Expected Claim Costs, Risk Classification

Expected claim cost: Claim cost must be paid by the insurer for a contract or group of contracts. This cost represents the largest component of the fair premium for most types of insurance.

1. Homogeneous buyers: When a there is existed a large number or group of insurance buyers and each buyer has the same loss distribution then the buyers are said to be homogeneous. For example, among a group of buyer each buyers has a 0.15 probability of loss taka 1000 and 0.85 probability of having no loss. Here assume that is buyers each buyers loss is independent of the loss of other buyers. As we seen that a large number of homogeneous insurances can charge a premium equal to the expected claim cost and be able to cover to its claim costs. Thus a fundamental of insurance premiums is the expected claim cost. If the insurer charged less then the expected claim cost average claim cost would exceed average revenues. On the other hand, competitor keeps the insurer from charging the more than the expected claim cost.
2. Heterogeneous buyers: When there are existed two groups of consumers with different loss distribution then the groups are called heterogeneous buyers.

Risk classification the process by which insurers estimate the expected claim cost for different buyers and changed premiums that vary according to expected claim costs. Buyers in risk classes with higher expected claim costs are charged higher rates. Insurers have strong incentives to classify buyers based on all information that helps predict differences in claim costs across buyers provided that the information can be obtain at a sufficiently low cost.

2. Investment income: Given the ability of insurers to earn investment income on premiums prior to the payment of claims the fair premium reflects the discounted value of expected claims costs .As a result the fair premium is inversely related to the level of interest rates and to the length of the claims.
3. Administrative costs: The fair premium includes an expense loading to cover the insurer’s administrative costs including both underwriting expenses and loss adjustment expenses.
4. Fair profit loading: The fair premium includes a profit loading to compensate investors for the disadvantages like double taxation of investment returns of investing in an insurance company other thing being equal. The fair profit loading is higher for lines of insurance with more uncertainty concerning future claim costs because the insurer needs to hold more capital to achieve a given probability of insolvency.