Chapter 9 – Underwriting and Rating Personal Auto Insurance
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Introduction
Automobile insurers are in business to make a profit. Accomplishing this objective requires effective underwriting and appropriate rating. Underwriting refers to the selection and classification of profitable insureds. Applicants for Automobile Insurance are accepted or rejected based on the company's underwriting policy. If the applicant for Automobile Insurance is accepted, he/she is placed in the proper underwriting class and charged an appropriate rate for that class. Class rating commonly used in private passenger Automobile Insurance means the same underwriting class and charging each person the same rate. The premiums collected from the class, as a whole should be sufficient to pay all claims and expenses and to yield a profit to the company during the policy period.
Competition among Insurers
There often is intense price competition among automobile insurers. Competition is an extremely important factor in determining the number of underwriting classes that an insurer has. If a group of better-than-average drivers can be identified, they can be assigned to a new underwriting class and charged a lower rate, thereby
improving the insurer's competition position in the market. Conversely, if a group of
below-average drivers can be identified, they can be removed from their present
classification, placed in a new class and charged a higher rate. This will enable an insurer to reduce rates for the remaining drivers in the former class, which should also improve the insurer's competitive position to the extent that insurers are able to compete in this manner. The effect is reduced rates for better-than-average drivers and increased rates for below average or substandard drivers. As a result, policy owners receive more equitable treatment since the good drivers pay less for the protection and the poorer drivers pay more.
Rating Terms
A rate is the cost for a unit of insurance. With Automobile Insurance, a base rate is published for each specific coverage, such as Bodily Injury and Property Damage Liability. A premium is the product of the base rate multiplied by the applicable rating factor. Automobile rating is the process of determining base rates and applicable rating factors and then calculating individual coverage premiums and the total premium for the policy. Separate premiums are determined for each of the four major Personal Auto Coverages. These separate premiums must then be added to obtain the total premium. Example:
Coverage Premium
Liability 250
Damage to your auto 100
Medical payment 50
Uninsured motorist 15
Total Premium $415
Rate Regulations
Automobile insurers, however, do not have unlimited freedom to charge any price they desire for the coverages they provide. Insurers are constrained by rating laws that require the rates to meet certain statutory standards. In general, rates are required by law to be adequate, reasonable (not excessive) and not unfairly discriminatory. With the exception of Illinois, all states have rating laws that affect the pricing of Automobile Insurance.
The rating laws can generally be classified into the following categories:
Prior Approval Laws - The majority of states have some type of prior approval law. Under a Prior Approval Law, the rates must be approved by the State Insurance Departments before they can be used. Prior Approval Laws have been criticized by insurers because there is often considerable delay in obtaining a rate increase. The rate increase may be inadequate, and the statistical data required by the State Insurance Department may not be readily available.
File and Use - File and use simply means the company files the policy and rates with the State and immediately begins marketing the product without prior approval from the State.
Open Competition Laws - This type of rating law is the most liberal. Under an Open Competition Law (also called a No-Filing Law), rates do not have to be filed with the State Insurance Department and insurers can charge rates based on their own experience and market conditions. This type of law is based on the assumption that price competition in the marketplace will keep rates reasonable and competitive. Thus, market prices based on competition rather than the discretional act is how regulatory authorities determine the price and availability of insurance. However, insurers may be required to furnish rate schedules and supporting statistical data to regulatory officials. Also, the State Insurance Department has the authority to monitor competition and disapprove the rates based on the standards of market share and workable competition.
Mandatory Rates - Under this type of law, rates are set by some state agency or rating bureau and all licensed insurers are required to use these rates. In Texas and Massachusetts, Automobile Insurance rates are determined by the state agency and all companies that are doing business in the state must use the rates. Texas, however, allows certain rate deviations. In North Carolina, a rating bureau determines the Automobile Insurance rates. Again, all insurers are required by law to use these rates and rate deviations are allowed.
Selection of Insureds
As noted earlier, the basic objective of automobile underwriting is to select profitable insureds. The goal of profitable business, however, often conflicts with the public's right to buy insurance.
For most drivers, Automobile Insurance is viewed as an absolute necessity for two reasons. First, motorists require Automobile Insurance for protection against financial hardships or ruin from liability suits. Second, Automobile Insurance may be required by the government in order for a driver to legally operate in a practical way to meet the State's Financial Responsibility or Compulsory Insurance Law. Thus, motorists generally believe they should have an unequivocal right to buy Automotive Insurance.
However, because of the underwriting goal of profitability, Automobile Insurers do not make available to the public unlimited amounts of Automobile Insurance. Automobile Insurance is not available to all drivers in the standard markets since some drivers with a high loss potential are rejected by insurers based on their underwriting standards. Other drivers may be able to obtain the insurance only by the payment of substantially higher or surcharged premiums.
