Start Here: 5 Things You MUST Know
Pure Premium Method builds a rate from scratch. Loss Ratio Method adjusts an existing rate.
Advisory orgs file loss costs, NOT final rates. Each insurer adds its own expense and profit loading.
Loss reserves are the BIGGEST liability on an insurer's balance sheet -- often 60-70% of total liabilities.
IBNR = losses that happened but the insurer doesn't know yet. IBNER = reported but reserved too low.
Under-reserving makes an insurer look falsely profitable and can lead to insolvency. Over-reserving makes them look less profitable and overcharge.
2. Loss Ratio Method
When to Use
Use this method when you already have an existing rate and want to know if it needs to go up or down. Instead of building from scratch, you compare your actual loss experience to what you expected.
The Formula
Rate Change = (Actual Loss Ratio / Expected Loss Ratio) - 1
If the result is positive, rates need to increase. If negative, rates could decrease. The expected loss ratio is the one built into the current rate structure.
Worked Example: Auto Insurance Rate Adjustment
The Setup: An insurer charges $1,000/year for auto insurance. When they set that rate, they expected 65% of each dollar to go toward losses (expected loss ratio = 65%). After a year of experience, actual losses came in at 72%.
Given Data:
Current rate: $1,000
Expected loss ratio: 65%
Actual loss ratio: 72%
Step-by-Step Calculation:
Step 1: Calculate the Rate Change Factor
72% / 65% = 1.1077
Losses are running 1.1077 times what was expected.
Step 2: Convert to Percentage Change
1.1077 - 1 = +0.1077 = +10.77%
Rates need to increase by 10.77%.
Step 3: Apply to Current Rate
$1,000 x 1.1077 = $1,107.70
Losses are running 10.8% higher than expected, so rates need to increase by 10.8% to stay adequate.
Quick Logic Check
If actual loss ratio = expected loss ratio, the formula gives (65/65) - 1 = 0% change. The rate is perfectly adequate. If actual is LOWER than expected, you get a negative number (rate decrease). Makes sense!
3. Judgment Method
When to Use
Use when there is insufficient statistical data for actuarial analysis. This is the method of last resort -- less precise, but sometimes the only option. Common for new lines, unique risks, and emerging risks like cyber insurance.
What the Actuary Relies On:
Similar Lines of Business
Using aviation liability data to help price drone insurance
Industry Data
Pooled data from advisory organizations even if limited
Expert Opinion
Engineers, scientists, and risk consultants assess the hazard
Engineering Studies
Technical failure rate analysis, stress testing results
Real-World Scenario: Drone Delivery Insurance
The Setup: A startup launches a drone delivery service. They need liability insurance. No historical drone delivery loss data exists anywhere.
What Happens: The actuary pieces together data from aviation liability, product liability, and tech E&O policies. They consult engineering assessments of drone failure rates, battery fire risks, and collision probabilities.
The Result: A rate is estimated using professional judgment informed by analogous data. The rate will likely be high (reflecting uncertainty) and will be refined as actual loss data emerges over time.
4. When to Use Which Method
Pure Premium
Situation: New line, no existing rate
Data needed: Plenty of historical loss data
Output: A brand-new rate from scratch
Precision: High (data-driven)
Think: "I have data but no rate"
Loss Ratio
Situation: Existing rate needs adjustment
Data needed: Recent actual loss experience
Output: Percentage increase or decrease
Precision: High (data-driven)
Think: "I have a rate -- is it still right?"
Judgment
Situation: No data, emerging or unique risk
Data needed: Analogous data, expert opinion
Output: Best estimate based on judgment
Precision: Low (subjective)
Think: "I have no data -- best guess"
5. Advisory Organizations
Advisory organizations pool loss data from many insurers and develop prospective loss costs (pure premiums without expense loading). They file these with regulators. Insurers can then adopt, modify, or ignore them and add their own expense and profit loading.
ISO / Verisk
The largest advisory organization. Collects data from thousands of insurers.
Focus: Commercial and personal lines loss costs, policy forms, and classification systems
Key fact: Most insurers use ISO forms and rates as a starting point
NCCI
National Council on Compensation Insurance. Specializes in one line only.
