Insurance is a practice of exchanging a contingent claim for a fixed payment called premium. It is closely associated with underwriting and is the determination of what rates or premiums to charge for insurance. If, for example, the underwriter decides that the most important factor in discriminating between different risk characteristics is age, the rates will be differentiated according to age.
Insurance Company is a business; it is obvious that the rate charged should be adequate and must cover losses and expenses and allow for a profit otherwise the Insurance Company would not be successful. The principle of assigning premiums according to the underlying risk is an essential element of actuarial science. Based on the proportional hazards (PH) different risk-adjusted premiums are proposed for pricing risks. For the same underlying risk, the risk-adjusted premium is larger for a party which is more risk-averse. For an insurer, the risk-adjusted premium automatically and consistently adjusts the risk loading relative to the expected loss for different risks. The essential requirement is that the rate must be sufficient to meet insurer's losses and expenses of administration and the first obligation is to keep the insurer solvent. The premium or the rate is the price charged for insurance. The rate has essentially only two functions :
It should produce total funds sufficient to cover the insurer's obligation.
It should distribute the cost of insurance fairly among insured persons.
Pricing of insurance product is a complex task, as premium rates to be charged depend upon variety of factors namely, expected losses, operating expenses, income from investments and profit margin of the insurance company. Actuaries employed by the insurer calculate and determine the premium rates to be charged for different policies and from people of different age. If the premium charged is very low, the company would not be able to collect sufficient amount to pay claims, bear expenses and earn some profit. On the other hand, excessively high premium charged will result in loss of prospective clients of the insurance company because company may lose the prospective insurer to its competitors in the market. Pricing also depends on the market forces of demand and supply of insurance products. Pricing refers to the methods used to calculate rate of premium to be charged on insurance products. Premium is a price for which the insurer is willing to accept the risk. The payment of premium by the proposer is acceptance of the price charged by the insurer for providing the life insurance cover.
Life Insurance Pricing Elements
Rate of death of large number of insured persons
Administration cost and other expenses of the insurer
Income from investment of premium
Rate of Death of Large Number of Insured Persons - The mortality rates depend on the age, occupation, life style and medical history of the insured. The premium rates charged are calculated on the basis of rate of deaths of very large number of persons insured, i.e., the past experience of large number of cases is taken into consideration before deciding on mortality rate. (Refer chapter-3 for further details)
Administration Cost and other expenses of the Insurer - Every insurer incurs certain expenses or administrative costs related to the service provided. The administration cost incurred may depend on frequency of payment of premium and the volume of records kept. If the premium is paid annually, cost is lesser as compared to quarterly and half yearly or monthly payments.
Income from Investment of Premium - Premium collected by the insurance company from various policyholders is again invested and the income earned on the same helps the insurance company to bear various expenses incurred and benefits given to policyholders.
OBJECTIVE OF RATE MAKING
Pricing of insurance products is a crucial subject in relation to the business of insurance. Insurance prices called 'premiums' or 'rates' are based on per unit of exposure. The insurance companies generally adopt comprehensive pricing strategy. However, in a competitive world, it is difficult to sell the product at statistically calculated prices. Moreover, the insurance companies are required to give incentives which leads to reduction in the realized prices.
The non-life insurance business in India is considerably regulated by the Insurance Act, 1938 which empowers the tariff advisory committee (TAC) constituted under it, to control and regulate the rates as well as prescribe the terms and conditions offered by insurers in respect of general insurance business.. These rates are based on statutory standards while all other products are non-tariff. Non-life Insurance pricing is based on claims cost, business acquisition costs, management expenses, margin for fluctuations in claims experience and expected profits. These prices are obliviously subject to wide fluctuations as the insurers make estimates based on past experiences, which are reviewed periodically.
In contrast, life insurance pricing is less complicated and the prices do not change frequently. This is because, the determining factors for life insurance pricing, namely, mortality rate, expenses and interest rate are relatively stable.
Because insurance rates - primarily property and liability rates - are regulated by the states, certain statutory and regulatory requirements must be satisfied. Also, due to the overall goal of profitability, certain business objectives must be stressed in rate making. The following are the objectives kept in mind while deciding upon the pricing of various insurance products :
The rating system must generate sufficient premium income for the insurance company to be able to pay its claims and expenses; to cover expected losses, to give a reasonable rate of return to the investors of funds and to finance continuing growth and expansion. In other words, the premium rates fixed by the insurance company should be adequate in order to pay the benefits promised to the policyholders and meet all the operating expenses. A corollary of this is that the insurer must maintain solvency in order to pay claims.
The rate must not be unduly high as to allow abnormal gains to be earned by the insurer and it will further lead to loss of insurance business to the competitors in the industry.. The rate should be justifiable. The rates of the premium charged to the policyholders should not be too high. Also, charging excessive premium is therefore unfair to the customers.
To produce rates that includes an adequate provision for profit/ contingencies.
