0 INTRODUCTION 1

Chapter 9
Experience rating
0 Introduction
The rating process is the process of deciding on an
appropriate level of premium for a particular class
of insurance business.
The contents of this chapter are
The rating of general insurance business
Experience-rating systems
Denition of no claims discount systems
Steady state analysis
The eect of NCD systems on the propensity
to claim
1 THE RATING OF GENERAL INSURANCE BUSINESS 2
1 The rating of general insurance business
1.1 Basic methodology
The rating process may start with a calculation of
the pure risk premium, before loadings are added
for commission, expenses, prot and other contin-
gencies to give the oce premium.
Alternatively, where there is an established rating
structure, the process may be to identify changes
that need to be made in the relative levels of pre-
mium for dierent categories within that struc-
ture, and then to determine the overall percentage
adjustment that needs to be applied to the existing
premiums to achieve the desired nancial result.
1 THE RATING OF GENERAL INSURANCE BUSINESS 3
1.2 The risk premium
The risk premium is derived from the base data
and then projected, making allowance for any changes
in cover, ination and any expected experience
trends.
1 THE RATING OF GENERAL INSURANCE BUSINESS 4
1.3 Data required
In order to carry out an examination of the ap-
propriateness of the premium structure an insurer
needs to produce a specication of the data re-
quirements, assuming that the insurer has main-
tained appropriate records for this purpose.
1 THE RATING OF GENERAL INSURANCE BUSINESS 5
1.4 Calculation of base values
The premiums will be based on the past experience
of either the insurer or the market.
Premiums are usually quoted in relation to a unit
of exposure.
In practice it is more common to analyze the ele-
ments of claim frequency, cost per claim and ex-
posure per policy separately.
These elements are analyzed separately so that
trends in experience can be spotted and projected
into the future.
1 THE RATING OF GENERAL INSURANCE BUSINESS 6
Pure risk premium per unit of exposure
= Expected claim amount per unit of exposure
The basic elements of the pure risk premium can
be derived by expanding the claim amount per
unit of exposure as follows:
Total claim amount
Exposure
=
No. of claims
Exposure

