Actuarial Standard of Practice No. 29
Expense Provisions in Property/Casualty Insurance Ratemaking
STANDARD OF PRACTICE
TO: Members of Actuarial Organizations Governed by the Standards of Practice of the Actuarial Standards Board and Other Persons Interested in Expense Provisions in Property/Casualty Insurance Ratemaking
FROM: Actuarial Standards Board (ASB)
SUBJ: Actuarial Standard of Practice No. 29
This booklet contains the final version of actuarial standard of practice (ASOP) No. 29, Expense Provisions in Property/Casualty Insurance Ratemaking.
This standard was developed by the Subcommittee on Ratemaking of the ASB’s Casualty Committee. The Casualty Actuarial Society’s Statement of Principles Regarding Property and Casualty Insurance Ratemaking identifies and describes principles applicable to the determination and review of property/casualty insurance rates. These principles are limited to that portion of the ratemaking process involving the estimation of costs associated with the transfer of risk. For most lines of business, the expense component is a significant portion of the rate. For some lines of business, the expense component can actually exceed the loss component. For this reason, it is necessary to have a standard of practice to provide guidance to actuaries in the determination of a proper expense component.
This standard was exposed for review in October 1994, with a comment deadline of March 15, 1995. Thirty-one comment letters were received. The Subcommittee on Ratemaking reviewed all the comments carefully, and many of the suggestions were incorporated into the final standard. In particular, the subcommittee expanded the discussions concerning (1) residual market and statutory assessment provisions, (2) the provision for reinsurance, and (3) policyholder dividends. (For a detailed discussion of the issues raised in the comment letters, and the subcommittee’s responses to such, please see Appendix 2.)
A number of format changes have also been made since publication of the exposure draft. The ASB voted in May 1996 to change the format of all future actuarial standards of practice. Thus, sections 3 and 4 now form an appendix titled, Background and Current Practices. (Appendix 1 of this standard contains sections 3 and 4 of the exposure draft.) Further, sections 5 and 6 of the exposure draft have now been renumbered as sections 3 and 4. The “new” sections 3 and 4, along with sections 1 and 2, now form the actual standard of practice. The heading Preamble, which used to apply to the first four sections of the standard, has been deleted. The board made these format changes to help the reader distinguish between a standard’s substantive requirements and language intended for general information.
The Subcommittee on Ratemaking and the Casualty Committee thank everyone who provided input during the exposure process. The comments were helpful in making revisions. The Casualty Committee also thanks the following former subcommittee members, who made significant contributions to this work: Daniel J. Flaherty, Gary Grant, and Robert Lindquist. The ASB voted in July 1997 to adopt the final standard.
Subcommittee on Ratemaking of the Casualty Committee
Steven G. Lehmann, Chairperson
Frederick F. Cripe Marc B. Pearl
Robert W. Gossrow Jonathan White
R. Michael Lamb Paul E. Wulterkens
Casualty Committee of the ASB
Michael A. LaMonica, Chairperson
Christopher S. Carlson Karen F. Terry
Douglas J. Collins Margaret W. Tiller
Anne Kelly William J. VonSeggern
Steven G. Lehmann Mark Whitman
Robert S. Miccolis
Actuarial Standards Board
Richard S. Robertson, Chairperson
Phillip N. Ben-Zvi Roland E. King
Harper L. Garrett Jr. Daniel J. McCarthy
David G. Hartman Alan J. Stonewall
Frank S. Irish James R. Swenson
The ASB establishes and improves standards of actuarial practice. These ASOPs identify what the actuary should consider, document, and disclose when performing an actuarial assignment. The ASB’s goal is to set standards for appropriate practice for the U.S.
Section 1. Purpose, Scope, Cross References, and Effective Date
The purpose of this standard of practice is to provide guidance to actuaries in estimating costs for property/casualty insurance ratemaking other than (1) incurred losses, (2) the provision for profit and contingencies, (3) investment expenses, and (4) federal and foreign income taxes.
This standard of practice applies to all property/casualty insurance coverages. This standard also applies to property/casualty risk financing systems, such as self-insurance, that provide similar coverages. References in the standard to risk transfer should be interpreted to include risk financing systems that provide for risk retention in lieu of risk transfer.
If the actuary departs from the guidance set forth in this standard in order to comply with applicable law (statutes, regulations, and other legally binding authority), or for any other reason the actuary deems appropriate, the actuary should refer to section 4.
1.3 Cross References
When this standard refers to the provisions of other documents, the reference includes the referenced documents as they may be amended or restated in the future, and any successor to them, by whatever name called. If any amended or restated document differs materially from the originally referenced document, the actuary should consider the guidance in this standard to the extent it is applicable and appropriate.
