Prepared By-Savika TayalRoopam RajeshPooja Gupta Sagar Shukla

COMPUTATION OF INSURANCE PREMIUM

Insurance is a practice of exchanging a contingent claim for a fixed payment called premium.

Premium is the consideration money that a policyholder has to pay in lieu of the benefit that the insurer promises to confer on the happening of the scheduled eventuality

Premium needs to be paid in advance and regularly to keep the policy in force.

The principle of assigning premiums according to the underlying risk is an essential element of actuarial science.

DEFINITION

It should produce total funds suffi cient to cover the insurer’s obligation.

It should distribute the cost of insurance fairly among insured persons

FUNCTIONS OF PREMIUM

The premium can be paid at one time, when it is called a single premium. It can also be paid in instalments i.e. yearly, half–yearly, quarterly or monthly.

Half–yearly, quarterly and monthly mode instalment is obtained by dividing the tabular premium by 2 or 4 or 12.

For monthly mode, an extra addition of 5% to the tabular premium is made before dividing the tabular premium by 12

Premium can also be paid through salary savings scheme which is in fact a monthly mode but for this, no extra is charged.

MODES OF PAYMENT OF PREMIUM

Premium is always payable in advance. Insurers allow some rebate on the premium for yearly

and half–yearly mode because the insurer earns interest on the advance payment and also because the administrative expenses are reduced because of lesser frequency of issuing renewal premium notices and receipts and maintaining the record.

Similarly rebate is also permitted for large sum assured and these rebates diff er from plan to plan.

CONT.

ELEMENTS IN PREMIUM COMPUTATION

Mortality

Expenses of

management

Expected yield in its

premium

Inflation

The mortality tables are prepared by the insurers on the basis of their experience over a number of years.

The mortality rates depend on the age, occupation, lifestyle and medical history of the insured.

Though the rate of mortality increases with the increase in age, all insurers charge a level premium which remains constant over the entire duration of the policy term.

This prediction or estimation of mortality is true for a very large group of insured people and not for any individual insured.

The small premium charged from the total group is used to pay a big sum assured to the unfortunate few who die early. It is also called pooling of resources. Insurance is also known to be a co–operative action.

MORTALITY

Any insurer has to incur expenses for conducting the insurance business that keeps on changing due to inflationary market conditions.

Huge expenses are incurred for procurement of new business, for payment of commission to the agent and other incidental expenses like preparation of policy document etc.

Expense is also incurred for servicing of the policies, e.g. collection of renewal premium, valuation to determine bonus payable, payment of Survival Benefit and Death claim and Maturity Benefit etc.

EXPENSES OF MANAGEMENT

The expected yield on investment of the collected endowment component of premium goes to reduce the premium rate.

However, as the future yield cannot be determined exactly, it is necessary for a prudent insurer to keep a reserve to take care of unexpected fall in the rate of yield.

EXPECTED YIELD ON INVESTMENT

High, persistent inflation grievously harms the insurance industry

Insurance is a contract in which money is paid today in expectation of return of a greater amount to cover a named risk at some uncertain future date.

That named risk has a value to the insured, generally related to the amount it will cost at a future date to heal the damage related to that risk.

For example, fi re insurance is paid when one’s house burns down. The idea is that the amount of the insurance payment should be reasonably related to the cost of resolving the damage at that future date.

INFLATION

In an environment of high inflation, the amount that would be necessary to cover the future risk will be much higher than in a non-inflationary environment.

The higher the expected rate of inflation, the greater portion of current income must go to cover the future risk and the less certain that the coverage will be suffi cient.

At some point, people stop buying insurance and the insurance business dries up.

Longer term insurance is more vulnerable than short term insurance

CONT.

To maintain solvency in order to pay

claims

To ensure fairness in premium for

customer

To produce rates that includes an

adequate provision for profit and contingencies

The rates should be reasonably stable,

adaptive, responsive to changes and

should be able to satisfy the rate

regulators.

The rating system must be consistent, simple and easy to understand by the

customer

The rate mechanism should promote the reduction of losses

by providing incentives to the

insured to prevent losses.

OBJECTIVES OF PREMIUM COMPUTATION

It involves the following- Components of Premium

Risk Premium (Mortality) Net Premium (Margin of Interest) Offi ce Premium (Margin of Offi ce Expenses and exigencies)

Level Premium Loading on the premium Extra Premium

CALCULATION OF PREMIUM

Risk Premiu

m

Net Premiu

m

Office Premiu

m

COMPONENTS OF PREMIUM

The pure premium needed to cover the expected risks but with no allowance for expenses, commission or contingencies is to be made. Thus the cost to meet the risk of death for one year at a particular age is known as risk premium. The risk premium is based on the probabilities of death at various ages.

