An actuary hands you a filed rate built from last year's raw losses, no profit load, and one blended charge for teen and adult drivers. Three of the four ratemaking principles are already broken. Your job on exam day is to name which ones and why.
The Statement gives four principles. Treat each as a yes/no test you run against a pricing situation. A single scenario can pass some and fail others. Use the mnemonic Future, All, Individual, Reasonable.
Principle 1: Future costs. A rate is a forecast, not a record. It is an estimate of the expected value of costs the policy will generate during the future period it will be in effect. Historical data is only the raw material. You must develop losses to ultimate, trend both frequency and severity, and adjust for benefit or coverage changes.
TRAP: Using undeveloped, untrended calendar-year losses violates Principle 1. The number is backward-looking; the rate must be forward-looking.
Principle 2: All costs. A rate provides for all costs associated with the transfer of risk. The Statement names those costs as claims, claim settlement expenses, operational and administrative expenses...
Common mistakes
- Calling risk-based price differences unfair. Charging youthful drivers more is fair discrimination because the price gap matches an expected-cost gap. The unfair case is a $420 flat rate across unlike risks.
- Treating the profit provision as optional. Dropping it from $574.32 down to $531.25 violates Principle 2, not just a business preference. Capital has a cost.
- Dropping a cost element. A list-the-costs item wants all four of the Statement's elements: claims, claim settlement expenses, operational and administrative expenses, and the cost of capital. Leaving out the profit and contingency provision drops the cost of capital.
Bottom line
- Principle 1: a rate estimates the expected value of FUTURE costs, so raw historical losses must be developed and trended forward.
- Principle 2: a rate provides for ALL costs of risk transfer, which the Statement names as claims, claim settlement expenses, operational and administrative expenses, and the cost of capital.
- SOP Section III names 18 ratemaking considerations, from Exposure Unit to Actuarial Judgment, each taught in depth elsewhere in the cluster.
- Principle 3: a rate provides for the costs of an INDIVIDUAL risk transfer, so rates reflect differences in expected cost through classification.
Exam shortcut
Run the mnemonic Future, All, Individual, Reasonable on every scenario. Undeveloped losses hit Future, a missing load hits All costs, one price for unlike risks hits Individual. For a list-the-costs item, recite the Statement's four cost elements: claims, claim settlement expenses, operational and administrative expenses, and the cost of capital. Reinsurance appears among the considerations, not as a named cost element. Treat Principle 4 as the verdict, not the cause.
The full lesson (about 2,679 words, 18 min read) adds 2 worked examples, all 7 common mistakes, a self-check, free in the app.
Learning objectives
- A16
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