How are insurance premiums calculated?
23 January 2013
In the first of a series of articles aimed at demystifying Employers Liability insurance, Jim Wilkes discusses the make-up of an Employers Liability premium All Employers Liability (EL) premiums will factor in the fo
All Employers Liability (EL) premiums will factor in the following: Attritional claims cost Large claim loading Latency load - long tail claims Expenses Profit The major problem for an EL insurer is making a judgment on an imponderable i.e. the likely incidence and cost of future claims The attritional claims cost is the insurers prediction of how many claims (and their cost) the particular policyholder is likely to produce in the next twelve months period of insurance.
The usual starting place is to look at the number of claims produced in the last three or five years by that policyholder.
While getting a claims experience for five years seems to offer more predictability than three years, there is also a greater likelihood that the hazards presented by an individual policyholder may have changed because of technological factors, making the older historical experience potentially less useful for predicting the future.
Moreover, at the smaller end of SME risks, the number of claims suffered by an individual policyholder is usually very low and not of any statistical predictive value. In such circumstances insurers tend to look at their own historical experience of risks of that or similar trades to help them make a prediction. Sometimes policyholders consider that they would like a premium based entirely on their own experience which sounds attractive especially if their individual claims experience is minimal.
However, there is a downside to this. Significantly large claims, say those that could cost in excess of £500,000 tend to occur randomly and are not necessarily restricted to certain hazardous activities. So, if you were attracted by the idea of an EL premium calculated exclusively on your own experience, and you experienced a claim of that magnitude your future premiums would rise astronomically.
Insurers tend to smooth this out by factoring in the cost of such large claims across their entire account so an individual policyholder is not funding the entire cost in their own experience. This leads to the second item in the cost make up; that of the large claim loading. All risks will include a contribution towards the Insurers experience of large claims. Clearly the large claim load for a hazardous activity like roofing would be larger than that for an office based risk.
While most people are familiar with EL insurers dealing with claims arising from accidents, a significant portion of the claims received by Insurers relate to diseases. Included under this heading would be respiratory diseases like asbestosis/mesothelioma, and also noise induced hearing loss and vibration white finger. Disease claims are immensely difficult to predict, but what is certain is that they will occur, sometimes in surprising workplace activities, for example cleaners in entertainment venues getting exposed to amplified sounds.
Disease claims are known as long latency claims because the exposure can occur for many years before the condition becomes apparent at which stage a claim is likely to be made. EL insurers load premiums for the potential for disease claims (the latency load). This load will vary with the trade activities involved.
Insurers also have to factor in all the usual costs which any product supplier has. The insurers expenses are largely staff and premises engaged either in the original underwriting of risks or the handling of claims. Because most insurers re-insure themselves, that cost would also be factored in. Finally, there is the question of profit. In common with all major businesses insurers are subject to market expectations in terms of profit. All investments involve risk and as insurers very business is risk, investors will usually be looking for a higher return than from some other forms of business activity.
EL insurers are issuing policies that will indemnify for claims that arise in the period of insurance but also for claims that arise in the future from current exposures. EL insurers are currently dealing with disease claims where the exposure may go back to the 1960s, so setting premiums in the knowledge that claims may not arise until many years into the future is fraught with unknowns.
For this reason insurers have to monitor continually the external economic and legal environments as one legal decision can alter the risk environment dramatically.
Jim Wilkes is a Senior Casualty Underwriter at Zurich Insurance.
(A future article will look at the impact of a policyholders risk management regime has on an insurers premium assessment.)