Annex: How are premiums calculated?

Insurance premiums are calculated so that they can reasonably be expected to cover the likely claims arising from an insurance contract with a safety margin to ensure the long-term viability of the insurer. The calculation is generally based on the probability of the insured event occurring, combined with the likely financial loss resulting from the claim. This “risk premium” is then adjusted to cover the expenses of the insurance company and to provide some profit:
(Expected claim amount x probability) + expenses + profit + safety margin = premium
The expense adjustment must cover:

•• the initial cost of writing the product (including processing the application and performing underwriting)

•• regular costs associated with maintaining the product

•• any additional costs incurred at the point of claim (including processing the claim and any expenses due to verifying the claim)

How these expenses are charged to the premium depends on the type and structure of the product and how the expenses are incurred. They may be fixed amounts, percentage increases based on the size of the potential claim amount (the sum assured) or a combination of both.

The probability of a claim is commonly determined by analysing historical data from homogeneous groups representing similar risks and by forward-looking risk analysis.
For example, life assurance policyholders may be split into groups based on:

•• age
•• occupation
•• geographical location
•• smoker/non-smoker

This is on the assumption that individuals in the same group experience broadly consistent mortality. Analysis of the historical data for these risk groups provides a good indication of the probability that a policyholder falling into each group will claim (in this example that the policyholder will die) in each year following the inception of the policy.

Generally, the more risk factors that can be included to divide policyholders into similar groups, the more accurate the assumptions on which the probability of a claim being made will be. However, when determining the number of risk groups to split policyholders between, a balance must be found between having too few groups (in which case the risks are not homogeneous) and too many groups (in which case the number of policyholders in each group may be too small for the analysis to be statistically significant). Similarly, groups must be selected so that sufficient historical data is available in order to perform meaningful analysis. Where historical data is not available, insurers can look to other sources such as industry data, publically available statistics, or data from reinsurance companies. The final premium also depends on the individual business strategy of the insurer. For example, a company may wish to position its products as the cheapest in the market in order to gain market share by reducing the level of profit in the premiums.

What is the combined ratio?
It is important that companies regularly review their claims experience against the premiums charged to ensure that the premiums remain appropriate for the risks and that underwriting practices are aligned with the setting of premium rates, so that the risks that the company takes on are consistent with those that have been priced. One way of doing this in non-life insurance is by using a combined ratio. This is the ratio of expenses and claims losses to premiums and it can be applied to monitor how well the company has priced its products (relative to its business plan) and the efficiency of its underwriting in matching the risks to the pricing structure.

If the combined ratio is less than 100%, the premium charged is sufficient to cover the payments and there is an underwriting profit. If the combined ratio is greater than 100%, the company will have made an underwriting loss.