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

488 ARCHITECTURE FOR RESIDENTIAL PROPERTY INSURANCE RATEMAKINGexpected cat loss costs from simulation tools (“cat models”),and underwriting expenses.² Indivisible base premium should be replaced with several partialbase premiums by peril; for example, hurricane, otherwind, fire, liability/medical, and all other perils (AOP).² Partial base premiums should be modified by distinct class andterritory (geographic location) rating plans for several reasons.Property attributes affecting equitable risk classification varysignificantly by peril, and the cost of capital is not generated(and should not be allocated) uniformly among perils.² Rating for base premium adjustments and miscellaneous endorsementsshould be recalibrated to take advantage of theunbundling of base premiums.Why does the classical rating plan doom insurers to poor longrununderwriting results? Recalling fundamental principles ofactuarial science [4], improper insurance prices can result fromtwo distinct ratemaking failures:1. Failure to recover all costs associated with risk transferin the final premium;2. Failure to differentiate rates for identifiable classes ofrisks with demonstrable differences in expected cost ofrisk.Indivisible base premium in residential property insurance facilitatesboth failures. Two components represent the bulk of thepremium for the product–expected loss costs and cost of capital.In turn, these components are generated by an aggregation ofindividual perils insured against–the largest contributors oftenfire, liability, and windstorm. In recent years, it has become apparentthat the loss costs and costs of capital for distinct perils aredistributed in an extremely lopsided fashion or “maldistributed” 11 The use of this term is with a respectful nod to Bailey and Simon’s seminal 1959 paperon class ratemaking.