Total claim amount
No. of claims
This gives the usual formula for the pure risk pre-
mium:
Pure risk premium
= Expected claim frequency Expected cost per
claim
1 THE RATING OF GENERAL INSURANCE BUSINESS 7
1.5 Choice of base experience statistics
Internal data
An insurer that has been writing a class of
business for some years should have a bank
of past experience from which to derive the
base values.
1 THE RATING OF GENERAL INSURANCE BUSINESS 8
External data
Where an insurer has insucient or unsuit-
able internal data, it will be necessary to
make use of external data. These may take
the form of aggregate market statistics, or
competitors rates for a similar product.
1 THE RATING OF GENERAL INSURANCE BUSINESS 9
1.6 Adjusting the base values
Many dierent situations may arise to cause the
base experience to be dierent from that expected
during the new rating period.
Suitable adjustment will need to be made for:
Unusually heavy/light experience
Large or exceptional claims
Trends in claim experience
Changes in risk
Changes in cover
Changes in the cost of reinsurance
1 THE RATING OF GENERAL INSURANCE BUSINESS 10
1.7 Projecting the base values
The total claim cost and exposure values produced
from the initial analyses will be expressed in the
money terms of the base period.
Therefore, as well as allowing for future trends and
any proposed risk or cover changes, the projections
need to allow for the expected eect of in-
ation on claims between:
the mean payment date of claims in the base
period, and
the mean payment date of claims arising during
the exposure period of the new rating series
1 THE RATING OF GENERAL INSURANCE BUSINESS 11
When revaluing base values for future premium
rates, there are two parts to the calculation:
inating base values to the present day using
(broadly) known ination rates
projecting from the present day to the future
using estimated future ination rates
1 THE RATING OF GENERAL INSURANCE BUSINESS 12
1.8 Projecting exposure values
In order to arrive at a risk premium rate, the pro-
jected claim cost must be divided by a correspond-
ing projected value of the exposure.
For example, with private motor insurance,
the premium is quoted per vehicle-year. One
vehicle-year is the unit of exposure.
1 THE RATING OF GENERAL INSURANCE BUSINESS 13
Where these exposure units are expressed in terms
of monetary units, the base exposure values need
to be projected at an appropriate rate of ination.
This may not be the same as that applied to claim
cost. Here, the projection is only to the mid-point
of the exposure period arising under the new rates.
For example, in many forms of property in-
surance, the premium is quoted per 1,000
sum insured. In these cases, high ination
does not necessarily mean that the premium
rate must be increased. If the exposure mea-
sure inates as quickly as the average claim
amounts, then premium rates might stay
constant.
1 THE RATING OF GENERAL INSURANCE BUSINESS 14
For example, a premium rate of 2 per 1,000
sum insured set in 1956 might still be ap-
propriate in 2005. But we very much doubt
whether a, premium of 15 per vehicle year
set in 1956 would still be acceptable in 2005!
1 THE RATING OF GENERAL INSURANCE BUSINESS 15
1.9 Allowing for investment income
Insurers will be able to invest part of the premiums
for a period of time.
This can be particularly signicant for the longer-
tailed classes of business.
For long-tail classes, premiums may be invested for
many years before being needed to settle claims.
The assumption regarding investment returns is
then signicant.
Note also that the ination assumptions are far
more signicant for long-tail classes.
1 THE RATING OF GENERAL INSURANCE BUSINESS 16
1.10 Adjustments for commission, expenses and other load-
ings
Insurers adopt many dierent ways of loading the
risk premium for commissions, expenses, the cost
of reinsurance and other margins, and may allow
for the investment income likely to be generated
by holding the premium until claims are paid.
Those who start by calculating pure risk premi-
ums will load those premiums, either by applying
a simple overall percentage addition or by allowing
for expenses in a more detailed way, having regard
to their xed or variable nature.
Those who estimate the overall percentage change
required in the existing premium rates should make
due allowance for expected changes in expense lev-
els.
1 THE RATING OF GENERAL INSURANCE BUSINESS 17
1.11 Example of premium rating and premium rating formula
An example of premium rating
A sample premium rating formula
2 DEFINITION OF NO CLAIMS DISCOUNT SYSTEMS 18
2 Denition of no claims discount systems
2.0 Experience-rating systems
An experience-rating system is one in which the
premium for each individual risk depends, at least
in part, on the actual claims experience of that
risk.
Concept underlying experience-rating system: HIGH
RISK tends to remain HIGH RISK.
Experience-rating system and SELECTION RISK
Number-based / cost-based SYSTEM
Prospective / retrospective BASIS
2 DEFINITION OF NO CLAIMS DISCOUNT SYSTEMS 19
2.0.1 Prospective vs retrospective basis
With prospective rating, the premium at the re-
newal date depends on the experience of the risk
prior to that renewal.
The insurer takes on all underwriting risk in such
and arrangement.
NCD in private motor is a prospective system of
experience-rating system.
With retrospective rating, the premium for the
current policy period is adjusted, based on the ex-
perience of that period of risk.
A deposit premium, paid at the inception of the
policy, will usually be followed by an adjustment
premium, or refund, at the end of the period.
The underwriting risk to the insurer is reduced
with retrospective rating.
2 DEFINITION OF NO CLAIMS DISCOUNT SYSTEMS 20
2.0.2 Number-based systems
With number-based system, the premium adjust-
ments (whether prospective or retrospective) are
based on the number of claims paid in respect of
the policyholder, and the amounts of the claims
are ignored.
NCD system / bonus-malus system (BMS system)
2 DEFINITION OF NO CLAIMS DISCOUNT SYSTEMS 21
2.0.3 Cost-based systems
With cost-based system, the premium adjustments
(whether prospective or retrospective) are based
on the total amounts of claims incurred in respect
of the policyholder over a dened period.
System based on the cost of claims tend to be
used for larger risks or group of risks where the
aggregate cost of claims experienced within a year
may be a more suitable indicator of the relative
level of the underlying risk.
Motor eet (for larger eets) / employers liability
2 DEFINITION OF NO CLAIMS DISCOUNT SYSTEMS 22
Prot sharing, where the insurer charges a higher
initial premium, and returns some prot to poli-
cyholders whose claims are lower than expected.
This is a typical retrospective arrangement based
on claim amount.
2 DEFINITION OF NO CLAIMS DISCOUNT SYSTEMS 23
The policyholder pays an end of year adjustment
premium to reect the amount of exposure during
the year (e.g. as in employers liability).
This is not the example of experience-rating.
2 DEFINITION OF NO CLAIMS DISCOUNT SYSTEMS 24
2.1 Discount categories
There are two parts to a NCD system:
the discount categories which are often referred
to as the number of claim free years.
a set of rules for moving between these cate-
gories.
In addition, in order to investigate the properties
of a NCD system the chance that a policyholder
makes a claim each year also needs to be known.
2 DEFINITION OF NO CLAIMS DISCOUNT SYSTEMS 25
Question 9.3 on page 12.
A motor insurer operates an NCD sys-
tem with discount levels of 0%, 30%, 40%,
50% and 60%. The rules are as follows:
1. At the end of a claim free year, a poli-
cyholder moves up one level (or remains on
maximum discount).
2. At the end of a year in which exactly one
claim was made, a policyholder drops back
two levels (or moves to zero discount).
3. At the end of a year in which more than
one claim was made, a policyholder drops
back to zero discount.
What premium does a motorist who rst
took out a policy on 1 January 1989 pay for
insurance cover in the year 2000, if the pol-
icyholder made claims on 15 August 1990,
3 February 1994, 17 September 1994 and 14
November 1999, and the full premium for
the year 2000 is 750pa?
2 DEFINITION OF NO CLAIMS DISCOUNT SYSTEMS 26
2.2 The transition matrix
The probability that a policyholder in category i
moves to category j from one year to the next can
be written as a matrix of transition probabilities.
_
_
_
_
_
_
p
00
p
01
p
02

