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Insurance premium rates

By Michael F. Rellosa

Insurance premium rates, what they are, how they are derived, and what their importance is are subjects very few people truly understand. Most see them only as the price one has to pay when one gets one's property, one's health or one's life insured. Yes, that may be correct, but what a premium signifies goes way deeper than that and, more importantly, the "balance" between adequate rates (one that ensures the rate charged is appropriate to cover the risk and ensure claims are paid) and affordability (where rates remain fair and reasonable to the insured) are maintained.

People probably wonder what companies do with the premiums collected. They use the premiums they collect to ensure that they have enough liquid assets to be able to provide financial compensation to policyholders in the event of a claim. If the amount of money they secure exceeds what they pay in claims costs and operational expenses, the difference is considered their profit. This is also why insurers have a fiduciary duty, much like banks, as the amount they collect is not yet theirs and belongs to the insuring public until after the life of the policy, which in non-life insurance is usually one year.

Insurance premium is defined as the amount of money an individual or business pays for an insurance policy (rate X the sum insured). The rate given is determined by a variety of factors, depending on the class of business. Let us take fire insurance on a house as an example. The underwriting factor to be considered under the fire class of business is the construction of the building. Timber structures are more vulnerable to fire and, therefore, carry a higher rate as compared to buildings made wholly of concrete. Another factor to be considered is the location. Is the building in a congested area where fire trucks could not penetrate, or is it a wide street easily accessed by the fire services? Still, another factor is its exposure. Is the building next to a gasoline station? Is it located on its own (detached from other buildings)?

You guessed right; a building adjacent to a gas station would obviously carry a higher rate as it is next to a gas station, which has a higher chance of catching fire. Still another factor is the occupancy. A factory building where paints or volatile materials are manufactured carries a higher rate than a building occupied only as a residence. Finally, insurers determine the presence of firefighting or loss-mitigating equipment. Buildings peppered with fire extinguishers as well as smoke alarms and a sprinkler system will definitely carry a lower rate as compared to a comparable building with little to no firefighting equipment. There are other considerations that may affect the rate, such as its loss history, good housekeeping and maintenance, among others, but the underlier is the building's propensity to catch fire or, on the opposite end, its safety. People who own or reside in safer structures get charged lower rates than people who live in run-down, ill-maintained buildings located in congested areas.

The risk rate (discussed above) is not the only component of the premiums to be paid. In addition to the risk rate, you have the taxes imposed by the government, currently around 27.5 percent of the total premium, and then usually the companies' general and administrative expenses (GAE) and a reasonable margin of profit are factored in. This is where the differences in premiums lie. More efficiently run companies have lower GAEs; companies with sound underwriting practices have lower loss ratios and can adjust their premium rates accordingly. This happens in an ideal world unhampered by unbridled competition.

In an effort to sort out the Gordian knot currently besetting the industry, it has embarked on a quest first to find out what the true cost of risk currently is and to pass this through the actuarial crucible, taking into consideration premiums and losses or claims, and ultimately coming up with a rate reflective of the risks involved but nevertheless is fair and affordable for the insuring public. This is a major initiative of the industry through its association, PIRA, and will take about a year or so to complete. Once done, it will redound to the benefit of the industry but, more importantly, to the insuring public, as they can rest assured that when a claim is made, there are sufficient funds to indemnify all that need to be indemnified.


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