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

INCORPORATION OF FIXED EXPENSES 683² If there were nonrecurring expense items during the historicalperiod, the actuary should examine the materiality and natureof the expense to determine how to best incorporate the expensein the rates–if at all. If the aggregate dollars spent areconsistent with dollars spent on similar non-recurring projectsin other years, the expense ratios should be similar and noadjustment is warranted. If, however, the expense item representsan extraordinary expense, then the actuary must decideto what extent it should be included. Assume, for example,the extraordinary expense is from a major systems project toimprove the policy issuance process. That project clearly benefitsfuture policyholders and should be included in the rates.Assuming the new system will be used for a significant lengthof time, it may be appropriate to dampen the impact of theitem and spread the expense over a period of several years. Ifthe actuary consistently selects the three-year average, the expensewill automatically be spread over three years, assumingrates are revised annually. 3 On the other hand, the actuary maydetermine that it is inappropriate to charge future policyholdersfor a given nonrecurring expense. If so, the actuary shouldexclude the expense from the ratemaking data altogether. Inthat case, the expense is basically funded by existing surplus.² Finally, a few states place restrictions on which expenses canbe included for the purpose of determining rates. For example,Texas does not allow insurers to include charitable contributionsor lobbying expenses. These expenses must be excludedfrom the calculation of the historical expense ratios when performingthe analysis for that state. If such expenses are recurring,overall future income will be reduced by that state’sproportion of the expenses.3 This assumes all of the expense is booked in that year. Statutory accounting guidelinesallow some expenses to be amortized over several years. If the extraordinary expense isamortized over three years, then the use of a three-year average will actually spread theexpense over five years. The three-year average expense ratio will increase for the firstthree years and decrease for the last two years.