To encourage loss control. This refers to designing the classification plan to provide discounts for loss prevention behaviour.
The rates must not be unfair and inequitable, in sense that it should not be the same for heterogeneous buyers and must not be different for homogenous buyers (say of different age groups). In other words, the rates charged to the policyholders with the same expected losses and other costs should be equal. This is known as rate equity. It means that the insurance company should charge premiums in accordance with the expected payment of benefits and expenses. For example; if the two individuals of different ages, say one 25 years and other 50 years intend to purchase same policy for the same time period with same terms, the insurer will be charging the higher rate of premium from the person who is 50 years old as there is comparatively higher death probability of the older client. In the case of the young person of 25 years the company cannot associate very high death probability. If there are two persons of the same age who want to take same policy with same terms and conditions but one person is chronically ill, the insurer must charge them different rates as the ill person has higher probability of dying at a certain age (so should be giving higher premium).
The rating system must be simple and easy to understand by the customer and should not change very frequently.
To produce reasonably stable rates and responsive to changes and should be able to satisfy rate regulators.
The pricing system should not be very costly to use and the rates should not be subjected to wide variation in costs year after year.
The mechanism should promote the reduction of losses by providing incentives to the insured to prevent losses.
Although competition would compel businesses to meet these objectives any way, the states want to regulate the industry enough so that fewer insurers would go bankrupt than would otherwise be the case if competition was the main factor in determining the viability of a company so as to protect the many customers dependent on insurance companies. The main problem that many insurers face in setting fair and adequate premiums is that actual losses and expenses are not known when the premium is collected, since the premium pays for insurance coverage in the immediate future. Only after the premium period has elapsed, will the insurer know what its true costs are. Larger insurance companies maintain their own databases to estimate frequency and the dollar amount of losses for each underwriting class, but smaller companies rely on rating bureaus for loss information.
DEFINITIONS IN RATE MAKING
Ratemaking - is the process of establishing rates used in insurance or other risk transfer mechanisms. This process involves a number of considerations including marketing goals, competition and legal restrictions to the extent they affect the estimation of future costs associated with the transfer of risk. This statement is limited to principles applicable to the estimation of these costs by estimating past losses experience and industry statistics. Such costs include claims, claim settlement expenses, operational and administrative expenses and the cost of capital. Summary descriptions of these costs are as follows:
Incurred Losses - are the costs of claims insured.
Allocated Loss Adjustment Expenses - are claims settlement costs directly assignable to specific claims.
Unallocated Loss Adjustment Expenses - are all costs associated with the claim settlement function not directly assignable to specific claims.
Commission and Brokerage Expenses - are compensation to agents and brokers.
Other Acquisition Expenses - are all costs, except commission and brokerage, associated with the acquisition of business.
Taxes, Licenses and Fees - are all taxes and miscellaneous fees except federal income taxes.
Policyholder Dividends - are a non-guaranteed return of premium charged to operations as an expense.
General Administrative Expenses - are all other operational and administrative costs.
The Underwriting Profit and Contingency Provisions - are the amounts that, when considered with net investment and other income, provide an appropriate total after-tax return.
Rate - Price per unit of Insurance.
Exposure Units - Unit of measurement used in Insurance pricing like model year of car.
Pure Premium - portion of the rate needed to pay losses and loss adjustment prices i.e. loss related expenses. It is determined by actuarial studies.
Loading - amount that must be added to pure premium for other expenses, profit and a margin of contingencies.
Policy holders' surplus - difference between an insurance company's assets and liabilities.
Life Insurer's Net Gain from Operations - Total Revenues - total expenses, policy owner's dividends, and federal income taxes
Gross Rate - consists of the pure premium and a loading element
Manual (Class) Rate - exposures with similar characteristic are place within the same underwriting class, and each is charged the same rate.
Gross Premium - Premium charged to the insured which consists of the gross rate multiplied by the number of exposure units.
Net Single Premium - the present value of the future death benefit.
Loss Reserve - Estimated amount for :
Claims reported and adjusted, but not yet paid
Claims reported and filed, but not yet adjusted.
Claims incurred but not yet reported to the company.
Unearned Premium Reserve - is a liability item that represents the unearned portion of gross premiums on all outstanding policies at the time
Underwriting - process of selecting, classifying and pricing applicats for insurance
BASIS OF RATING IN INDIAN CONTEXT
In a contract of Insurance, the insurer promises to pay to the policyholder a specified sum of money in the event of a specified happening. The policyholder has to pay a specified amount to the insurer, in consideration of this promise. 'Premium' is the name given to this consideration that the policyholder has to pay in order to secure the benefits offered by the insurance contract. It can be looked upon as the price of the insurance policy. It may be a one-time payment which is not very common. Often, it has to be paid regularly over a period of time. A default in premium can endanger the continuance of policy. If that happens, the policy will be treated as 'lapsed' and the expected benefits may not be available. The consequences of default are specified in the policy conditions, explained in detail in chapter 9.
