Risk & Business Magazine JGS Insurance Magazine Fall 2018 | Page 30

PREMIUM CALCULATION
BY: BRIAN RUANE
NATIONAL DIRECTOR OF
REAL ESTATE AND HOSPITALITY
JGS INSURANCE
Insurance
Premium
Calculation 101
PART 1
T
hroughout my career, I have
often met with clients who
are perplexed by the complex
process of underwriting and
premium development. Many
have experienced significant variations
over time, and they seek an understanding
of the determining factors in premium
development. One CFO of a hotel company
once told me, “If I priced my hotel rooms
like insurance premiums, I would not be in
business very long.”
Most people try to understand premium
development in the context of their
own business. The unique challenge
insurance companies have is that while
they can accurately forecast fixed costs,
they have limited control and, in some
cases, predictability in their largest cost
component—insured losses.
Insurance companies base much of their
decisions on past experience, past being
prologue. However black swan events are
becoming increasingly common, creating
more challenges. Examples such as the
Sept 11th terrorist attacks; the unusually
active hurricane seasons of 2004 and
2005; Hurricane Sandy—a late season and
particularly destructive superstorm; and
last year’s devastating storms that struck
the Gulf Coast and the Caribbean. Governor
Cuomo of New York, bemoaning the
increase in frequency of these mega events,
noted that we seem to have so-called 100-
year floods every few years now.
The overall warming of the planet, whether
due to anthropogenic factors or not, is in the
opinion of many creating the environment
for more frequent and intense storms. This
is being exacerbated by the concentration
30
of real estate development in coastal areas,
leading to larger aggregate losses.
For third-party lines like general liability
and for workers compensation, the
escalation in medical and pharma costs
and the increase in the cost of torts (more
frequent and larger verdicts combined with
the erosion of defense against allegations
of negligence) renders predictably of future
claim costs more uncertain. An attorney
who represents insurance companies noted
that it is becoming increasingly difficult to
defend against allegations of negligence and
that we are living in an era of almost strict
liability
Like all businesses, insurance is measured
against performance standards. The key
insurance metrics are operating income,
combined ratios, industry surplus and
return on equity. Operating income is
essentially the difference between costs
(including losses) and investment income.
Combined ratio is a measurement of
underwriting performance. It is a function
of paid and reserved losses plus expenses
divided by premiums. Insurance companies
try to achieve a combined ratio of less
than 100 percent, which means they are
making money on underwriting without
the assistance of the returns on their
investments.
Industry surplus is the retained earnings
of insurance companies built over time,
and it functions as a metric on the supply
of insurance capacity. Expanding surplus
increases the supply of insurance and tends
to put a downward pressure on rates. This
pool of capacity has grown by $400 billion
from Sept 11, 2001, to year-end 2017. The
ability of the industry to absorb losses is
substantial.
Insurance companies seek a return on
equity of at least 10 percent, a performance
most companies in the Fortune 500 achieve.
Historically, the insurance industry has
fallen short of this goal, and this fact tends
to drive rates higher.
The majority of investments made by
insurance companies is in fixed income.
Thus, a lower interest rate environment, like
the current time period, puts more pressure
on insurers to achieve their operating
income goals by making more money on
underwriting. This does, in f