Expense Allocation in Insurance Ratemaking

Until the present time, the great majority of actuarial study and literature in the ratemaking area has revolved around analyzing and quantifying the loss component of the insurance rate. Actuaries have evolved an elaborate system in which losses are trended, developed and credibility weighted, and in which premiums are placed at current rates or at least current rate levels. At the same time, actuaries have virtually ignored the expensive portion of the insurance rate, preferring to treat expenses as a constant percentage of premium. Current economic and political conditions are forcing a reevaluation of this simplistic approach towards expense allocation. Consumer groups have charged that current expense allocation procedures are discriminatory, and insurance companies are attempting to improve their pricing position through the development of rates which more accurately distribute the costs of doing business. In this paper we shall take a look at the expense portion of the insurance rate. We shall examine the pros and cons of the traditional treatment of expenses and shall consider some alternate methodologies. Our focus will be on the personal lines; Automobile and Homeowners. At the same time, many of our conclusions and observations can be extended to other lines of insurance. This paper does not attempt to answer all of the questions regarding expense allocation. Rather, its intention is to lay a general foundation upon which specific, detailed expenses flattening procedures can be built. Experience Rating Plans, Expenses