The calculation of premium is a complex technical process, involving actuarial and statistical principles. Only trained professionals, called actuaries do it. Tables of premium rates for each plan of insurance are made available by insurance companies for the use of agents, who are required to quote the premium for a particular policy being offered to a prospect. Let us understand the rationale behind the premium calculations.
Components of Premium
Risk Premium (Mortality/ Natural Premium)
Net Premium (Margin of Interest)
Office Premium (Margin of Office Expenses and Exigencies)
Risk Premium - It is calculated on the basis of an expectation as to how many persons are likely to die within a year in an age group. This expectation, regarding the number of persons likely to die within a year, at each age, is calculated by actuaries on the basis of past experiences and made available as Mortality Tables.
Net Premium - The premium worked out after taking into account the interest likely to be earned, is called the net premium or pure premium.
Loadings
The net or pure premium has to be increased for various reasons. Such increases are called 'loadings'. One of the loadings is because of expenses. The expenses of the insurer, to procure and to administer the business, have to be met out of the premiums paid by the policyholders. To the premium to be collected will be higher.
Bonus has to be given to participating policyholders. Bonus is declared out of the surpluses determined after actuarial valuations. Surpluses, in a way, reflect the profitability of the business or the quality of management of the business. Nevertheless, insurers load the premiums on account of the bonus. In practice, the actual bonus declared would be higher than the loading. Otherwise, it would mean that the quality of the management of the business leaves much to be desired.
Another loading would be for unexpected contingencies and fluctuations. A major catastrophe like an earthquake or accident or riots or epidemic, can raise the number of deaths to much higher levels than indicated by the mortality tables. The risk premium based on mortality tables would be found to be inadequate to meet such catastrophic claims. Insurers therefore, as a matter of safety, provide for such contingencies and fluctuations, by loading the premium suitably.
The premium is calculated on the basis of assumptions relating to the future experience on mortality, interest rates and expenses. These assumptions are based on the insurer's own experience in the past and therefore, not arbitrary. Yet, they are assumptions as far as the likely future experienced is concerned. The margin for contingencies is provided because of the uncertainty that these assumptions will turn out to be valid, as the future unfolds.
Level Premium
If it is expected that out of 10,000 persons at a specified age, the probability is that one may die within one year, the mortality rate at that age is said to be 0.01 %. The risk premium chargeable for persons at that age would be Rs. 0.10 per Rs. 1,000 SA. If a policy has a term of 20 years, the risk premium and therefore, the premium charged, would vary for each of the 20 years. It would be increasingly steadily from year to year. It would be difficult to administer annual charges in a continuing contract. Apart from that, the premium at later ages, towards the end of the policy term, would be very high and people may find it beyond their ability to pay. They will then be without the protection of insurance at times when they need it most. To offset this problem, insurers spread the risk premium on a uniform basis, throughout the term of the policy. The premium remains constant for 20 years. Such uniform premium is called 'Level Premium'. This implies that the premium collected would be more than necessary for the risk in the early ages and less than necessary towards the later part of the policy.
There is another reason for level premiums being charged. As mentioned already, it is possible that many policyholders would find the higher premium payable otherwise, towards the later part of the policy, too burdensome, and drop out. The persons who drop out are likely to be healthier than those who continue. The relatively unhealthy ones may try to pay somehow and continue the insurance cover. This would work against the insurer, as the assumptions made in calculating the premium would be disturbed. The continuing policyholders would not be of the same kind of population, as the mortality tables would have assumed. The mortality tables show the probabilities (of death) for a group of healthy persons, while in this case, the population of policyholders would have large than normal proportion of the unhealthy. This is referred to as 'Adverse Selection', because the result of the decisions of the healthier policyholders walking out of the group is adverse to the interests of the remaining community of policyholders. The calculations of the insurer and his experience would go awry. The practice of charging level premiums, avoids such adverse selection.
Exhibit : Level Premium
Averaging of expenses + Averaging of mortality
(Averaging of both gives 'Level Premium'
High Premium Low Risk
(Charged Extra)
Low Premium High Risk
(Charged Less)
Policy Term
Level Premium
Age
CASE APPLICATION
Client Name: Ekta; Status: 27, single, no children
Ekta earned an income of Rs.50,000 and had Rs.3000 of credit card debt and a Rs.15,000 car loan. She also had Rs.100,000 life insurance cover provided under her superannuation policy, which had an accumulated value of Rs.20,000.
After seeing a friend become financially vulnerable and unable to work following a skiing accident, Ekta decided it was a good time to take out insurance to help protect herself financially in case something similar happened to her.
With the help of her financial adviser, she selected Rs.200,000 Life, Total & Permanent Disability and Trauma cover in addition to the life insurance provided through her superannuation. The combination of superannuation and stand-alone insurance would provide Ekta with a lump sum if she became totally and permanently disabled or suffered a specified traumatic condition. It would enable her to pay for any necessary treatment or alterations to her apartment.
