4.3 Ratemaking and Premium Components

Rate vs Premium

A rate is the price of insurance per exposure unit. A premium is what the insured is charged for the policy. The relationship you must be able to apply on an application-based Associate in Insurance (AINS) item is:

Premium = rate × number of exposure units

If a homeowners rate is $4.50 per $1,000 of Coverage A and Coverage A is $400,000, the number of exposure units is $400,000 / $1,000 = 400. Premium = 400 × $4.50 = $1,800 before deductible or protective-device adjustments. If a businessowners policy (BOP) liability rate is $2.40 per $100 of gross receipts and estimated receipts are $800,000, exposure units = $800,000 / $100 = 8,000. Premium = 8,000 × $2.40 = $19,200.

The trap is treating "rate" and "premium" as synonyms, or using the wrong exposure base. $2.40 is not the premium. $800,000 is not the number of units. Dividing $800,000 by $1,000 when the plan is per $100 produces 800 units and a $1,920 premium — off by a factor of ten, and a very expensive exam miss.

A second homeowners pass: rate $5.00 per $1,000, Coverage A $360,000. Units = 360. Premium = 360 × $5.00 = $1,800. Same premium as the first house, different rate and different amount of insurance. Always show the units.

Components of the Rate

Insurers do not pull a rate from the marketing calendar. A gross rate is built from three families of cost:

1. Prospective loss costs, also called pure premium — expected losses and loss adjustment expenses (LAE) per exposure unit for a future period.
2. Expense loading — commissions, other acquisition costs, general expenses, and premium taxes, licenses, and fees.
3. Profit and contingencies — a provision for underwriting profit and for the chance that losses or expenses run worse than expected.

Prospective loss costs are often filed by advisory organizations as loss costs, not as final rates. The insurer then adds its own expense and profit provisions to produce a filed rate. That two-step structure is why a producer can see similar loss costs across companies and still see different premiums: the loadings differ.

This guide does not invent official AINS formula weights. The Institutes do not publish AINS-only percentages for "how much of every rate is profit." Use the names of the components, not a memorized unofficial split.

An illustration, labeled as an illustration

Suppose 2,000 earned house-years produced $780,000 of incurred losses and LAE. Pure premium = $780,000 / 2,000 = $390 per house-year.

Suppose, for illustration only, that expenses are provisioned at 25 percent of the gross rate and profit and contingencies at 5 percent. Then 70 percent of the gross rate is available for loss costs (the permissible loss ratio in this example). Gross rate = $390 / 0.70 = $557.14 per house-year.

Check: 0.70 × $557.14 ≈ $390 loss costs; 0.25 × $557.14 ≈ $139 expenses; 0.05 × $557.14 ≈ $28 profit and contingencies. Those 25 and 5 percent figures are a teaching illustration, not an AINS published weight. A personal-lines direct writer with lower commission might load expenses lighter; an independent-agency writer might load them heavier. On a round $1,000 premium built the same 70 / 25 / 5 way, $700 is prospective loss costs, $250 is expense loading, and $50 is profit and contingencies. Change the split and you change the rate; you do not change the names of the three components.

Class, Individual, and Judgment Rating

Class rating (manual rating) charges the same base rate to all insureds who share class characteristics: dwelling construction and protection class, auto driver class, or a BOP class code. Most personal lines and much small commercial is class rated. It is fast and statistical, and it is fair only if the class is homogeneous enough.

Individual rating modifies a class or starting rate for this insured:

• Experience rating uses the insured's own past losses compared with expected losses for the class. Workers compensation experience modification factors are the classic example. A three-year HO-3 on a tract house is generally not experience-rated like a $2 million payroll.
• Schedule rating applies credits and debits for specific characteristics the class rate does not fully capture: housekeeping, management, loss control, building features. Commercial property and general liability (GL) often allow schedule modifications within filed ranges.
• Retrospective rating sets a deposit premium and then adjusts the final premium after the policy period based on actual losses, subject to a minimum and maximum. It appears on large workers compensation and liability accounts, not on a standard HO-3.

Judgment rating is used when statistics are too thin for a credible class rate: unique inland marine, an unusual event, some surplus-lines property. The underwriter (or a specialist) sets the rate from analogs, inspections, and judgment. Judgment is not "whatever wins the account." It is still supposed to cover expected losses, expenses, and profit.

Exposure Bases

An exposure base should vary with expected loss, be easy to measure, and be hard to manipulate. Common bases:

• Car-year (or car-month) for auto — one car insured for one year.
• Payroll for workers compensation and some GL classifications — usually per $100 of payroll.
• Gross receipts or sales for many BOP and GL classifications — usually per $1,000 or per $100.
• Area (square footage) for some property and premises-liability classes.
• Amount of insurance or Coverage A / total insured value (TIV) for property, often per $1,000.

Using payroll to rate a building's fire exposure, or using square footage to rate a trucker's auto liability, is the wrong base. AINS items will hand you a base and a rate; your job is to compute units correctly and to notice when someone used $1,000 as the divisor for a per-$100 plan.

A payroll example: workers compensation rate $1.80 per $100 of payroll, estimated payroll $500,000. Units = $500,000 / $100 = 5,000. Premium = 5,000 × $1.80 = $9,000 before an experience modification. If a candidate divides by $1,000 instead, they get 500 units and $900 — again off by ten.

Adequate, Not Excessive, Not Unfairly Discriminatory

U.S. property-casualty rate regulation repeats three standards. Rates must be:

1. Adequate — high enough, with investment income considered as the jurisdiction requires, to pay expected losses and expenses and to avoid depleting surplus. Inadequate rates are how adverse selection and underwriting losses arrive together.
2. Not excessive — not unreasonably high for the risk and the market structure. "Not excessive" is not "the cheapest quote in town."
3. Not unfairly discriminatory — differences in rates must track differences in expected cost. Charging two houses different premiums because of construction, protection class, or claims history can be fair discrimination. Charging different premiums for a prohibited characteristic, or charging different prices to similar risks without a cost basis, is the problem.

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