RATEMAKING An insurance rate is the

RATEMAKING
An insurance rate is the price per unit of insurance. Like any other price, it is a function of the cost of production. However, in insurance, unlike in other industries, the cost of production is not known when the contract is sold, and it will not be known until some time in the future, when the policy has expired. One fundamental difference between insurance pricing and the pricing function in other industries is that the price for insurance must be based on a prediction. The process of predicting future losses and future expenses and allocating these costs among the various classes of insureds is called ratemaking. A second important difference between the pricing of insurance and pricing in other industries arises from the fact that insurance rates are subject to government regulation. As we noted in the preceding chapter, virtually all states impose statutory restraints on insurance rates. State laws require that insurance rates must not be excessive, must be adequate, and may not be unfairly discriminatory. Depending on the manner in which the state laws are administered, they impose differing limits on an insurer’s freedom to price its products. The ratemaking function in a life insurance company is performed by the actuarial department or in smaller companies, by an actuarial consulting firm. 1 In the property and liability field, advisory organizations accumulate loss statistics and compute loss costs for use by insurers in computing final rates, although some large insurers maintain their own loss statistics. In the field of marine insurance and inland marine insurance, rates are often made by the underwriter on a judgment basis. In addition to the statutory requirements that rates must be adequate, not excessive, and not unfairly discriminatory, there are certain other characteristics considered desirable. To the extent possible, for example, rates should be relatively stable over time, so that the public is not subjected to wide variations in cost from year to year. At the same time, rates should be sufficiently responsive to changing conditions to avoid inadequacies in the event of deteriorating loss experience. Finally, whenever possible, the rate should provide some incentive for the insured to prevent loss.