p
10
p
11
p
12

p
20
p
21
p
22



_
_
_
_
_
_
where p
ij
is the probability that a policyholder
moves from category i to category j.
Question 9.4 on page 13.
Given the transition matrix
_
_
0.2 0.8 0
0.2 0 0.8
0 0.2 0.8
_
_
for the system with States 0, 1 and 2, us-
ing the convention given above, what is the
probability that a policyholder who starts in
State 0 is in State 0 again 2 years later?
2 DEFINITION OF NO CLAIMS DISCOUNT SYSTEMS 27
2.3 Distribution of policyholders
The transition matrix can be used to estimate how
many policyholders are expected to be in each dis-
count category each year.
The expected proportion of policyholders in cate-
gory i is denoted by
i
.
Note that

i
= 1.
Also, the proportions in the discount categories
can be represented as a vector, = (
0
,
1
,
2
, . . . ,
n
).
Then we can write

(n+1)
=
(n)
P.
Example on page 14.
3 STEADY STATE ANALYSIS 28
3 Steady state analysis
3.1 The equilibrium distribution
It is possible to continue nding
(n)
for larger
values of n.
Under reasonable conditions,
(n)
will tend to a
limit as n .
When this happens, the system has reached equi-
librium or its steady state.
This limit is denoted .
Letting n gives = P.
This is a set of equations which can be solved to
nd noting that

i
= 1.
An example on pages 16-17.
3 STEADY STATE ANALYSIS 29
3.2 Heterogeneity in the portfolio
One of the reasons which is used to justify NCD
systems is that they result in automatic premium
rating. In other words, policyholders who make
fewer claims pay less than those who make more
claims.
While this is obviously true, most do not work as
well as is hoped and the premiums policyholders
ultimately pay are not proportional to their likeli-
hood of making a claim.
This is partly because of the small number of cat-
egories of discount and the relatively low levels of
discount that are oered.
But it is also due to the relatively low probabilities
of claims occurring and hence the high probabil-
ities of all policyholders reaching the maximum
discount level at some stage.
Another reason why NCD systems do not work as
well as might be hoped is because of noise in
the system. Peoples actual claim rates dier from
those that might be expected.
3 STEADY STATE ANALYSIS 30
Given the probabilities of claiming for all policy-
holders, it would in fact be possible, mathemati-
cally, to determine a NCD system that would re-
sult, over the long term, in all policyholders paying
a pure premium that was directly proportional to
their probability of claiming.
However, this would be an extremely complex sys-
tem to administer and understand.
The following example takes the situation to the
opposite extreme, by assuming that there are only
two possible types of policyholder and there are
only three categories of discount. However, even
in this simple situation it is not easy to produce a
system that matches premiums to the probabilities
of claiming.
An example on pages 18-19.
4 THE EFFECT OF NCD SYSTEMS ON THE PROPENSITY TO CLAIM 31
4 The eect of NCD systems on the propensity to
claim
4.1 Reassessment of transition probabilities
In what has been done so far, it has been assumed
that the probability that a driver makes a claim
is the same, no matter which discount category he
or she is in.
The policyholder may take into account the in-
creases in future premiums when deciding whether
to make a claim or not.
This can be considered by comparing the change
in premiums when a claim is made.
The number of future years considered is called
the policyholders horizon, and the propensity to
claim will also depend on this horizon.
Example on page 21.
4 THE EFFECT OF NCD SYSTEMS ON THE PROPENSITY TO CLAIM 32
4.2 Calculating the transition probabilities
It can be seen from this that the probability that
a policyholder incurs a loss (eg has an accident)
is not the same as the probability that a claim is
made.
If the distribution of the loss is known, the prob-
ability that a claim is made following an accident
can be calculated.
For example, considering the policyholder in the
previous example, who has an innite horizon, is
at present in the 25% discount category and has
just had an accident. A claim will only be made if
the cost of the accident is greater than 275.
If X is the random variable which represents the
cost of an accident, then:
P(Claim| Accident) = P(X > 275)
Since it is assumed that the distribution of X is
known, this probability can be evaluated.