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 sound rate provides for every cost tied to the transfer of risk.
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.
- Compressing the Section I costs. A list-the-costs item wants all nine categories. Candidates lose points by dropping policyholder dividends, taxes/licenses/fees, or the ALAE/ULAE split, or by writing reinsurance as an enumerated cost when it belongs to the Section III considerations.
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; SOP Section I enumerates nine cost categories (incurred losses, ALAE, ULAE, commission/brokerage, other acquisition, taxes/licenses/fees, policyholder dividends, general administrative, UW profit and contingencies), and reinsurance enters via the Section...
- 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 nine Section I categories: incurred losses, ALAE, ULAE, commission and brokerage, other acquisition, taxes/licenses/fees, policyholder dividends, general administrative, and UW profit and contingencies.
The full lesson (about 2,793 words, 19 min read) adds 2 worked examples, all 7 common mistakes, a self-check, free in the app.
Learning objectives
- A16
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