Ratemaking for Maximum Profitability

The goal of ratemaking methodologies is to estimate the future expected costs for a book of business. Using past experience, including both internal and external data, the actuary attempts to quantify the required premium level to achieve an acceptable profit. However, if one looks at the rate activity in a market, it is apparent that company actions do not always follow the indications. Surprisingly, such decisions often lead to successful results. It seems that there must be something going on that is invisible to the naked eye? Do indications really mean so little? Or are there other factors, buffed in the actuarial judgment of the experienced actuary' but difficult to quantify? It is the premise of this paper that such factors do indeed exist. One such factor is the effect of the rate change on market behavior. In this paper, we will describe one method for quantifying some of this effect. The methodology described will require much research to determine reasonable assumptions before it can used in practice. It is our hope that it will stimulate further discussion, research, and a move toward acceptance of dynamic economic principles in ratemaking.