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

ARCHITECTURE FOR RESIDENTIAL PROPERTY INSURANCE RATEMAKING 489with respect to many classification attributes, particularly territory.As an architectural matter, indivisible base premium precludesthe proper allocation of costs to class and territory, disallowingdevelopment of distinct and non-interacting class plansand for each peril based on construction features, not to mentiondistinct territory boundaries and rating factors. A corollaryis that the recognition of the full cost of capital in overall ratelevel is discouraged due to an inability to spread it fairly amongrisks.Now consider the consequences of failure to fairly allocatecosts to class and territory by peril. Even if overall premiumlevel generates adequate revenue to fund the losses of the diversebook of business, rating factors must apply to multiple andperhaps unrelated perils, generating unavoidable and perhaps severepremium subsidies. As some insurers improve rating plansto target the risks who are overpaying for certain perils, adverseselection by the affected risks will leave the insurers who fail tomodernize with underpriced segments of the market, which generatepoor underwriting results until overall rate level is raised.Raising the overall rate level without improving the distributionof premiums by rating factor amplifies the adverse selection, perpetuatesthe cycle and leads to a “death spiral” for the insurer.Cummins [7] contains a formal development of the economicsof adverse selection.The indivisible premium is a remnant of historical technologyand marketing architecture. When agents were expected to quotepolicies in the field with a pencil and rating manual, simplicityof rating logic was paramount. The days of hand-rating are longgone in standardized personal lines products, but the rating planbased on that limitation persists. Technology is an enabler ofmodern rating architecture in the form of rating engines accessiblefrom the field, as well as in geographic information systemsand simulation modeling applications. Regardless of theoreticalappeal, implementation of peril-specific rating would have beendifficult even twenty years ago.