Having organized cover to provide her with a lump sum to help deal with any immediate issues, Ekta was still concerned about the result of suffering an illness or injury that prevented her from working. How would she pay her bills and afford to live?
Ekta's employer provided up to four weeks of paid sick leave but without a regular salary, Ekta would have no other income to rely on. She chose Income Protection cover with a monthly benefit of Rs.3,125 (being the maximum cover available - 75% of her income), a four-week waiting period and benefits paid to age 65. Ekta chose to include an increasing claim option which would ensure that, if she was on claim, her monthly benefit would keep up with inflation.
Because Ekta wanted to avoid sudden increases in premium payments as she aged, she chose to pay level premiums. With level premiums she knew she would be paying a little more than stepped premiums in the first few years of the policy, but she would save in the long run. The premiums on a level premium contract are likely to remain the same, unlike stepped premiums which usually increase as the insured gets older.
Key Questions :
Comment on her decision.
Level premiums are slightly more expensive than stepped premiums in the first few years of the policy, but over the term of the policy, its longer-term savings typically far outweigh short-term savings of stepped premiums. Explain.
Office Premium - The premium figures arrived at after loading the net premium or pure premium is called the office premium. The premium figures printed in the promotional literature and brochures are office premiums. They are also referred to as Tabular Premiums.
Illustration
There are 1000 persons who are in the age gropu of 25-30 who are want to get their insurance done for the Sum Assured Rs. 20,000/-.
Calculation of premium is as under :
(mortality)
1000 ----- 20000/- ------- 10 --------- 20000 Rs. 200/- (Pure Risk)
(people) (sum assured) (Probability)
(rate of interest)
10 % ---------- 200 - 20 Rs. 180/- (Net Premium)
(management exp.)
10 /- ---------- 180 + 10 Rs. 190/- (Office Premium)
(adverse contingencies)
10 /- ---------- 190 + 2 Rs. 192/- (Tabular Premium)
Extra Premiums
Extra premiums may be charged on any particular policy. This may happen because of :
the grant of some benefit in addition to the basic benefits under the plan called riders (discussed in detail in chapter no. 9).
Extra premiums may become chargeable because of decisions relating to the extent of risk in any particular case.
If the risk of the person to be insured is assessed as more than normal, because of health (called health extra) or because of occupation (known as occupation extra) or habits, insurers may charge extra premiums. These are usually stated as Rs. 2 per thousand, and will be added to the premium otherwise chargeable.
Points to Ponder
Lump Sum Injection
In addition to regular premiums, the client can make lump-sum injections during the premium-paying period when he/ she want.
Lump Sum Injection facility for unitized plans :
There could be a number of injections, but the amount injected in a policy year should not exceed 25 % of the basic sum assured.
A supplementary Accumulation Account will be created for this, which will earn returns at the same rate and in the same manner as returns declared in the Accumulation Account.
The client have the option of using the Supplementary Accumulation Account created for "Lump sum injections" to pay premiums, if need arises. (This would be done only at the request from the clients and not automatically)
The lump sum injections may be considered as Supplementary Premium Payments, which give rise to supplementary Sum Assured and supplementary Accumulation Account. There are separate premiums rates for supplementary Sum Assured that depend only on term to maturity in years.
Lump Sum Injection facility for unit-linked plans :
This facility with all unit-linked plans upto 25 % of the cumulative premiums paid till that date.
Service Tax
The Finance Act has brought life insurance business within the ambit of service tax. Service tax, as you know, is an indirect tax and has to be collected by the insurance Company and paid to the Government. This tax has to be calculated on the risk premium and would be levied at the prevailing service tax rate, as applicable from time to time.
On which policies will service tax be leived ?
Service Tax to be levied on :
First year and renewal premium for all policies that will be purchased.
Renewal premium for all policies already in force.
How will it work ?
To pay the service tax to the Government of India, the Insurance Company will recover and amount equal to the service tax liability.
Exhibit 2 : Life Insurance Marketing in India, the Changing Product & Pricing Norms
"We will design our products specifically for every segment of Indian consumers and not just hawk our North American products in the country."
- Gary M C Standard, Vice President, Sun Life Canada, in 1997.
"We would not lack in our efforts to innovate new products."
- G. Krishnamurthy, former LIC Chairman, in 2000.
The Changing Product Profile
In July 2002, India's state-owned insurer Life Insurance Corporation of India (LIC) launched a new insurance policy, 'Anmol Jeevan' (Priceless Life). This was seen by industry observers as something LIC 'had' to do in the wake of the increasing competition in the insurance sector. Before the launch of Anmol Jeevan, two of LIC's major competitors, ICICI Prudential Life and HDFC Standard Life had launched similar, competitively priced insurance products. In the newly opened Indian insurance sector, private insurers were coming up with many innovative products, offering riders1 on the policies in order to woo the consumers. LIC, which had been exercising monopoly in the Indian insurance sector, had been offering only 'plain' policies without any riders to its policyholders.