Focus: Workers' compensation data, rates, and classification system
Key fact: Operates in approximately 38 states
AAIS
American Association of Insurance Services. A smaller alternative to ISO.
Focus: Serves small and regional insurers who need an alternative to ISO
Key fact: Same concept as ISO but smaller scale
How the Process Works
Insurers Report
Loss data submitted
Advisory Org Pools
Data aggregated
Loss Costs Filed
With regulators
Insurers Use/Modify
Add own expenses
Critical Distinction for the Exam
Advisory organizations file LOSS COSTS (pure premiums without expense loading) -- NOT final rates. Each insurer adds its own expense and profit loading to create its final rate. This is why two insurers can use the same ISO loss costs but charge different premiums.
6. Loss Reserves -- The Biggest Liability on the Balance Sheet
What are loss reserves? Money set aside to pay for losses that have already occurred but have not yet been fully paid. They represent the insurer's best estimate of what they will ultimately owe.
Loss reserves are typically the largest single liability on an insurer's balance sheet -- often 60-70% of total liabilities. Getting reserves wrong has massive consequences.
The Four Types of Loss Reserves
Case Reserves
Estimates for individual known claims that have been reported but not yet paid. Set by claims adjusters based on the specific facts of each claim.
Example: A car accident is reported. The adjuster reviews the damage, medical bills, and estimates the total cost at $15,000. A $15,000 case reserve is established for that specific claim.
IBNR (Incurred But Not Reported)
Losses that have already happened but the insurer doesn't know about them yet. The insurer must estimate how many unreported claims are out there.
Example: A hailstorm damages a roof in October. The homeowner doesn't notice the damage until April. The loss is "incurred" in October but won't be "reported" until April -- a 6-month IBNR gap.
Biggest IBNR risk: Long-tail lines (liability, workers comp) where claims can emerge years or even decades later. Think: asbestos exposure, sexual abuse claims.
IBNER (Incurred But Not Enough Reported)
Also called "development on known claims." Claims that HAVE been reported, but the case reserve is too low. This is the most common type of reserve adjustment.
Example: A workers comp claim is initially reserved at $50,000. The claimant's condition worsens and requires additional surgery. Reserve must be increased to $150,000. The $100,000 increase is IBNER.
Reopened Claims Reserves
Claims that were closed (settled and paid) but later get reopened due to a change in circumstances.
Example: A workers comp claim is closed after the claimant returns to work. Two years later, the injury flares up and the claimant needs another surgery. The claim is reopened and a new reserve must be established.
60-70%
Of total liabilities are loss reserves
Case
Known claims, adjuster-set
IBNR
Happened but unknown
IBNER
Known but under-reserved
7. Loss Development
Claims change over time -- initial estimates are almost NEVER the final cost. Loss development factors measure how much claims grow from initial report to final settlement. Actuaries use loss development triangles to track these patterns.
Short-Tail Lines
Claims develop quickly -- typically 1-2 years to final settlement.
Examples: Property insurance, auto physical damage. A house fire is reported, inspected, and settled within months.
Long-Tail Lines
Claims can develop for 10-20+ years before final settlement.
Examples: General liability, workers comp, medical malpractice. A child injured at birth may not file a lawsuit until age 18. Asbestos claims emerged decades after exposure.
Why Accurate Reserves Matter
Under-Reserving (Too Little Set Aside)
The insurer looks more profitable than it really is because liabilities are understated.
May pay excessive dividends to shareholders based on phantom profits.
May lead to inadequate rates (if you think losses are low, you charge too little).
Ultimate risk: insolvency when the true cost of claims is revealed.
Over-Reserving (Too Much Set Aside)
The insurer looks less profitable than it really is because liabilities are overstated.
May charge excessive premiums, losing customers to competitors.
Tax implications: reserves are a tax deduction, so over-reserving reduces taxable income.
Regulators watch for this too -- it can be a sign of income manipulation.
Regulatory Requirement
State regulators examine reserve adequacy annually. An appointed actuary must certify that reserves are adequate. If regulators find reserves are deficient, they can require the insurer to increase them -- which immediately reduces reported surplus and may trigger regulatory action.
