5 questions = 7% of the exam Chapter 10 Pricing Factors 5 questions = 7% of the exam

Learning Objectives: After studying this chapter, you should be able to: Identify and explain the underlying factors that should be considered in assessing a risk premium Describe the effect of expense cost on premium rates Identify the concept of the return on capital employed Explain insurance premium tax and other levies

Risk Premium “The expected ultimate cost in claims of the risk being accepted, including an allowance for the degree of uncertainty attaching to the claims cost” = The amount of money required to fund claims. Certain claims can take a long time to settle so with inflation and potential changes to legislation could mean the real cost of the claim could be higher.

Risk Premium When reviewing the cost of claims you would look at… Frequency: You know this… Severity: You know this… Large Claims: How many can they expect ? Reinsurance costs: Insurers protecting themselves Claims run-off: an insurer may repudiate a claim and then lose a legal argument and have to pay. Such claims movements are an example of “run-off” and may produce a surplus or claims deficit

Risk Premium IBNR (incurred but not reported): An estimate of the costs for claim-generating events that have taken place but have not yet been reported to the insurer Catastrophe claims: A lot of individual claims for a common event such as flooding Latent claims: Some times called long tail claims, an extreme form or IBNR Claims inflation: Inflation or legislation changes (Ogden) Exposure: Historical adjusted to reflect current exposure

10 People died 52 People seriously injured Damage to Trains and Tracks Cost of claims £30 million

Expenses To come up with a premium you need to work out the risk premium then add to that the insurers running costs. Staff Premises Utilities Tech Adverts Commission

Expenses Fixed expenses – These do not vary with the size of the risk i.e. Issuing policy documents Variable expenses – These do vary with the size of the risk Underwriting: Alterations, Risk management, Services Commission: % of the premium and varies from class to class, Volume bonuses Claims handling: A charge per claim reflecting the varying amounts of work required

Return on Capital Employed (ROCE) Return on capital employed is a financial ratio that measures a company's profitability and the efficiency with which its capital is employed. ROCE is calculated as: Operating profit / Capital Employed x 100 = ROCE So If I invest £1 million pound in setting up new company and it makes £100’000 in it’s first year you have 10% ROCE Important to investors: Are they making enough money from their investments?

Investment Income Historically there has been unease in general insurance at allowing for investment income in pricing… But why? The underwriting result is the business result without investment; it is referred to as the combined operating ratio (C.O.R) and is arrived at by combining loss ratio, commission ratio and expense ratio. It often used as a measure of an insurers financial health. It is this relationship between profit and the yield of the underwriting result which leads to the cyclical nature of insurance…

Income Only or Capital Gains too? Insurers tend to divide their investments between two classes: Interest bearing investments Investments that can be expected to grow in line with the economy (equities – stocks and shares) What are capital gains? Profit from the sale of property or investments If the contribution of capital gains were ignored returns would be underestimated and the insurer may become uncompetitive through over pricing. But they are volatile

Actual or Expected Rates of Return If capital gains are included, the investment returns are likely to be volatile. Even the income only element is likely to move with the economic cycle. Current data will only reflect historical rates.

Insurer HMRC Quarterly Insurance Premium Tax The tax on insurance is either 12% or 20% depending on the class of business There are exceptions: Risks based in the Channel Islands or Isle of man Insurance written in overseas territories Reinsurance and certain marine contracts Engineering inspection contracts which pay VAT Insurer HMRC Quarterly

Levies Financial Services Compensation Scheme (FSCS): The FSCS levies a surcharge based on a percentage of gross direct premium to fund claims by policyholders whose insurer has become insolvent. Motor Insurers Bureau (MIB): There is an annual levy based on claims experience. The rate for individual insurers varies based on their mix of business.

Under variable expenses, an insurer would NOT typically include: a. underwriting costs. b. commission. c. rent d. claims handling costs.

Which class of insurance is more likely to have long tail claims? Employers liability Extended warranty Glass Theft

How is the underwriting result of an insurance company calculated? Combination of investment income, loss ratio, expense ratio and commission ratio. Combination of loss ratio, commission ratio and investment income. Combination of loss ratio, expense ratio and commission ratio. Combination of loss ratio, capital employed return and commission.

Jim is an analyst who is looking at Large Insurance PLC Jim is an analyst who is looking at Large Insurance PLC. What ratio is he MOST likely to look at to establish the quality of its profits, excluding investment income? a. The commission ratio. b. The expense ratio. c. The combined operating ratio. d. The loss ratio.

An insurer has a total income of £10 million, claims of £7m and expenses of £2.5m. If the capital employed by the company is £5 million what is the return on capital employed? -50% 10% 50% 100%