Insurance companies, like any other business organizations have the goals of maximizing their profits, through maximizing on revenue, at the minimum costs. The revenue of Insurance Companies comprises mainly of premiums, which are generated by the Insurers promising to make good any occurrence of loss situation occasioned by a peril covered in the contract.
The premiums charged are arrived at through a rating process, whose main objective is to enable the insurer collect premiums that would enable them to meet their business expenses and provide some profit.
The rating process has a history as long and as winding as the development of the Insurance policy cover itself.
For an underwriter to quote rate for a subject matter of insurance, the risks surrounding that property must be properly assessed. This means that the underwriter must have all the information on the risk. The information is usually availed by the proposer through filling the proposal form and additionally by the insurer having the risk surveyed.
Once all the information is at hand, the underwriter using his knowledge and experience will assess the acceptability of the risk, considering the hazards the risk is exposed to, namely the Physical and Moral hazards.
Upon verification of all these factors, then the underwriter may rate the risk. Rating helps in determining the commensurate/adequate premiums to charge for a risk.
Risks within the same classification can be differentiated with peculiar features present and then loaded appropriately for bad features such as physical and moral hazards, substandard construction, floor openings, wood linings, artificial lighting and heating.
Discounts on the other hand may be allowed for good features such as, superior construction, existence of automatic fire alarms and sprinklers, and other fire extinguishing appliances.
The rate arrived at this stage, taking into consideration the experience of the portfolio is known as the technical rate. The technical rate must be loaded by predetermined loading factors for the company to be able to meet all its obligations and expense, which may include reinsurance expenses, claim settlement and expenses, management expenses, business acquisition expenses and commissions, taxes to the Government and provide some returns on equity (profits/dividends) to the shareholders.
It is important to note that a company is only able to meet these expenses through premiums generated.
This is the risk based approach to rating.
In as much as the rating process is well defined, Insurers seldom use it. They resort to market practices and end up succumbing to pressure from competition, which results in serious rate undercutting. Consequently, the insurance industry has seriously suffered from the effects of not charging the commensurate rates.
The new approach which is being investigated in the developed markets of the US and UK is known as rate/premium optimization; and the extent to which it is utilized has the potential to take insurance pricing into completely new realms.
While a full definition is hard to come by, price optimization generally refers to an insurer’s practice of varying rates based on non-risk-related factors. It involves analysis and incorporation of data not related to expected cost for risk characteristics — that is, it involves factors not related to expected loss and expense experience. Such data may include the prior year changes in premium and whether policyholders renewed after such change.
What Is Price Optimization?
Price optimization is not a new concept — it has been used in the retail and travel industries for years. But there is no widely accepted method and definition of it in the insurance industry.
Some refer to price optimization as relying on predictive modeling and “big data” while others refer to price optimization to mean using information about consumers’ price sensitivity as a rating factor.
Insurance firms have always taken account of the price elasticity of demand for their products, but this had previously been done only on aggregated basis. Now they are attempting to do so at the level of the individual consumer.
Price elasticity of demand is a measure of the responsiveness of the quantity of a good or service purchased to a change in its price.
By measuring each consumer’s price elasticity of demand, the insurance firm can optimize the price for each consumer, setting the premium at the greatest price each consumer would accept without causing them to switch to another insurance firm.
Critics of price optimization in insurance believe it produces premiums that are unfairly discriminatory and as such against most countries laws.
Supporters believe it produces outcomes that are fairer for the consumers.
Effectively price discrimination can give a bargain to one consumer over another with the same risk.
For example: Consumer A and consumer B are both women of the same age residing in the same state, with similar driving records, credit history, and other factors. Both A and B have bought auto insurance from the same carrier and pay the same premium. But now A is discovered by the carrier to be browsing multiple insurer websites looking for a better deal on her car insurance, prompting the insurer to gives her a 10 percent discount. B is not browsing for a better deal online and gets no such offer.
From the proceedings, it clear that this difference in treatment is potentially unfair.
Insurance firms are in a difficult position as they are under threat from disruptive outsiders trying to break into their markets. They are also under pressure to be more innovative and adventurous in how they engage with customers.
There should be more research around pricing of Insurance Products, particularly in the COMESA region.
Kenneth Obong’o Oballa.
Training Manager, Zep-Re