Mortality studies, reflecting the experience of Indians, are made by Mortality and Morbidity Investigation Bureau (MMIB), set up jointly by the Life Insurance Council and the Actuarial society of India to help insurers.

RISK PREMIUM

A net premium is the premium calculated on the basis of the valuation assumptions to provide the contractual benefits at outset. Its calculation only allows explicitly for interest and mortality. Thus the net premium covers the risk factor as well as interest earned on investment of fund by the insurers. Net premium is always less than the risk premium.

NET PREMIUM

The premium arrived at after loading net premium is called offi ce premium.

The premium figures printed in the promotional literature and brochures are offi ce premiums.

Also known as tabular premium.

OFFICE PREMIUM

Premium keeps on increasing as the age increases and this is the natural premium paying system but it is impractical because the insurer cannot ask the insured to pay extra premium every year and moreover in the latter years the cost of insurance would become unaff ordable resulting in lapse of policies.

In view of this insurers charge a level premium and the cost is distributed evenly over the period during which premiums are paid. The premium remains the same, and is more than the actual cost of protection in the earlier years of the policy and less than the actual cost in the latter years. The excess paid in the early years builds up the reserve.

LEVEL PREMIUM

The amount added to the pure premium to cover the administrative expenses is known as loading. When these expenses are added to the net/pure premium it becomes the gross premium/offi ce premium which is actually charged from the customer.

LOADING

It is charged on case-to-case basis; unique for every policy. This may happen because of grant of some extra benefit in addition to the basic benefits under the plan like accident benefit or premium waiver benefit. Riders provide additional benefit or premium waiver benefit

Extra premium may also become chargeable because of decisions relating to the extent of risk in any particular case.

EXTRA PREMIUM

Class Rating

• Pure Premium Method

• Loss Ratio Method

Merit Rating

• Schedule Rating • Experience

Rating• Retrospective

Rating Method

DETERMINATION OF PREMIUM IN PROPERTY AND LIABILITY

INSURANCE

Used when the factors causing losses can either be easily quantified or there are reliable statistics that can predict future losses.

These rates are published in a manual, and so the class rating method is sometimes called a manual rating.

Two methods to determine a class rated premium or to adjust it- Pure premium method Loss ratio method

CLASS RATING METHOD

In the pure premium method, the pure premium is 1st calculated by summing the losses and loss-adjusted expenses over a given period, and dividing that by the number of exposure units. Then the loading charge is added to the pure premium to determine the gross premium that is charged to the customer.

Pure premium= Gross premium= Pure premium + Load

CONT.

The loss ratio method is used more to adjust the premium based on the actual loss experience rather than setting the premium. The loss ratio is the sum of losses and loss-adjusted expenses over the premiums charged.

If the actual loss ratio diff ers from the expected loss ratio, then the premium is adjusted according to the following formula: Rate change =

CONT.

Merit rating is based on a class rating, but the premium is adjusted according to the individual customer, depending on the actual losses of that customer. 

Merit rating is usually used when a class rating can give a good approximation, but the factors are diverse enough to yield a greater spread of losses than if the composition of the class were more uniform.

Three methods to determine merit rating- Schedule rating Experience rating Retrospective rating

MERIT RATING METHOD

Schedule rating uses a class rating as an average base, then the premium is adjusted according to specific details of the loss exposure. Some factors may increase the premium and some may decrease it—the final premium is determined by adding these credits and debits to the average premium for the class.

CONT.

Experience rating uses the actual loss amounts in previous policy periods, typically the prior 3 years, as compared to the class average to determine the premium for the next policy period. If losses were less than the class average, then the premium is lowered, and if losses were higher, then the premium is raised.

The adjustment to the premium is determined by the loss ratio method, but is multiplied by a credibility factor to determine the actual adjustment

Experience rating is typically used for general liability insurance, workers compensation and group insurance.

CONT.

Retrospective rating uses the actual loss experience for the period to determine the premium for that period, limited by a minimum and a maximum amount that can be charged. Part of the premium is paid at the beginning, and the other part is paid at the end of the period, the amount of which is determined by the actual losses for that period. Retrospective rating is often used when schedule rating cannot accurately determine the premium and where past losses are not necessarily indicative of future losses, such as for burglary insurance.

CONT.