2005
Insurance Reference Manual
Personal Insurance Federation of California Insurance Reference Book
RATEMAKING, PREMIUMS AND PROFITS
The first function of an insurance premium rate is to allow insurance companies to pay legitimate losses experienced by policyholders. People buy insurance because they can substitute the small, definite cost of the premium for a possible larger but uncertain monetary loss. They also buy some types of insurance because the state or a lender may require it. Most insurance buyers realize that the premiums paid by many policyholders (spreading the risk) will be used to compensate those who suffer loss.
In addition to paying for losses, the premium rate must cover the insuring company's expenses, including operating expenses, salaries, taxes, agent's commissions, plus allow for a reasonable profit. The need for adequate rates is recognized under California law and it is against the law to charge inadequate rates. Legislators who enacted the law understood that a bankrupt or financially unsound insurer will not be able to pay its policyholders' claims. The California Supreme Court re-enforced this principle in the 1989 Calfarm decision relating to Proposition 103. The court ruled unconstitutional a provision in Proposition 103 that companies could get a rate increase only after a finding "that an insurer is substantially threatened with insolvency." The court further stated that insurers are entitled to a fair profit and a reasonable rate of return.
Under California law, rates must not be excessive, inadequate or unfairly discriminatory. An insurer cannot charge excessive prices for insurance and cannot charge different rates for risks that are substantially the same.
RATEMAKING
Ratemaking in California generally falls into two categories, open competition and prior approval. Open competition is the ratemaking process where competition among companies determines rate levels. Rates for workers' compensation insurance are currently determined through this process. If a company can charge a lower rate and make a profit through greater efficiency or offer a level of service that attracts customers, this will force competitors to lower their rates or increase their services in order to compete and maintain market share.
"Prior approval" means that companies must submit proposed rate changes to the insurance commissioner prior to changing rates. The commissioner reviews the supportive evidence and decides whether or not a rate change is justified.
The commissioner can also hold public hearings on the rate change, or a public hearing can be requested by any member of the public. As a result of the passage of Proposition 103 in 1988, prior approval was instituted for most lines of insurance in California including auto and homeowners.
The data submitted to the California Department of Insurance (CDI) with each type of rate change includes loss payments, expenses for handling and paying claims, operating expenses of the insurance company and underwriting losses. In justifying rates, the companies must project these figures into the future, along with inflation and other factors that may have increased the cost of things for which insurance pays - such as doctor bills, hospital costs and repairing damaged or destroyed property. During a period of inflation, insurance company losses can exceed previous predictions to such an extent that rates become inadequate and payouts for claims exceed income.
When reviewing a rate change for motor vehicle insurance, the insurance commissioner must decide whether the rate change request is excessive, inadequate or unfairly discriminatory. In making that determination, the Department of Insurance must consider several factors enumerated in the California Insurance Code, Sections 1861.01 through 1861.09 and the California Code of Regulations. The factors to be considered include a company's past and prospective loss experience and administrative, selling and loss adjustment expenses. Also to be considered are investment income, cost of repairs, cost of medical services, adequacy of loss reserves, cost of reinsurance, trend factors and other relevant factors.
With the advent of Proposition 103, rates and premiums charged for an automobile insurance policy are determined by application of the following factors in decreasing order of importance: 1) the insured's driving safety record; 2) the number of miles he/she drives annually; 3) the number of years of driving experience the insured has, and 4) such other factors the commissioner may adopt by regulation that have a substantial relationship to the risk of loss. In addition, Proposition 103 also requires that rates must not be excessive, inadequate or unfairly discriminatory.
Public hearings may be held on any rate increase or decrease application. Under Proposition 103, qualified persons or consumer groups may intervene in CDI proceedings (rate hearings included). Intervenors are also allowed to charge for their time and expenses which are paid by insurance companies. Intervenors may intercede in rate increase or rate decrease hearings.
PREMIUMS AND PROFITS
Auto Insurance
Although the rate structures of insurance companies vary considerably, there are three basic components of an automobile insurance premium: 1) claim payments and costs; 2) general operating expenses of the insurance company; and 3) underwriting profit or loss.
The major portion of the insurance premium dollar goes for the payment of claims to compensate people for loss caused by personal injury or damage to their property. In cases involving personal injury, claim payments cover items such as medical costs, lost income because of disability, lost earning potential, and compensation for pain and suffering. In property damage cases, claim payments go for repairs to vehicles or for their replacement when the vehicle is a total loss or has been stolen, and property in addition to a vehicle damaged in an accident.
The portion of the premium dollar paid out in claims and claim costs varies by coverage and by company, and fluctuates sharply from year to year.
Insurance companies attempt to set their rates so the portion of the premium paid out in claims is the same in every section of the state. They also try to maintain the same payout percentage for each classification of driver (those qualifying for Good Driver discounts and others, under Prop. 103). In this way, each driver classification and geographical area pays its fair share of the total costs. This is known as "cost based" pricing.
In reality, however, insurers rarely experience identical payout percentages in every driver class and geographical area. Most companies experience greater payouts for young drivers and for people living in large urban areas.
The second largest portion of the premium dollar goes for the insurance company's general operating expenses. These include all the insurance company expenses not connected with settling claims.
Compensation to agents for marketing insurance and providing service to policyholders is the largest insurance company general operating expense. Many companies rely on independent agents for their sales force (see Section IV - Insurance Resources - for definition of an independent agent). Some insurers use agents who are salaried employees. A few companies have no agents, but sell their policies by direct mail, e-mail or through 1-800 numbers. Most insurers who use independent agents pay them negotiated commissions ranging generally from 5 to 15 percent of premium income. Independent agents and brokers represent a number of insurance companies.
Expenses, including agent commissions, can consume around 30 percent of the premium dollar in some insurance companies.
Other general expenses use up somewhere around 11 percent of the premium dollar in most insurance companies, although this too varies considerably by company. This includes salaries, buildings, equipment and other operating costs. Premium taxes and fees levied by the state take another three percent or so. Federal taxes generally require about 1 percent (see Section V - California Department of Insurance - for an explanation of how insurance company and agent fees fund the California Department of Insurance.
Insurance company profits account for the smallest portion of the auto insurance premium dollar. If a company pays out 65 percent of its premium
dollars in claims and claim costs and another 30 percent in expenses, it has spent 95 percent of its premium income. The remaining five percent is called underwriting profit.
An insurance company's stock and trade is money. It receives money from customers and pays money to accident victims. While the insurance company has the money in its possession, the funds are invested in securities. The interest, dividends, and capital gains the insurer earns from these securities is called investment income.
Insurance critics often ask why investment income is not considered when insurance rates are established. The fact is, investment income has always been considered in rate filings, even before Proposition 103 put the requirement into law.
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