1. Fixed Expenses
    • Expenses assumed to be the same for each risk, regardless of amount of premium
    • E.g., overhead costs associated with the home office
  2. Variable Expenses
    • Expenses vary directly with premium (i.e., constant percentage of premium)
    • E.g., premium taxes and commissions
  3. Name the three procedures to derive expense provision for ratemaking
    • 1. All Variable Expense Method
    • 2. Premium-based Projection Method
    • 3. Exposure/Policy-based Projection Method
  4. All Variable Expense Method
    • Does not diff erentiate between fixed and variable
    • Expenses assumed to be a constant percentage of premium
  5. Relate historical expenses to either historical written or earned
    • Use written if believe expense generally incurred at onset of policy
    • Use earned if believe expense generally incurred throughout the policy
  6. Selection of expense provision
    • Based on latest year or multi-year average
    • Also use management input, prior expense loads, and judgment
    • Expense load should reflect expectations in the future
  7. If non-recurring expense items during the historical period, the actuary should:
    • Examine the materiality and nature of the expense to determine how/if should be incorporated
    • May choose to spread out over several years or not include at all
  8. Potential Distortions of All Variable Expense method:
    • Assumes all expenses vary directly with premium
    • However, portion may be fi xed

    • Understates premium need for small premium risks
    • Overstates premium for large premium risks
  9. Options for companies using the All Variable Expense method to deal with distortion
    • Premium discount to reduce expense loadings for larger premium polices
    • Expense constants to handle expenses such as policy issuance and auditing
  10. Compare All Variable Expense Method to Premium-Based Projection Method
    Similarity: Premium-Based assumes expense ratios during projection period will be same as historical

    Enhanced: Prem-Based calculates fixed and variable expense ratios separately
  11. What are the steps in the Premium-Based Projection Method?
    1. Determine percentage of premium attributable to expenses for each of the expense categories

    • 2. Divide ratio into fi xed and variable ratios:
    • Ideally split based on detailed company data;
    • Without needed data, make reasonable assumptions

    3. Sum expense ratios across categories to determine fi xed and variable provisions

    Note: this gives you the fi xed expense ratio, which is a ratio to premium - this is used with the loss ratio approach (Ch. 8)

    If using the pure premium approach, convert to fixed expense per exposure: Fixed per Exposure = Fixed Expense Ratio * Projected Average Premium
  12. Potential Distortions of premium based projection
    1. Rate changes can impact the historical expense ratios and lead to an excessive or inadequate overall rate indication

    2. Signifi cant premium trend between the historical experience period and the projected period can lead to an excessive or inadequate overall rate indication

    3. Can create inequitable rates for regional or nationwide carriers because it uses countrywide expense ratios and applies them to state projected premiums to determine the expected fi xed expenses
  13. What are the steps in the Exposure/Policy-Based Projection Method?
    • 1. Divide expenses into fi xed and variable amounts
    • 2. Divide fi xed expenses by corresponding exposures (written/earned, countrywide/state)
    • 3. Divide variable expenses by corresponding premium

    Note: this gives you the fi xed expense per exposure - this is used with the pure premium approach
  14. Selecting projected average expense per exposure in the Exposure/Policy-Based Projection Method
    • Similar expense ratios over several years implies expenses and exposures are increasing or decreasing proportionately
    • Must consider impact of economies of scale given expected growth
  15. Other Considerations / Future Enhancements in the Exposure/Policy-Based Projection Method
    • 1. The actuary splits expenses into fixed and variable
    • 2. Allocates countrywide fi xed expenses to each state based on exposures
    • 3. Some expenses considered fi xed vary by other characteristics
    • 4. Existence of economies of scale in a changing book
  16. Trending Expenses
    • Variable Expenses
    • No trend needed
    • Constant % of premium

    • Premium-based Projection Method
    • If average expenses and average premium changing at same rate: Need no trending
    • If assume average fi xed expenses changing at diff erent rate than average premium: Trend fixed expense ratio

    • Exposure-based Projection Method
    • If inflation sensitive exposure base used: No trending necessary if assume expenses & exposure base changing at same rate
    • If non-inflation sensitive base or policy counts: Trending necessary b/c ave FE expected to change over time
  17. What are two ways to consider Reinsurance Costs in ratemaking analysis
    Reduce projected losses for reinsurance recoveries and premiums for cost of reinsurance

    Net cost of non-proportional reinsurance may be included as an expense item: i.e., cost of reinsurance minus expected recoveries
  18. Total Pro fit
    Investment Income + UW Pro fit
  19. Two major sources of investment income
    • Investment income on capital
    • Capital belongs to owners of the company
    • Substantial disagreement whether this investment income should be included in ratemaking

    • Investment income earned on policyholder-supplied funds
    • Two types - unearned premium reserves and loss reserves
    • Longer the tail of the line, the longer opportunity for investment
  20. Underwriting Pro fit
    Sum of pro fits generated from insurance policies
  21. Variable Permissible Loss Ratio
    • VPLR = 1.0 - Variable Expense % - Target Profi t % = 1.0- V - Q
    • Portion of each dollar of premium to be spent on Projected Loss, LAE & Fixed Expense
  22. Total Permissible Loss Ratio
    • PLR = 1.0 - Total Expense % - Target Profi t % = 1.0 - F -V - Q
    • Portion of each dollar of premium to be spent on Projected Loss & LAE
    • If all expenses treated as variable, VPLR = PLR
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