1.4 Effective Date
This standard will be effective with respect to work performed after December 1, 1997.
Section 2. Definitions
The definitions below are defined for use in this actuarial standard of practice.
2.1 Commission and Brokerage Fees
Compensation to agents and brokers.
2.2 Expense Limitations
Legislative or regulatory rules that disallow or limit certain categories of expenses in determining rates.
2.3 General Administrative Expenses
All operational and administrative expenses (other than investment expenses) not specifically defined elsewhere in this section.
2.4 Loss Adjustment Expenses (LAE)
All expenses incurred in investigating and settling claims.
2.5 Other Acquisition Expenses
All costs, other than commission and brokerage fees, associated with the acquisition of business.
2.6 Policyholder Dividends
Nonguaranteed returns of premium or distributions of surplus.
Those expenses that vary in direct proportion to premium, e.g., premium taxes. These expenses are sometimes referred to as variable expenses.
An estimate of the expected value of future costs.
2.9 Residual Market Provision
A provision for the entity’s costs that represents its share of residual market profits or losses.
2.10 Statutory Assessment Provision
A provision for the entity’s costs stemming from any mandated assessment.
2.11 Taxes, Licenses, and Fees
All taxes and miscellaneous fees except federal and foreign income taxes.
Section 3. Analysis of Issues and Recommended Practices
3.1 Categorizing Expenses
The actuary should be familiar with the pertinent requirements for defining expenses, such as those prescribed in the Instructions for Uniform Classification of Expenses, published by the National Association of Insurance Commissioners (NAIC), or Regulation 30 of the New York State Insurance Department. The actuary should also be familiar with the entity’s own methods of classifying and assigning expenses.
3.2 Determining Expense Provisions
The actuary should determine the provisions for loss adjustment expenses; commission and brokerage fees; other acquisition expenses; general administrative expenses; and taxes, licenses, and fees that are appropriate for the policies to be written or coverages provided during the time the rates are expected to be in effect. In addition, where appropriate, the actuary should consider subdividing the expense categories. Expense provisions should reflect the conditions expected during the time these policies or coverages are expected to be in effect and should include all expenses expected to be incurred in connection with the transfer of risk.
For expenses other than premium-related expenses, the actuary should consider estimating these expenses on a basis that is not directly proportional to premium, such as per policy, per coverage, a percentage of claim losses, or per unit of exposure. Studies or actuarial judgment may support such estimates.
3.3 Start-Up Costs
The actuary may amortize start-up or development costs using an appropriate amortization period.
3.4 Expense Trending
In determining the future expense components of the rate, the actuary should be guided by Actuarial Standard of Practice (ASOP) No. 13, Trending Procedures in Property/Casualty Insurance Ratemaking.
3.5 Policyholder Dividends
The Statement of Principles Regarding Property and Casualty Insurance Ratemaking of the Casualty Actuarial Society (CAS) classifies policyholder dividends as an expense to operations. When the actuary determines that policyholder dividends are a reasonably expected expense and are associated with the risk transfer, the actuary may include a provision in the rate for the expected amount of policyholder dividends. In making this determination, the actuary should consider the following: the company’s dividend payment history, its current dividend policy or practice, whether dividends are related to loss experience, the capitalization of the company, and other considerations affecting the payment of dividends.
3.6 Residual Market and Statutory Assessment Provisions
The actuary should include a provision in the rate for any residual market costs or statutory assessments expected to occur during the period of time the rates are expected to be in effect. If these costs are assessed retrospectively, it may be appropriate to include a provision to recover these costs to the extent they were not included in previous rates.
3.7 Provision for Reinsurance
The actuary may elect whether to include the cost of reinsurance as an expense provision. If a provision for reinsurance is included, the actuary should consider the amount to be paid to the reinsurer ceding commissions or allowances expected reinsurance recoveries and other relevant information specifically relating to cost, such as a retrospective profit-sharing agreement and reinstatement premiums between the reinsured and the reinsurer.
Section 4. Communications and Disclosures
4.1 Conflict with Law or Regulation
The rate filed with a regulator may differ from an actuarially determined rate because of expense limitations. If a law or regulation conflicts with the provisions of this standard, the actuary should develop a rate in accordance with the law or regulation and disclose any material difference between the rate so developed and the actuarially determined rate to the client or employer.
The actuary should be guided by the provisions of ASOP No. 9, Documentation and Disclosure in Property and Casualty Insurance Ratemaking, Loss Reserving, and Valuations.