Analysts pointed out that LIC never seemed to have had any proper strategy for bringing out innovative products and customer-friendly pricing of its products. Though LIC offered around 60 products, only seven to eight were popular with policyholders.
With almost all private players' premium rates being more or less similar to LIC's premium rates, the only areas where they could distinguish themselves was in the marketing, distribution and product innovation. The private insurers decided to develop products that would not compete with LIC's money back and endowment policies at the initial stages (Refer to Exhibit I for a note on various kinds of insurance products).
Thus, the new players launched a host of group insurance and term-life schemes, as LIC had not focused intensively on these aspects of insurance. However, the private players soon began to launch products that competed with LIC's 'core products.' With innovative product designing and intelligent pricing methods being adopted by these players, industry observers commented, LIC seemed to have realized that it would have to rapidly adapt itself to the changing market dynamics. The decision to launch 'Anmol Jeevan' was, thus, not entirely unexpected.
RATE MAKING IN PROPERTY AND LIABILITY INSURANCE
Liability insurance is designed to protect an individual against the possibility that he will be held responsible in a court of law for injury to another person, property or other interests. The property owner is held responsible for accidents happening on his property if negligence can be established or legal liability exists by statute. Similarly, the contractor is held responsible for accidents that result from his operations, and the manufacturer for accidents arising from the use of his product, while the professional may even be held liable for the advice he gives. The insurance for these diverse forms of liability is provided by several lines of insurance which are generally grouped together under the title 'General Liability Insurance'. Manuals of rules and rates for general liability insurance are published by several independent insurance companies.
The rating techniques used by the general liability underwriter are in some ways similar to those used by fire underwriters despite their superficial antitheses. Both liability and fire insurance premiums are determined by a complex process in which the rates are influenced by the business of the insured occupying the premises and by risk characteristics that modify the hazard (e.g., the existence of elevators); however, the actuarial procedures used to establish the rates charged by the general liability underwriter are closely related to the other casualty lines rather than property insurance. The determination of the overall rate level change closely resembles the procedure used for automobile liability insurance, while the determination of class rates mixes techniques borrowed from both automobile and workmen's compensation ratemaking with some unique procedures. Unlike many other lines of insurance, there is no single general liability insurance rate filing in a given state. Individual rate filings are made for each sub line of general liability insurance and for each coverage. The filings for individual sub lines differ considerably from each other because the form of liability insured under each of them is quite different; therefore, some knowledge of the coverage provided by the various sub lines is essential in understanding the ratemaking procedures.
Insurance pricing methods--also known as rate making--provide baseline or standard rates that form the basis for pricing individual case scenarios. Different pricing methods may rely more heavily on baseline rates when other factors like risk and claims history are involved. There are three methods for determining rates in property and liability insurance ; judgment rating, class rating, and merit rating. Merit rating can be further classified as schedule rating, experience rating, and retrospective rating.
Judgment Rating
Class Rating
Merit Rating
Schedule Rating Method
Experience Rating Method
Retrospective Rating Method
Judgment Rating
These types of ratings are used when the factors that determine potential losses are varied and cannot easily be quantified. i.e. when the loss exposures are so diverse that a class rate cannot be calculated or when credible loss statistics are not available to assess the probability and quantity of future losses. Hence, an underwriter must evaluate each exposure individually and use intuition based on past experience. Each exposure is individually evaluated and the rate is determined largely by the underwriter's judgment.
These ratings are predominant in determining rates for ocean marine insurance and in some lines of inland marine insurance. Because the various ocean-going vessels, ports of destination, cargoes carried and dangerous waters are so diverse, ocean marine rates are determined largely by judgment.
Class Rating
In class rating, exposures with similar characteristics are placed in the same underwriting class and each is charged the same rate. The rate charged reflects the average loss experience for the class as a whole. This type of rating is used when the factors causing losses can either be easily quantified or there are reliable statistics that can predict future losses. It is based on the assumption that future losses to insureds will be determined largely by the same set of factors. For example; major classification factors in life insurance include age, gender, health and whether the applicant smokes or is a nonsmoker. Accordingly, healthy persons who are the same age and gender and who do not smoke are placed in the same underwriting class and charged the same ordinal rate for life insurance. Smokers are placed in different class and charged higher rates with loading.
These rates are published in a rating manual and so the class rating method is sometimes called a Manual Rating. Class rating is widely used in homeowners insurance, private passenger auto insurance, workers compensation, life and health insurance.
Merit of using this method of rating is that it is simple to apply and also allows agents to give an insurance quote quickly.
There are two basic methods for determining class rates :
Pure Premium Method
Loss Ratio Methods
Pure Premium Method - pure premium is that portion of the gross rate needed to pay losses and loss-adjustment expenses. It is first calculated by summing the losses and loss-adjusted expenses over a given period and dividing that by the number of exposure units. Then the loading charge is added to the pure premium to determine the gross premium* (Gross Premium = Pure Premium + Load) that is charged to the customer.