The conflict between the public's belief that it has a right to buy Automobile Insurance and the insurer's goal of profitability is often resolved by government intervention. As a condition for doing business in a state, the state may require automobile insurers to make available certain minimum amounts of Liability Insurance so that some drivers who ordinarily would be refused insurance can obtain some protection. The influence of government is widely reflected in the development of Shared Market Plans.
Restrictions on Cancellation
Restrictions on Cancellation generally do not apply to new policies that have been in force for less than a certain period (such as 60 days). During this period, insurers can generally cancel new polices which gives them time to complete there initial underwriting and investigation of the applicant. However, after the new policy has been in force for a certain period, cancellation is permitted only for reasons specified in the law. The reasons vary from state to state, but cancellation generally is permitted for the following reasons:
Notice of Cancellation is required (such as twenty days). Most states also require that the reason for cancellation must be included in the notice or provided upon request. In addition, most states require the Cancellation Notice to indicate that coverage may be available from an Automobile Insurance Plan or from some other Shared Market Facility.
Restrictions on Non-Renewal
The preceding restrictions generally do not apply to the non-renewal of an existing Automobile Policy. Insurers generally have the right to refuse renewal of an existing policy for another term, subject to certain restrictions. First, the insured must be notified that the policy will not be renewed. Most states require at least 30 days advance notice that the policy will not be renewed. Second, most states require the insurer to give the reason for not renewing in the notice or to provide the reason on request. Third, some states forbid insurers to refuse renewal of a policy solely because of age, residence, race, color, creed, national origin, occupation, or because another insurer has refused to write the policy or has canceled or refused to renew an existing policy.
Restriction on Cancellation and Non-Renewal - All states have laws that restrict the insurer's right to cancel or not renew an Automobile Insurance Policy. These laws reflect the government's desire to protect the public because of the actions of some insurers that are perceived as being unfair to policy-owners, such as canceling a driver after a single claim, withdrawal from a certain geographical area, a decision to stop writing Automobile Insurance for certain groups, such as younger drivers, or a decision to discontinue the writing of automobile contracts for a particular agent.
Cost of Automobile Insurance
The factors that determine the cost of automobile insurance are discussed below. The discussion is confined to general principles since the actual systems vary in detail from insurer to insurer.
Primary Rating Factors
The major or primary factors for determining the cost of Automobile Insurance are:
Territory - Territory is one of the most important rating variables. A base rate for Automobile Liability Insurance and Physical Damage Insurance is first determined. The base rate is determined largely by the territory where the vehicle is used and garaged. Each state is divided into various rating territories that may include whole cities or parts thereof, the suburbs and rural areas.
Automobile Insurance is more expensive in densely populated territories because the number of accidents is directly related to the number of vehicles within the territory, medical care is more expensive in cities, automobile repair costs are higher and jury awards in cities are likely to be higher than in rural areas.
Age, Sex and Martial Status - Age is an extremely important rating factor since younger drivers are involved in a disproportionate number of automobile accidents. Drivers under age 25 account for about 22% of the total drivers in the United States but are involved in 34% of all accidents.
All insurers classify younger drivers. One Example of such a system is the following:
Young, unmarried male drivers who are the principal operators or owners of automobiles pay the highest rates since this group has the highest accident rate. Due to intense competition, automobile insurers have developed rating systems that consider the driving experience of younger drivers. Under these systems, the rates are scaled downward as the driver gets older.
Sex of the driver is also an important rating factor. Younger, unmarried female drivers tend to have better driving records and fewer accidents than unmarried male drivers do in the same age bracket.
Marital Status is also important because young, married male drivers tend to have relatively fewer accidents than unmarried male drivers in the same age bracket.
Although these have been traditional rating factors, several states no longer permit their use.
Use of the Auto - Use of the auto is another rating factor. Insurers classify vehicles based on use. The following is an Example for this type of classification:
Farm use has the lowest rating factor, which is followed next by pleasure use. If the vehicle is driven to work or used in business, higher rates are required.
Good Student Discount - Many companies make available a Good Student Discount that can reduce premiums by as much as 25%. The Good Student Discount is based on the premise that good students are better drivers. To qualify for the discount, the insured must be a full-time student in high school or college, at least age sixteen and meet one of the following scholastic requirements:
A school official must sign a form indicating that one of the scholastic requirements has been met.
Driver Education - If a young driver completes an approved Driver Education Course, he/she may be eligible for a driver education credit. The credit is commonly 10%. The rate credit is based on the assumption that Driver Education Classes for teenage drivers can reduce teenage accidents and hold down rates.
Secondary Rating Factors
The following secondary rating factors are also used to rate Automobile Insurance lines:
Type of Automobile - The type of automobile is another important rating factor. Considered, as part of this factor is performance, age of the vehicle and damage-ability because they affect the cost of Physical Damage Coverage.
Performance of the car is an important rating factor. Sports car, high performance cars and foreign specialty cars are more expensive to insure for a Physical Damage Loss than a standard sedan. Thus, a Porsche and a BMW require higher Physical Damage premiums than a Chevrolet Caprice.