The actuary should include the following, as applicable, in an actuarial communication:
a. in addition to the disclosure covered in section 4.1, the disclosure in ASOP No. 41, Actuarial Communications, section 4.2, if any material assumption or method was prescribed by applicable law (statutes, regulations, and other legally binding authority);
b. the disclosure in ASOP No. 41, section 4.3, if the actuary states reliance on other sources and thereby disclaims responsibility for any material assumption or method selected by a party other than the actuary; and
c. the disclosure in ASOP No. 41, section 4.4, if, in the actuary’s professional judgment, the actuary has otherwise deviated materially from the guidance of this ASOP.
Appendix 1 – Background and Current Practices
Note: This appendix is provided for informational purposes, but is not part of the standard of practice.
Inflation: Prior to the relatively high inflation of the 1970s, a predominant ratemaking technique involved including expenses, other than loss adjustment expenses, as a percentage of premium. In doing so, it was assumed that the expense portion of the rate was subject to the same trend (usually very low) to which the loss and loss adjustment expense portions were subjected. However, higher levels of inflation had a rather significant impact on the expected change in the various components of the rate. By the 1970s, the assumption that the trend in expenses would approximate the trend in losses was being questioned. Although the actuarially determined loss trend may have been applied to the loss and loss adjustment expenses as usual, a separate analysis and trend may have been necessary to properly reflect the anticipated change in certain other expenses.
Expense Flattening: Expense flattening techniques assign expenses to policies or other units of exposure rather than in proportion to premium or losses. Thus, expense flattening is a procedure sometimes used to determine that portion of the rate that does not vary in direct proportion to premium or losses.
Expense Trending: Expense trending reflects how changes over time affect expenses. Over the years, separate trending of expenses has become a more common ratemaking technique. However, including expenses as a proportion of premium is still used.
Actuarial Literature: Although the property/casualty actuarial literature is relatively sparse on the topic of expense provisions in ratemaking, techniques for separately trending losses and expenses and alternatives to premium-related expense provisions have been included in such literature. Also included are discussions about the inappropriateness, in some cases, of assuming proportional expenses for administrative ease when, in fact, some expense categories do not vary in direct proportion to premium.
Regulation: Beginning in the late 1970s, some regulators have applied expense limitations in either limiting or disallowing certain expenses and in requiring expense flattening.
Categories: Expenses other than investment expenses are generally divided into five broad categories to determine the expense component of the rate. These expenses are (1) loss adjustment expenses, (2) commission and brokerage fees, (3) other acquisition expenses, (4) general administrative expenses, and (5) taxes, licenses, and fees. Studies may be conducted to determine which expenses vary in direct proportion to premium, losses, number of policies, or other units of exposure, and which expenses may be independent.
Loss Adjustment Expenses: Loss adjustment expenses are generally of two types: allocated and unallocated. Allocated loss adjustment expenses (ALAE) are sometimes combined with and, thus, treated the same as, incurred losses (IL). ALAE are combined with unallocated loss adjustment expenses (ULAE) for some lines of business. ULAE may be expressed as a function of IL plus ALAE, but may also be expressed as a function of premium. For lines of business in which all loss adjustment expenses are combined, the loss adjustment expenses are generally expressed as a function of either IL or premium.
Commissions and Premium Taxes: Commissions and premium taxes are typically paid as a percentage of direct written premium. Such expenses are generally treated as premium-related expenses.
General Administrative Expenses and Other Acquisition Expenses: General administrative expenses and other acquisition expenses may be expressed as a function of premium; or may be partially related to premium, partially related to the number of policies, and partially related to the number of exposures.
Current Information: Historical expenses are generally analyzed in light of current relevant information to determine whether they will be representative of future costs.
Budgeted versus Historical Expenses: Because of the prospective nature of ratemaking, certain expenses, such as commissions, are generally based on budgets rather than determined from historical data.
Expense Trending: Historical expenses may be adjusted to reflect changes over time.
Residual Market and Statutory Assessment Provisions: Residual market costs and statutory assessments are often included as expenses. For those classes of business written in the voluntary market that caused the insurer to receive a share of the residual market, the residual market provision may be separately identified or embedded in the rate.
Appendix 2 – Comments on the Exposure Draft and Subcommittee Responses
The proposed standard of practice was approved for release as an exposure draft in October 1994, with a comment deadline of March 15, 1995. Thirty-one comment letters were received and reviewed by the Subcommittee on Ratemaking of the ASB’s Casualty Committee.
Click here to view Appendix 2 in its entirety.