PROCEEDINGS May 15, 16, 17, 18, 2005 - Casualty Actuarial Society

ARCHITECTURE FOR RESIDENTIAL PROPERTY INSURANCE RATEMAKING 487ratemaking for other residential and commercial propertyproducts.ACKNOWLEDGEMENTSThe author’s thanks go to Steve E. Wallace, CPCU for preparationof the figures and all Geographic Information Systems (GIS)analysis supporting the paper, and to Rade T. Musulin for salientcomments on, and thorough review of, early drafts.1. MOTIVATIONS: THEORETICALThe insurance industry has earned a chronically inadequaterate of return on its chief residential property line, the homeownersproduct, since the 1980s. Catastrophic (“cat”) events, thetoxic mold phenomenon, the growing popularity of vicious dogs,outbreaks of sinkholes, and other root causes of loss have repeatedlysurprised insurers in recent years. To date, responses havebeen almost exclusively reactive: underwriting restrictions, coveragelimitations and sharp corrections in overall price level.The classical “indivisible premium” rating plan in commonuse for residential property products is a significant obstacle limitingthe industry to reactive responses of questionable economicefficiency and actuarial equity. Actuaries can show strategic leadershipby engineering a proactive response–the development ofa modern architecture for ratemaking that improves overall ratelevel efficiency as well as risk classification equity. The classicalplan is demonstrably obsolete, particularly in catastrophe-proneareas, and greatly hinders the ability of insurers to identify, segregateand monitor the component drivers of loss costs. Harmoniousadvances in technology and actuarial science now allow usto overcome the obstacles to modern rating architecture.Specifically, these structural changes to rating plans are overdue:² Actuarially sound prices should reflect an explicit provisionfor cost of capital, in addition to actual non-cat loss costs,