Age and Original Cost of the vehicle are also considered by many companies in their rating system. The cost of insuring a new Cadillac is more than the cost of insuring a new Chevrolet sedan. As the car gets older, the rates decline and, in general, automobiles five or more years old have the lowest rates. Relatively less each year since the cost of repairing an older car generally is not more than repairing a newer car. In addition, it takes less damage to an older car to have a constructive total loss. For these reasons, the rate reduction for Physical Damage Insurance on older cars is relatively modest as the car ages.
Number of Vehicles - If the insured owns two or more vehicles, a Multi-Car Discount is available. The discount generally ranges from 10-25%. A Multi-Car Discount is based on the assumption that two vehicles owned by the same insured will not be driven as frequently as one vehicle owned by that person. As a result, the exposure to the insurer is less for two cars owned by the same person as compared with two cars owned by two different people.
Driving Records - The driving record of the owner or operator of the vehicle is another important rating factor. Most insurers use individuals driving record to determine if the applicant for Automobile Insurance is acceptable at standard or preferred rates. Most insurers also impose a surcharge on the insured's premium, that is, multiply the base premium by a given percentage, for a chargeable accident that exceeds a certain amount. The surcharge generally lasts three years.
Finally, many insurers have Safe Driver Plans, in which the premiums paid are based on the insured's driving record. Accident points are assessed for chargeable accidents and traffic violations and premiums are surcharged accordingly. Points are charged for speeding citations, drunk driving, failure to stop after an accident, driving with a suspended or revoked license, homicide or assault involving an automobile and other offenses. The actual premium paid is based on the total number of chargeable points.
Other Factors
Other factors, such as the following, are also important in determining rates:
Deductibles - The amount of the deductible for a Collision Loss and Other-Than-Collision (Comprehensive has a significant effect on the cost of Physical Damage Insurance on automobiles). Increasing the collision deductible from $100 to $200 reduces the Collision Insurance premium by 10-20% in many companies. The premium would be reduced even more if a $500 to $1,000 deductible were selected. The actual reduction depends on the age and make of the vehicle, where the vehicle is garaged and characteristics of the principal operator or owner (such as age, sex and marital status).
Liability Limits - For standard drivers, substantial amounts of Liability Insurance can be purchased without a proportionate increase in the premium. This can be illustrated by a simple example. Assume that the premium for $25,000 Bodily Injury Liability Insurance in one particular territory is $100. Additional amounts of Liability Insurance can be purchased as follows:
Liability Limit Premium
$ 25,000 $ 100
50,000 120
100,000 140
300,000 155
500,000 170
1,100,000 185
The major reason that liability premiums do not increase proportionately with higher limits is that the probability of a large claim is considerably lower than the probability if a smaller claim. Example: the number of Bodily Injury Claims under $25,000 is substantially higher than the number of $1 million claims.
Other Available Discounts and Credits - In addition to the Good Student Discount, Driver Education Credit, Multi-Car Discount, other discounts and credits that can reduce premiums may be available. Insurers commonly give discounts for anti-theft devices, passive restraints, completion of a defensive driving course and student's attendance at schools that are a specified distance from home. Discounts also may be given to senior citizens, farmers, non-smokers and females between the ages of 30-64 who are the only driver in the household.
Keep in mind when rating Auto Insurance, individuals with similar characteristics are placed in the same underwriting class and each person is charged the same rate. Thus, rates may be reduced for better-than-average drivers and increased for below-average drivers. Through laws and regulations, states control the rates charged for Auto Insurance. Rates must be adequate, reasonable (not excessive) and not unfairly discriminatory. Rate regulation may involve the use of Prior Approval Laws, File-and-Use Laws, Open Com-petition, or Mandatory State or Bureau Rates.
The states may expand the public's right to purchase insurance in the voluntary and shared markets through laws and regulations. States may also restrict the insurer’s right to cancel or not renew insureds except in specified situations.
Summary
Numerous factors determine the cost of Automobile mobile Insurance. Primary rating factors include: territory, age, sex, marital status, use of the auto, Good Student Discount and Driver Education Credits. Secondary rating factors include the type of automobile, number of vehicles and driving record. Other factors affecting the cost of insurance include deductibles, liability limits and a variety of specific discounts and credits.
Chapter 9 - Review Questions
1. Automobile insurers are in business to make a profit. Accomplishing this objective requires effective:
A. underwriting
B. rating
C. both A and B
D. neither A or B
2. Rating laws can be classified into the following categories:
A. Prior-approval laws
B. Open Competition Laws
C. File-and-Use Laws
D. all of the above
3. A primary rating factor would be:
A. type of auto
B. drivers education
C. both a and b
D. neither a or b
4. All are secondary rating factors except:
A. driver education
B. type of automobile
C. number of vehicles
D. driving record
5. The marital status of an insured driver is considered:
A. Primary rating factor
B. Secondary rating factor
C. Miscellaneous factor
D. all of the above
Answers
1. C
2. D
3. B
4. A
5. A