an underwriter (who determines the rate) may have some prejudices, statistical experience is primarily used.  Many years of record keeping supports their judgments in establishing rates.  A 21 year old with a sports car will pay a higher rate than will a 50 year old person who drives an economy car.  The underwriter will feel the risk imposed by the 21 year old driver is much higher than the risk imposed by the 50 year old driver.

Risk Categories

  Risks are usually stated in one of three ways:

1. preferred which is low risk,

2. standard which is average risk and

3. nonstandard which is high risk.

  No section on risk analysis would be complete without an adequate definition of insurance.  As previously stated, the often-used definition, the transfer of risk, is not totally accurate.  A more fully expanded definition of insurance would be either the accumulation of a fund OR a transfer of risk, though not necessarily both.  In addition, it must include a combination of a large number of separate, independent exposure units to make somewhat predictable the possible individual losses.  The predictable loss is then shared proportionately by all units involved.  This definition of insurance makes the point that both uncertainties are reduced and losses are shared.  Both are important aspects of insurance.

Insurance makes the point that both uncertainties are reduced and losses are shared.  Both are important aspects of insurance.

  Insurance policies allow an individual or a business to substitute a relatively small, defined premium cost for a possibly large, though uncertain, loss.  The fortunate many whom do not experience a loss will help to compensate the unfortunate few who do suffer a loss.  It is the “cookie jar” classic.  Many people put cookies into the jar, but only a few will find themselves in need of removing cookies.  A policyholder puts one cookie in, but may find themselves (due to a major loss of cookies at home) needing to replace those he had previously accumulated.  Having put one cookie into the jar enables the person to take out the dozen needed to replace their loss.  The extra 11 cookies taken out came from others who also placed one cookie into the jar.

Checking For Policy Errors

  When a new policy of any type is received, the policyholder is wise to check it for errors.  As the agent, you should mention this to your clients.  If the policy goes to the agent first, that agent would certainly want to do the same.  When an agent delivers a policy which contains errors, it makes the agent look as bad as the insurance company.

  Insurance products of all kinds have developed a reputation (not always deserved) of being easily misunderstood.  There are several factors involved in this concept.  Certainly, it is a field with a variety of products, each having their own policy design.  Some insurance fields, such as Medicare supplements, have attempted to standardize the product brochures.  Other types of policies allow great variations.  Often confusion arises from a lack of understanding or knowledge of insurance terms.  However, many analysts feel a major problem is simply the preconceived idea held by the consumer that an insurance contract is unreadable.  It is unfortunate that so many consumers believe, without ever trying, that they will not be able to read and understand their own insurance policies. 

  The producer (the insurance agent selling the product) is in an ideal position to dispel some of those outdated beliefs.  The producer is usually the first, and perhaps the only person, who can act as an educator.  Of course, to do so requires the agent to be educated himself.  To be a successful educator, the agent must have a grasp of the basics of insurance principles and guidelines.

  An insurance policy is the document containing the contract between the insured and the insurer (the policy owner and the insurance company).  The length and complexity will vary with the type of contract and the complexity of coverage.  Regardless of the length or complexity of the document, the policy will define the rights and duties of the contracting parties.

  Insurance policies generally follow the same basic format which includes:

1. declarations,

2. insuring agreements,

3. exclusions,

4. conditions and miscellaneous provisions and

5. definitions.

  Some types of policies will follow this format precisely while others may consist of multiple parts which must be combined to make a complete contract.

  An automobile policy will tend to follow this format with easily recognizable parts.  On the other hand, a homeowner’s policy will consist of two parts which must be combined to make the complete contract.

Declarations

  Declarations are descriptive phrases which describe the subjects covered, persons insured, premiums to be paid, period of coverage, policy limits, and warranties made by the insured to the policyholder regarding the nature of a hazard.  The declarations usually appear as a separate form or as the first page of the policy.  This section personalizes the policy to the specific policyholder.  It could be said that the declarations are the who, what, where and why of the policy.

Insuring Agreements

The coverage in an insurance policy is broadly defined in the insuring agreements.  Insuring agreements may sometimes also define important terms in the contract.  In most policies, the insuring agreements appear immediately after the declarations.

Exclusions

Exclusions eliminate specific coverages.  Exclusions may also be referred to as limitations in some types of policies.  There may be many reasons why the insurer (insurance company) may use exclusions in a contract.  They may wish to:

1. maintain management of physical and/or moral hazards,

2. eliminate duplicate coverages,

3. eliminate coverages not generally needed,

4. eliminate or minimize uninsurable perils, and 

5. eliminate specialized coverages that the insurer is not qualified to offer.

Conditions & Miscellaneous Provisions

  Conditions and Miscellaneous Provisions may be seen as the ground rules under which the contract operates.  From a legal standpoint "Conditions" and "Miscellaneous Provisions" are distinct from one another.  Even so, they usually appear together.  Since insurance policies are conditional contracts, the conditions with which the insured must comply are listed here.  They control the insurer’s liability for covered losses by imposing obligations on both the insured and the insurer (the policy owner and the insurance company respectively).  They may include such things as time limits for paying claims, alterations of the policy, assignment, cancellation, fraud or optional settlements, to name just a few of the possible conditions.

Definitions

Definitions are simply a list of terms and phrases with their fully defined meanings stated.  Wherever those words or phrases appear in the policy, they are printed in boldface type to remind the reader that a specifically listed definition applies.  Often endorsements and riders will appear in the same section as definitions. Any endorsements or riders or other forms supersede those of the preprinted policy to which they are attached.

  Since endorsements and riders have been mentioned here, it should be noted how they are used.

Endorsements and Riders

Endorsements and riders are often used when standard or preprinted policies do not entirely meet a specific situation.  Modification of the standard or mass-printed policy is obtained by adding special provisions to the basic contract.  The term "endorsement" is used in property and liability insurance.  The term "rider" is used in life insurance contracts.

  Endorsements and riders are used to complete a contract, alter coverage or change a policy that is in effect.  For example, a standard fire policy is not considered complete until the endorsement is added which describes the property which is to be covered.

Perils

  A peril is defined as a cause of a potential loss.  That loss may be due to a multiple of causes such as an accident, fire, explosion, flood, negligence or theft.

Hazards

  A peril is different than a hazard.  A hazard is anything that increases the seriousness of a loss or increases the chances that a loss may occur.  There are four types of recognized hazards:

1. Physical Hazards which come from material, structural or operational features.  A physical hazard is, as the name implies, something that exists physically.                                                                                               

2. Moral Hazards involve people and their actions.  Arson is a moral hazard because it involves the actions of a person or persons.                        

3. Morale Hazards are different than moral hazards (note the difference in the spelling of #2 and #3.  Morale (with an "e" on the end) involves human carelessness or irresponsibility rather than an intentional act.

4. Legal Hazards come as a result of court actions which increase the likelihood of a loss or increase the size of the loss itself.  We live in an age of increasing lawsuits and this is a legal hazard

  We recognize that authorities do not always use the same definitions for any given term.  The terms perils and hazards, for example, are often interchanged from one policy to another and from one text to another.  Even with these variations, most authorities consider:

1. Perils to be the things that cause losses and

2. Hazards to be the catalysts that bring about or increase perils.

End of Chapter 9