*Gross Premium - It is determined by adding a loading allowance to the Net Annual Level Premium. The loading must cover all operating expenses; provide a margin for contingencies, margin for dividends (if participating policy). major types of expenses are reflected in the loading allowance :
Production Expenses
Distribution Expenses
Maintenance Expenses
Loss Ratio Method - It is used more to adjust the premium based on the actual loss experience rather than setting the premium i.e. actual loss ratio is compared with expected loss ratio. The loss ratio is the sum of losses and loss-adjusted expenses over the premiums charged. If the actual loss ratio differs from the expected loss ratio, then the premium is adjusted according to the following formula :
Merit Rating
Merit Rating is based on a class rating, but the premium is adjusted accordingly upward or downward based on individual actual loss experience of that customer. It is based on the assumption that the loss experience of a particular insured will differ substantially from the loss experience of the other insured. Merit rating often determines the premiums for commercial insurance and in most of these cases, the customer has some control over losses. Merit rating is usually used when a class rating can give a good approximation, but the factors are diverse enough to yield a greater spread of losses than if the composition of the class were more uniform. Thus, merit rating is used to vary the premium from what the class rating would yield based on individual factors or actual losses experienced by the customer. Further various plans are used to determine merit rating.
Schedule Rating - This plan uses baseline rates as a starting point and then each exposure is individually rated depending on the degree of risk they carry which is then modified by debits or credits for undesirable or desirable physical features. These rating methods are used within the commercial property insurance, where factors like, location, size and business purpose provide baseline indicators for determining pricing rates. Baseline indicators rely on identified risk factors found within a group or class of policyholders that have similar characteristics such as age, sex and line of work. These indicators provide the starting points or baseline rates, which are used to calculate a premium rate for individual policyholders. For example; used in commercial property insurance for large complex buildings like industrial plant where each building is rated on :
Construction
Occupancy
Protection
Exposure
Maintenance
Experience Rating - This plan rely more heavily on a policyholder's past claim experience when determining what premium rates to be charged and the class or manual rate is adjusted upward or downward based on his/ her past loss experience. Experience Rating uses the actual loss amounts in previous policy periods, typically the prior 3 years, as compared to the class average to determine the premium for the next policy period. If losses were less than the class average, then the premium is lowered and if losses were higher, then the premium is raised. The insured's past loss experience is used to determine the premium for the next policy period. Price rates are determined according to a 'credibility factor'*, which uses a person's past claim history as an indication of the level of risk involved and the likelihood that future claims will be filed. Once a risk level is determined, the credibility factor is measured against a baseline pricing rate that represents to average rate charged to a class of policyholders that have similar characteristics. In determining the magnitude of rate change, the actual loss experience is modified by this creditability factor based on the volume. Adjustments are then made to the baseline pricing rate based on each policyholder's credibility rating. The adjustment to the premium is determined by the loss ratio method and is multiplied by a credibility factor to determine the actual adjustment. The greater the credibility factor, larger the adjustment of the premium up or down. As the credibility factor for small businesses is small, they are not generally eligible for experience rated adjustments to their premiums.
Experience rating is typically used for general liability insurance, workers compensation and group insurance. It is also extensively used for auto insurance, including personal auto insurance, because losses obviously depend on how well and how safely the individual drives.
* Credibility Factor is the reliability that the actual loss experience is predictive of future losses. In statistics, the larger the sample, the more reliable the statistics based on that sample. hence, the credibility factor is largely determined by the size of the business-the larger the business, the greater the credibility factor, and the larger the adjustment of the premium up or down. Because the credibility factor for small businesses is small, they are not generally eligible for experience rated adjustments to their premiums.
Retrospective Rating - This plan uses the actual loss experience for the period to determine the premium for that period, limited by a minimum and a maximum amount that can be charged. Part of the premium is paid at the beginning and the other part is paid at the end of the period, the amount of which is determined by the actual losses for that period. Retrospective rating is often used when schedule rating cannot accurately determine the premium and where past losses are not necessarily indicative of future losses, such as for burglary insurance where the odds of predicting how often a business would be burglarized are more difficult than predicting health risks, such as heart disease or diabetes with health insurance ratings.
According to this, the retrospective rating method relies more on a policyholder's actual claims experience when setting pricing rates as opposed to baselines or standard pricing rates. In order to do this, a company may require premium payments to be made in increments, with a portion due at the start of a policy term and the remainder due at the end of a policy term. In the case of burglary insurance, the amount of the remaining premium payment is based on whether a burglary occurred since the start of the policy period.
