The general insurance industry offers an array of products such as motor, travel, home, marine, commercial and many more insurances. When we buy an insurance product, we pay a certain sum of money to the insurer, called the premium, in installment or in a lump sum have you ever thought of how that premium is calculated? How the price of a particular policy is decided and who helps in valuation those policies?
Have you ever thought of how that premium is calculated? How the price of a particular policy is decided and who helps in valuation those policies?
That’s where actuaries play a significant role. The major role of an actuary in general insurance is in pricing and reserving. Other than these two roles, actuaries help in risk and reinsurance, investment and regulatory requirements.
In this article, we are going to discuss mainly the techniques used in pricing and reserving. Some of the techniques which are commonly used in general insurance companies by actuaries, in the valuation of premiums and claims reserve requirement, are:
- Generalized Linear Model
- Chain Ladder Method
Now, let’s see how premiums are calculated.
Generalized Linear Model
One of the models which are commonly used by the pricing team of the general insurance company for premium calculation is Generalised Linear Model (GLM). This model can accommodate many factors on the basis of which premium is calculated, resulting in more
accuracy in the premiums calculated.
As depicted by the above pictorial representation, the steps to calculate the actual premium to be charged by general insurance companies are as follows:
Step 1: The benchmark premium is decided taking profit margin, expected claim cost and claim related expenses such as commission, into consideration.
Step 2: Underwriting adjustments are made in the benchmark premium. These adjustments differ for different groups of homogeneous policyholders, depending upon factors of the policy.
Step 3: In this step, actuary comes into the picture. The actuary calculates the technical premium and this premium is calculated by considering the past experiences of the claims.
Step 4: In this step, the premium is aligned with the sum assured in such a way that they remain parallel at all levels of sum assured.
Step 5: Actuary lowers the premium by lowering the expenses due to fierce competition. The premium calculated in this step is known as the target premium.
Step 6: A walkaway premium is decided by the company by reducing the target premium due to the motive of sustaining in the market.
Step 7: Now, the CEO of the company comes into play. Due to competition, the underwriter wants to reduce the walkaway premium, but the actuary disagrees on this. To solve this dispute, the CEO decides the actual premium being charged.
Thus, this is how the actuary works in deciding the premium of the policies, to be charged by the company.
Chain Ladder Method (CLM)
This is a method used for calculating the claims reserve requirement in a general insurance company. It is used by insurers to forecast the number of reserves that must be established in order to cover future claims.
This actuarial method is one of the popular reserve methods. It calculates Incurred But Not Reported (IBNR) loss estimates, using run-off triangles of paid losses and incurred losses. Run-off triangle (also known as Delay Triangle) is a technique used to calculate the reserve in both Property & Casualty and Health Insurance. The run-off triangles are used to estimate
how many claims have been incurred in a reporting period but are not yet reported and a reserve is held for this.
Insurance companies usually set aside a portion of the premiums received, called reserves, to pay for the claims that may be filed in the future. The difference between the number of claims forecasted and the number of claims that are actually being paid, determine the amount of profit received by an insurer.
It is assumed that patterns in claim activities in the past will continue to be seen in the future. In order for this assumption to hold, data from past loss experiences must be accurate. If the assumptions differ from observed claims, the insurer may have to make adjustments to the model.
The basic steps to apply the chain ladder method to calculate the number of reserves are:
Step 1: Compile claims data in a loss development triangle. Here, a loss development triangle is a methodology to track how claims, both known and unknown, change over time.
Step 2: Calculate age-to-age factors, also called loss development factors or link ratios, which represent the ratio of loss amounts from one valuation date to another, and they are intended to capture growth patterns of losses over time. These factors are used to project where the ultimate amount of losses will settle.
Step 3: Calculate averages of the age-to-age factors.
Step 4: Select claim development factors.
Step 5: Select the tail factor.
Step 6: Calculate cumulative claim development factors.
Step 7: Project ultimate claims.
Thus, the actuary mostly uses this method to calculate reserves in a general insurance company.
It is to be noted, that there are many more complex methods and techniques used by actuaries in a general insurance company other than the two discussed in this article.
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