Cheat Sheet
Print this page for quick referenceFormulas
Pure Premium: Gross Rate = PP / (1 - Exp% - Profit%)
Loss Ratio: Rate Change = (Actual LR / Expected LR) - 1
Pure Premium: PP = Adjusted Losses / Exposure Units
Method Selection
Pure Premium: Have data, no existing rate
Loss Ratio: Have existing rate, need to adjust
Judgment: No data, emerging/unique risk
Advisory Orgs
ISO/Verisk: Largest, commercial + personal lines
NCCI: Workers comp only, ~38 states
AAIS: Smaller alternative, regional insurers
Key rule: File LOSS COSTS, not final rates
Four Reserve Types
Case: Known claims, adjuster estimates each one
IBNR: Happened but insurer doesn't know yet
IBNER: Reported but reserved too low (most common adjustment)
Reopened: Closed claims that get reopened
Exam Trap Alerts
1. Pure Premium vs. Loss Ratio -- Don't Mix Up When to Use Each
Pure Premium = building from scratch (no existing rate). Loss Ratio = adjusting an existing rate. If the question says "an insurer wants to determine if its current rates are adequate," that is the Loss Ratio Method. If it says "developing a rate for a new market," that is the Pure Premium Method.
2. Advisory Orgs File LOSS COSTS, Not Rates
A question might say "ISO files rates that all insurers must use." This is FALSE. ISO files prospective loss costs (pure premiums). Each insurer adds its own expense and profit loading. Insurers can also develop their own independent rates.
3. IBNR vs. IBNER -- The Name Tells You
IBNR = "Not Reported" -- the insurer doesn't even know the claim exists yet. IBNER = "Not ENOUGH Reported" -- the insurer knows about the claim but has set aside too little money. If a question describes a known claim that grows, that is IBNER, not IBNR.
4. Under-Reserving Makes You Look PROFITABLE (Not Poor)
This is counterintuitive. If you don't set aside enough for losses, your liabilities are understated, which makes your net income look higher. The danger is false profitability leading to excessive dividends and eventual insolvency.
5. The Denominator in Pure Premium Formula is NOT Just Expenses
The formula divides by (1 - Expense Ratio - Profit Factor). Students sometimes forget the profit factor. If expense ratio is 30% and profit is 5%, the denominator is 0.65, not 0.70. This makes a significant difference in the final rate.
6. NCCI is Workers Comp ONLY
Don't confuse NCCI with ISO. NCCI handles workers compensation exclusively (in ~38 states). ISO handles commercial and personal lines broadly. If a question mentions workers comp classification codes or experience modification, think NCCI.
7. Loss Development Applies to ALL Methods
Whether using Pure Premium or Loss Ratio, the historical data must be developed to ultimate. A claim reported 6 months ago has not finished developing. Failing to adjust for development means your rates are based on incomplete data and will be too low.
8. Long-Tail vs. Short-Tail Affects EVERYTHING
Long-tail lines have more IBNR, higher development factors, greater reserve uncertainty, and more investment income on reserves. Property = short tail (1-2 years). Liability/WC/Med Mal = long tail (10-20+ years). This distinction shows up in multiple exam contexts.
Quick Reference Summary
Pure Premium Method
Builds rate from scratch: PP / (1 - Exp% - Profit%)
Loss Ratio Method
Adjusts existing rate: (Actual LR / Expected LR) - 1
Judgment Method
Expert opinion when no statistical data exists
ISO / Verisk
Largest advisory org, files loss costs (not rates)
NCCI
Workers comp only, ~38 states
Case Reserves
Individual known claims, adjuster-set estimates
IBNR
Losses happened but insurer doesn't know yet
IBNER
Known claims reserved too low (most common adjustment)
Loss Reserves
60-70% of total liabilities, annually examined
Under-Reserving
False profit, excessive dividends, insolvency risk
Short-Tail Lines
Property, auto PD -- develop in 1-2 years
Long-Tail Lines
Liability, WC, med mal -- develop 10-20+ years