CONCEPT OF TARIFF AND MARKET AGREEMENT
Pre-Liberalisation
The first General Insurance Company in India - Triton Insurance Company Limited - was set up in 1850 under the control of the British. Its first Indian counterpart, the Indian Mercantile Insurance Company Limited, launched its operations in Bombay in 1907. Although the general insurance business was not nationalised along with life insurance, a code of conduct for fair and sound business practices was framed in 1957 by the General Insurance Council (a wing of the Insurance Association of India). In 1968, the Insurance Act was amended to provide for greater control over the General insurance business. In 1971, the management of non-life insurers was taken over by the Government of India (GoI).
In 1972, it was announced that the Indian Non-life insurance sector was to be nationalised with effect from 1 January 1973. At that time there were 107 general insurance companies within the country. They were mainly large city-oriented companies of different sizes catering to the organised sector (trade and industry). Upon nationalisation, these businesses were assigned to the four subsidiaries of the General Insurance Corporation (GIC) of India namely - the New India Assurance Co Ltd (NIACL), Oriental Insurance Company Ltd (OIC), United India Insurance Co Ltd (UIIC) and the National Insurance Company Ltd (NIC). The goals behind this structure were :
The subsidiary companies were expected to set up standards of conduct, sound practices and provision of efficient customer service in the general insurance business
The GIC was to help control the expenses of the subsidiaries
It was to help with the investment of funds for its four subsidiaries
It was to bring general insurance to the rural areas of the country, by distributing business to the four subsidiaries, each operating in different areas in India
The GIC was also the designated national reinsurer. By law, all domestic insurers were to yield 20% of their gross direct premium in India to the GIC
All four subsidiaries were to compete with one another.
The risks underwritten by an insurance company in the Non-life segment are usually covered under fire, motor and sundry/ miscellaneous insurance segments. The sundry portfolio covers engineering, aviation, health and other retail classes of risk. The rates, terms, and conditions that insurers could offer for their products were governed by the Tariff Advisory Committee (TAC), a statutory body created under the Insurance Act of 1938, the main insurance legislation in effect during the pre-liberalization period. Under this tariff system, premiums were fixed at the same rate for all companies, products were undifferentiated and coverage was limited in almost every segment. Non-life products were classified by whether they were regulated by tariffs: fire, insurance, motor vehicle insurance, engineering insurance and workers' compensation, among others that came under tariff; and burglary insurance, mediclaim, personal accident insurance, among others that did not. In addition, specialised insurance (eg racehorse insurance) did not fall under tariff regulations. Further, the monopoly structure and the closing of the market to foreign and domestic private companies enabled domestic public insurers to freely conduct business without having to face any competitive challenges. Under this market structure, there was no need for brokers. Besides, brokers were effectively kept out of the country by regulations that prevented them from charging fees or commissions for their services.
Just as in the case of the life insurance sector, policy makers also had to consider bringing about policy reforms in the general insurance sector once the new industrial policy was introduced by the government of India in 1991. Moreover, the level of penetration in the general insurance segment was below even the level of penetration in the life insurance segment. As a result, the need for liberalisation of the general insurance sector was also emphasized upon. Just like the life insurance sector, there was a need to offer wider range of innovative products to suit specific customer needs and to change people's attitude towards general insurance. Thus the general insurance industry along with the life insurance industry was liberalised by the year FY00.
Post Liberalisation
The passage of the Insurance Regulatory and Development Authority (IRDA) Act of 1999 liberalised the India insurance market. The Act represents the Indian Government's unanimous agreement, after years of deliberation, that opening the market to both Indian and foreign private companies could help the economy meet its growing insurance needs, spark insurance growth in rural areas, and promote India as a regional reinsurance hub. The specific provisions of the IRDA Act were to repeal the GIC monopoly and:
Establish the Insurance Regulatory and Development Authority (the IRDA) to oversee and regulate industry operations
Re-designate the GIC as a national reinsurer to which all of the country's direct insurers must continue to yield 20% of their business
Lift the ban on domestic private companies
Open the market to foreign participants - albeit with certain restrictions.
Thus in Nov 00, the Government of India restructured the General insurance industry by making GIC the 'Indian Reinsurer'.
Restructuring of the General Insurance Segment: A notification, at the request of the Insurance Regulatory and Development Authority (IRDA) was issued, which called for the splitting up of the reinsurance business from the general insurance business within the GIC. The General Insurance Business (Nationalisation) Amendment Act, 2002 was passed by both Houses of Parliament and consented by the President of India on August 7, 2002. The GIC was de-linked from its four subsidiaries. Each subsidiary, with their headquarters based in the four largest metropolitan areas, became independent. Consequently, GIC now undertakes only reinsurance business, while the four public sector undertakings (PSUs) - National Insurance Company Limited (NIC), New India Assurance Company Limited (NIACL), Oriental Insurance Company Limited (OIC) and United Indian Insurance Company Limited (UIIC) continued to handle the General insurance business. However, the government still remains the sole owner of the four former GIC subsidiaries. Further, GIC has now ceased to do any direct business in India, except for crop insurance. As the sole reinsurer in the domestic reinsurance market, GIC provides reinsurance to the direct general insurance companies in the Indian market.
