Question

What is the basis of Insurance company regarding on rates? What insurance business is all about?

Answer 1

Rate making or insurance pricing, is the determination of what rates, or premiums, to charge for insurance. A rate is the price per unit of insurance for each exposure unit, which is a unit of liability or property with similar characteristics. For instance, in property and casualty insurance, the exposure unit is typically equal to $100 of property value, and liability is measured in $1,000 units. Life insurance also has $1000 exposure units. The insurance premium is the rate multiplied by the number of units of protection purchased.

Insurance Premium = Rate × Number of Exposure Units Purchased

The difference between the selling price for insurance and the selling price for other products is that the actual cost of providing the insurance is unknown until the policy period has lapsed. Therefore, insurance rates must be based on predictions rather than actual costs. Most rates are determined by statistical analysis of past losses based on specific variables of the insured. Variables that yield the best forecasts are the criteria by which premiums are set. However, in some cases, historical analysis does not provide sufficient statistical justification for selling a rate, such as for earthquake insurance. In these cases, catastrophe modeling is sometimes used, but with less success. Actuaries set the insurance rate based on specific variables, while underwriters decide which variables apply to a specific insurance applicant.

Because an insurance company is a business, it is obvious that the rate charged must cover losses and expenses, and earn some profit. But to be competitive, insurance companies must also offer the lowest premium for a given coverage. Moreover, all states have laws that regulate what insurance companies can charge, and thus, both business and regulatory objectives must be met.

The primary purpose of ratemaking is to determine the lowest premium that meets all the required objectives. A major part of ratemaking is identifying every characteristic that can reliably predict future losses, so that lower premiums can be charged to the low risk groups and higher premiums charged to the higher risk groups. By offering lower premiums to lower risk groups, an insurance company can attract those individuals to its own insurance, lowering its own losses and expenses, while increasing the losses and expenses for the remaining insurance companies as they retain more of the higher risk pools. This is the reason why insurance companies spend money on actuarial studies with the objective of identifying every characteristic that reliably predicts future losses.

The pure premium, which is determined by actuarial studies, consists of that part of the premium necessary to pay for losses and loss related expenses. Loading is the part of the premium necessary to cover other expenses, particularly sales expenses, and to allow for a profit. The gross rate is the pure premium and the loading per exposure unit and the gross premium is the premium charged to the insurance applicant, and is equal to the gross rate multiplied by the number of exposure units to be insured. The ratio of the loading charge over the gross rate is the expense ratio.

Insurance is a contract, represented by a policy, in which an individual or entity receives financial protection or reimbursement against losses from an insurance company. The company pools clients' risks to make payments more affordable for the insured.

Insurance policies are used to hedge against the risk of financial losses, both big and small, that may result from damage to the insured or her property, or from liability for damage or injury caused to a third party.

There is a multitude of different types of insurance policies available, and virtually any individual or business can find an insurance company willing to insure them, for a price. The most common types of personal insurance policies are auto, health, homeowners, and life. Most individuals in the United States have at least one of these types of insurance, and car insurance is required by law.

Businesses require special types of insurance policies that insure against specific types of risks faced by a particular business. For example, a fast food restaurant needs a policy that covers damage or injury that occurs as a result of cooking with a deep fryer. An auto dealer is not subject to this type of risk but does require coverage for damage or injury that could occur during test drives. There are also insurance policies available for very specific needs, such as kidnap and ransom (K&R), medical malpractice, and professional liability insurance, also known as errors and omissions insurance.