Insurance Services Office

How Rates for Insurance Are Determined

An automated insurance rating system allows for multiple quotes to be obtained in a matter of minutes, saving time and money. “Rate making” (aka insurance pricing) is the way in which insurers determine what rates or premiums to charge for their insurance.

A rate is defined as “the price per unit of insurance for each exposure unit, which is a unit of liability or property with similar characteristics.” For example, in property and casualty insurance, the exposure unit is typically equal to $100 of property value, and liability is measured in $1,000 units.

Insurance companies, wholesalers, and Program Administrators need to base how much they charge consumers on an amount that must cover their losses and expenses, and still earn some profit, otherwise the insurer would not be successful. However, all states have laws that regulate what insurance companies can charge, and thus, both business and regulatory objectives must be met.

Protecting the customer

The main regulatory objective of the state is to protect the customer, while also realizing that the insurer must maintain solvency in order to pay claims. Thus, the three main regulatory requirements regarding rates is that:

They be fair compared to the risk involved
Premiums must be adequate to maintain insurer solvency, and
The same rates should be charged for all members of an underwriting class with a similar risk profile

Although competition basically ensures that businesses meet these objectives anyway, the states want to regulate the industry in a way so that fewer insurers will go bankrupt, since many customers depend on insurance companies to avoid their own personal financial calamity.

The main problem that many insurers face in setting fair and adequate premiums is that actual losses and expenses are not known when the premium is collected. Only after the premium period has elapsed will the insurer know what its true costs are. Larger insurance companies maintain their own databases to estimate frequency and the dollar amount of losses for each underwriting class, but smaller companies rely on rating bureaus for loss information.

A rating bureau is a company that collects loss information to sell to insurance companies. A major rating bureau in the United States is the Insurance Services Office (ISO). Nonetheless, ISO, for instance, does not suggest what rates to charge, but only sells the loss data, letting the companies determine what rates to charge, which is why they often rely on some type of automated insurance rating system to help quickly calculate the best rates being offered and then deliver this information to the consumer.