Principles and Practice – Study 3

Ratemaking is the process of establishing rates. This function is carried out by actuaries.

Rate is the price of a unit of insurance for a period of one year.

Premium is the total cost of an insurance policy.

E.G. A piece of jewellery has a rate of 50 cents per $100 of coverage. $10,000 of coverage is required.

Rate (.50 / $100) X Amount of coverage ($10,000) = Premium $50

Premium Determination

The law of large numbers – the larger the sample the more reliable the outcome

The theory of probability – the likelihood of an event expressed as:

The number of actual occurrences / The number of possible occurrences

= the probability or the chance of an event happening

Other factors include; the size of the sample, the period in time over which a sample is taken and conditions in the past relative to future conditions.

Steps in Rate Determination

1. A classification of risks is established based on:

1. type of objects insured
2. hazards of exposure

2. Statistics on losses, based on insurers’ classification are gathered.
3. Pure premium is determined.
4. Total premium is determined (pure premium + loadings, expenses and overhead)
5. Determine rate.

Underwriting is the selection of risks.

• A peril is an event that may cause a loss to occur.

• Casualty insurance frequently refers to liability, crime and plate glass insurance.

• Inland marine insurance usually refers to movable property but may include bridges tunnels and pipeline because they are instruments of transportation (or real property).

• In all risk policies coverage is determined by the extent of the exclusions.

• Liability policies primarily cover negligence.

 

Negligence is the doing of something a reasonable person would not do or not doing something a reasonable person would do.

• A hazard is a condition that may cause a loss or peril to occur. Hazards can be physical or moral.
• A physical hazard refers to the features of a risk e.g. poor maintenance, overfusing, loose carpet.
• A moral hazard relates to the character of the insured e.g. history of fraud or carelessness.

In underwriting terms risk is the subject of an insurance contract. An application is the request for insurance either oral or written. Underwriters may accept, reject or accept a risk subject to certain conditions. Based on the following criteria:

1. personal information about applicant (moral hazard)
2. details of the physical hazards and exposures to the risk
3. any special factors pertaining to a type of risk.

Exposure total amount for which the insurer is at risk.

Retention is the amount an insurer retains.

Reinsurance is when an insurer decides to share its risk with another insurer (a reinsurer).

Rating is applying established rates to specific items to be insured, can be carried out by computers or manually.

Loading is an additional charge due to a hazard not reflected in the normal rate for a risk.

Deductions or credits are applied when a risk is less hazardous than normal.  

Sample Exam Questions - Principles and Practices

Study 3  -  Risk and Insurance

Multiple Choice Questions

December 2001

1. The law of large numbers

1. indicates the likelihood of an occurrence
2. indicates the probability of an event occurring
3. means that predictability increases with the number of cases
4. refers to the number of losses actually occurring divided by the number of losses that could have occurred

2. Underwriting can best be described as the

1. calculation of the rate of premium to be charged
2. drafting of the policy wording
3. reduction of hazards to insure against
4. selection of risks to insure

3. Which of the following is true of an insurance policy that covers all risks of direct physical loss or

damage?

1. Every possible type of loss and damage is covered
2. In actual fact, the extent of coverage is determined by the exclusions
3. Such policies contain no exclusion
4. The perils covered are listed and all types of resulting damage are covered

July 2001

4. Pure premium

1. Does not take into consideration such factors as loss trends or profit
2. Is not affected by statistics or past losses
3. Is the total premium required by the insurer
4. Is the total premium less the brokers commission

5. The primary responsibility of an underwriter is to

1. rate the risks to be insured
2. select the risks to insure
3. sell the applicant the most appropriate policy
4. write the appropriate policy for the risks to be insured

April 2001

6. The law of large numbers

1. affects the reliance to be placed on a given probability
2. identifies loss exposures
3. improves loss prevention and safety
4. reduces the chance that an event may happen

7. Which of the following is true of the ratemaking process?

1. A large sampling of past loss experience over a long period of time provides a reliable

resource for ratemaking purposes.

2. The law of averages is applied to past statistics to determine who will have losses in the

future.

3. The premium is the price of a unit of insurance
4. Statistics gathered for rating purposes are classified according to location and insurability of risks.

8. Which of the following is true of an insurance policy that covers all risks of direct physical loss or

damage?

1. Every possible type of loss and damage is covered.
2. In actual fact, the extent of coverage is determined by the exclusions
3. Such policies contain no exclusions.
4. The perils covered are listed and all types of resulting damage are covered.

9. The physical hazards of a property are determined by the

1. amount of insurance on the property
2. character of the insured
3. construction of the property and its location with respect to fire fighting facilites
4. cost of renovating the entire property

December 2000

10. The law of large numbers

1. indicates the likelihood of an occurrence
2. indicates the probability of an event occurring
3. means that predictability increases with the number of cases
4. refers to the number of losses actually occurring divided by the number of losses that could have occurred

11. Which of the following is NOT part of the ratemaking process?

1. Evaluating the reduction in uncertainty
2. Classifying the risks
3. Gathering statistics of past losses
4. Determining applicable loadings

12. Moral hazard

1. can usually quite readily be identified and measured
2. refers to the subject matter of insurance
3. refers to whether or not the insured has a criminal record
4. refers to conditions that have to do with the human element of risk

13. Exposure is

1. the amount of money an insurer will likely pay on a given risk
2. the danger of loss arising from what may happen to other risks nearby
3. the danger of loss associated with the materials used in a building
4. the degree of risk associated with a given piece of property

April 2000

14. An insurer’s retention on any risk can be defined as being:

1. the proportion of the premium it intends to keep as its profit
2. the proportion of the premium it requires to cover its production and

administrative expenses

3. the amount of insurance it will keep for its own account
4. the maximum amount of insurance that it can write under a policy covering a particular class of risk

15. The primary job of an underwriter is to:

1. select the risks to insure
2. sell the applicant the most appropriate policy
3. rate the risks to be insured
4. provide support for the producer of sales person

Essay Questions

April 2001

1. Identify briefly how an insurer determines the rates to be charged for a particular class of

insurance. (10 marks)

2. Explain the difference between physical and moral hazards. Use examples.  (8 marks)

April 2001 and July 2000

3. (a)  Briefly describe the steps and insurer will take in determination if a rate on a specific class

      class of business. (10 marks)

1. Briefly explain:

1. the law of large numbers (5 marks)
2. the theory of probablity (5 marks)