An insurer files for a 12% rate increase. The regulator pushes back: "Your data doesn't support this." If the loss data uses calendar year instead of accident year, prior-year reserve changes contaminate the picture. If exposures don't match the premium period, the loss ratio is meaningless. The exam tests whether you know what data to use, why, and how each piece feeds the fundamental insurance equation.
HIGH-FREQUENCY: The equation and the CY/AY/PY distinction appear on nearly every ratemaking problem.
Every dollar of premium is allocated. In ratio form: loss ratio + LAE ratio + expense ratio + profit ratio = 1.
KEY: Premium = Losses + LAE + UW Expenses + Profit. Every dollar is allocated. The loss ratio is the primary indicator of pricing adequacy.
- ALAE: assignable to a specific claim (legal fees, independent adjusters)
- ULAE: overhead (claims staff salaries, office costs)
An exposure is the unit of risk: car-year (auto), house-year (homeowners), $100 of payroll (workers' comp). Use earned exposures for ratemaking.
Common mistakes
- Using written premium instead of earned in the loss ratio. Written premium includes unearned portions for policies not yet expired. Using it inflates the denominator and understates the loss ratio. Trap: a deceptively low loss ratio.
- Confusing CY and AY loss ratios. CY incurred losses include prior-year reserve changes. If reserves strengthened by $2M, CY losses jump by that amount. Trap: a CY loss ratio that reflects reserve movements, not current-year performance.
- Using total reported claims in severity when some closed at zero. If 500 of 2,500 claims closed without payment, severity using 2,500 is $7,500 but using 2,000 paid claims is $9,375. Read the problem for "closed with payment" vs. "total reported." Trap: the wrong claim count.
Bottom line
- Fundamental equation: Premium = Losses + LAE + UW Expenses + Profit (every dollar is allocated)
- Pure premium = Frequency Severity = Losses / Earned Exposures
- Use earned premium and earned exposures, not written
- Accident year preferred for losses (groups by when the accident occurred)
Exam shortcut
When given ratemaking data, immediately check three things: (1) earned or written? (2) calendar year or accident year? (3) developed to ultimate or raw? These three distinctions drive most adjustments in later lessons. Remember: "AY for losses, CY for expenses." Pure premium: "how often times how much." The fundamental equation: "PLAN". Profits, Losses, Adjustment expenses, Non-loss expenses.
The full lesson (about 1,409 words, 9 min read) adds 2 worked examples, all 5 common mistakes, a self-check, free in the app.
Learning objectives
- 5b
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