What it means
The rate is not the premium, and mixing the two causes most of the confusion around this term. The rate is the price for a single unit of exposure, while the premium is that rate multiplied by how many units of exposure the customer actually has.
Setting a rate starts with the pure premium, which is the expected claims cost for one exposure unit over one year. Actuaries estimate it from historical claims, adjusted for inflation and for any change in the mix of customers.
That gives the cost floor below which the insurer loses money on every policy it writes. The pure premium is then grossed up for expenses, commission and a target profit margin, usually expressed through the permissible loss ratio.
If expenses and profit together are expected to consume 25% of every premium dollar, only 75% is left to pay claims, so the pure premium has to be divided by 0.75. This step is where pricing arguments happen, because sales teams see the loaded rate while actuaries see the underlying loss cost.
Rates are then split by rating factor so that similar risks pay similar prices: location, age of the asset, claims history, trade, security measures and sum insured. A rate that ignores a genuine cost difference will attract the worst risks and lose the best ones, a drift known as adverse selection.
That is why rate reviews happen on a cycle rather than once. A common variant is the manual rate, a published table rate for standard risks against which an underwriter applies credits or debits for specific features.
Large commercial accounts may instead be experience rated, where the customer's own claims record carries most of the weight.
In practice
Real-world examples.
Example
A regional insurer reviewing its shop contents book finds claims costs rising faster than premiums. The actuaries recompute the pure premium at $300 per $100,000 of stock and the gross rate at $400, a 12% increase on the rate currently in use. Underwriting agrees to phase the rise in over two renewal cycles to limit customer losses.
Example
A vehicle fleet operator asks why its renewal quote jumped. The insurer explains that the actuarial rate per vehicle year rose from $400 to $460 because the fleet's own claims frequency roughly doubled over two years. The operator responds by funding a driver training programme designed to bring the rate back down at the following renewal.
Example
A state regulator rejects a filed rate increase on household cover because the supporting data mixes two very different regions into one average. The insurer refiles with separate rates of $520 and $340 per $100,000 of dwelling value, each supported by its own claims experience. The revised filing is approved without further challenge.
Formula
Calculation
Pure premium rate = expected losses / number of exposure units
Gross actuarial rate = pure premium rate / (1 - expense ratio - profit margin)
Worked example: an insurer prices a commercial vehicle book where expected losses are $600,000 across 2,000 exposure units, each unit being one vehicle insured for one year. The pure premium rate is 600,000 / 2,000 = $300 per vehicle year. Expenses are expected to take 20% of premium and the target profit margin is 5%, so the permissible loss ratio is 1 - 0.25 = 0.75. The gross actuarial rate is 300 / 0.75 = $400 per vehicle year. A customer insuring 3 vehicles therefore pays 3 x $400 = $1,200 before any individual credit or debit is applied.Case study
Seen in the real world.
Harbour Mutual is an illustrative, fictional insurer that built a fast growing book covering small coastal guest houses. Its sales team priced new business against the cheapest quote in the market, and for three years the book grew while claims stayed quiet.
When a severe storm season arrived, claims on that book came to $8,400,000 against premiums of $6,000,000, a loss ratio of 140%. A rate review found the pure premium had always been around $400 per $100,000 of sum insured, yet the gross rate charged averaged only $390, less than the bare loss cost before any expenses. Harbour Mutual had been selling cover below the price of the risk and had been rewarded with growth for doing so.
In this fictional recovery the insurer rebuilt the rate from the loss cost upwards, declined around a fifth of the renewals, and accepted a smaller but profitable book. The useful point is that in insurance a pricing error does not announce itself through lost sales, it announces itself through claims some years later.
Watch out
Common mistakes.
- Confusing the actuarial rate with the premium, then comparing a rate per unit against a total price and concluding the insurer is overcharging.
- Setting the rate from competitor prices instead of expected claims, which hides a loss making book until the claims eventually arrive.
- Forgetting to load the pure premium for expenses and profit, so every policy sold loses money on administration alone.
Questions
People also ask.
Why do two businesses in the same trade pay different rates?
Because rating factors such as location, claims history, security measures and sum insured change the expected claims cost for each one.
Is a lower rate always better for the buyer?
Not necessarily, because a rate set too low can leave the insurer unable to pay claims or force a steep correction at the next renewal.
How often are actuarial rates reviewed?
Most insurers review them at least annually, and sooner if claims experience, inflation or the mix of customers shifts noticeably.
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