Innovation and Expansion: After the opening of the sector to private players, several new products were introduced. They included products liability, corporate cover, professional indemnity policies, burglary cover, individual and group health policies, weather insurance, credit insurance, travel insurance etc. Some of these products were completely new (eg weather insurance) while others were already available through the public insurance companies. Areas in the country which were previously uninsured were slowly and gradually starting to go in for insurance cover. As a result, the general insurance market in India expanded.
Free Price Regime: Another major factor that provided an impetus to the non-life sector is the gradual introduction of a free-pricing regime. A Tariff Advisory Committee (TAC) was set up to specify tariffs for products offered by various companies. The IRDA set in motion the first phase of de-tariffing by withdrawing the administered pricing mechanism (effectively de-tariffing the regime) in respect of fire, engineering and motor insurance in 01-Jan-07. The free-price regime has led to a decline in cross-subsidisation between tariff and profitable portfolios like fire insurance and nontariff like health insurance. The new regime is also partly responsible for inducing general insurers to design new, innovative and suitable products for different sets of customers.
De-Tariffication: The removal of tariffs effective from Jan 01, 2007 was one of the most important steps taken in the general insurance segment since opening up of the insurance sector. Before de-tariffication about 70% of the General Insurance business was driven by various tariffs being prescribed by Tariff Advisory Committee (TAC), which was established under the Insurance Act of 1938, to control and regulate the rates, terms, advantages and conditions in the general insurance business. The major classes of general insurance business under tariff regime were fire, petrochemicals, engineering and motor insurance. The Regulator's purpose was to ensure that the rates were fixed appropriately and equitably keeping the interests of both the insurer and policy holder in mind through a scientific method of rating. However, a major hurdle came up in the form of lack of updated data and the absence of a system to disseminate the data to the public. Even the PSU insurers were not able to publish consolidated data on each class of insurance. As a result pricing of different classification of risks was done in an ad-hoc manner which resulted in cross subsidisation among different class of risks and also within a class. Apart from this, the insurer in a regulated market did not have flexibility in pricing or innovation of products as they had to adhere to the terms and conditions of the tariff. Added to that, as the PSU insurers were enjoying monopoly status and profitability was not given a priority. Lack of flexibility and increase in level of complacency resulted in erosion of underwriting skills of the insurers and of their income. It was these above reasons that prompted the IRDA to de-tariff the general insurance industry. In order to facilitate filing of products to be used in de-tariffed market, the Authority came up with draft guidelines on File & Use requirements for general insurance products (See Annexures). It fixed the requirement for obtaining board approval for underwriting policy, the responsibilities of the Compliance Officer, Classification of Products for filing, Data support and Role of Appointed Actuary etc.
The IRDA roadmap to a detariffed market envisaged insurers filing the policies which they proposed to sell in the detariffed regime, but in recent months there has been a reconsideration of whether complete detariffication will occur. The General Insurance Council (GIC), a statutory body established under Section 64C of the Insurance Act 1938 which represents the collective interests of non-life insurance companies, was given the responsibility of developing standard market wordings for fire, engineering and motor risks for insurers to follow after de-tariffication. The GIC states that its objectives are:
the smooth transition of the market from tariff to tariff-free regime;
assurance of minimum standards to insurance buyers;
clarity of policy terms and conditions and uniformity of interpretations; and
introduction of best global practices.
Minimum Standard Wordings
The GIC has published its proposed minimum standard wordings for fire, engineering and motor risks and says that these wordings "have been developed as base level, with scope for customization through endorsements for addition or deletion of covers". Endorsements have also been drafted by the GIC.
Although the wordings are lengthy and currently under review by sections of the market, and although the GIC has said that the minimum standard wordings are not intended to restrict insurers from creating their own wordings, fundamental questions have been raised about the GIC's stated objectives.
In terms of achieving a smooth transition of the market from tariff to tariff-free regime, the more liberal elements of the market have asked why the minimum standard wordings are needed. Those who want the market to determine wordings, subject to oversight by the IRDA, ask whether the publication of minimum standard wordings is not simply 'tariff lite'.
The laudable intention of an assurance of minimum standards for the insurance-buying public has also attracted comment. Despite the absence of any public demand for minimum standard wordings, insurers wishing to sell a policy in the detariffed regime will first have to file it with the IRDA for approval before marketing it to the public. The public appears to have endorsed new insurers and the products which they have been offering since liberalization in 2000, without expressing concerns over the absence of minimum standards in the form of minimum standard wordings. Minimum standards have hitherto been satisfied by the 'file and use' procedure for all policies continuing post-detariffication.
It has been asked whether a smooth transition of the market from tariff to tariff-free regime would not be better achieved by obliging insurers to offer existing tariff covers alongside new detariffed wording for a period of time so that the market could take its time gaining confidence in the new covers. Alternatively, the minimum standard wordings could comprise broad guidelines rather than actual wordings.
