Figuring out what the cost of an insurance premium should be is quite complicated — so complicated that insurance companies employ entire actuarial departments to do just that. Rating variables are an indispensable tool for setting the cost of insurance.

In a new paper, Insurance Rating Variables: What they are and why they matter, the Insurance Information Institute (I.I.I.) and the Casualty Actuarial Society (CAS) explain why actuaries apply variables when setting rates – for example using a driver’s age and gender, accident history and vehicle model year to calculate the premium on an auto policy.

Rating variables are basically the characteristics of individual policyholders that can help approximate the cost of their risks. Insurance companies have been using rating variables to help set rates (and thereby price their policies) for decades.

However, the use of some rating variables has recently generated discussion within the United States. Some states have even passed legislation controlling the use of certain variables, such as gender.  “Variables are designed to make insurance affordable and available to everyone,” said Ken Williams, FCAS, CAS staff actuary. “When a variable is removed from rate setting, the consumer stands to lose the most because lower-risk individuals will end up subsidizing higher-risk individuals; or, insurance companies may choose to accept fewer applications from consumers who might cause them to lose money.”

The paper explains that when regulators restrict the use of a particular variable, actuaries may replace it with another variable as a “proxy,” which might not help them price policies as well.

“Imagine that male drivers have higher accident costs and are more likely to drive pickup trucks,” Williams explained. “If gender is restricted, the proxy for gender could become pickup trucks. In this scenario, rates for pickup trucks may increase while rates for other types of vehicles may decrease.”

It is important to note that all rating variables, including proxies, are regulated in every state. For example, rating variables and proxies cannot directly or indirectly impact groups based on certain characteristics, such as race.

The paper notes that the use of rating variables has resulted in a drastic reduction in the number of consumers seeking coverage in state-supported auto risk pools. Since the increased use of rating variables, the number of consumers in assigned risk pools has decreased almost 90 percent.

James Lynch, FCAS, chief actuary and vice president of research and education at the I.I.I., added, “Rating variables are regulated by state and federal authorities and they meet a variety of important criteria: they are credible, objective, and verifiable. They are an essential tool for setting accurate prices that are lower for low risk customers, higher for high risk customers, yet sufficient to cover an insurer’s costs.”

Here are a few key points from the report:

• Insurance companies use rating variables to develop premiums that better reflect the risks that consumers face.
  • Rating variables are characteristics of individual consumers that can help approximate the cost of their risks, like vehicle model year in auto insurance or the age of a building in homeowners insurance.
  • Rating variables help ensure that less risky consumers pay lower rates than consumers who are at greater risk.
• Rating variables are studied rigorously by actuaries for their effectiveness and impact on the societal goal of keeping insurance available and affordable. They are also closely regulated.
  • Actuaries are very careful to make sure that each variable is effective and is subject to a wide range of criteria, including being credible, objective, verifiable, and inexpensive to administer.
  • Actuaries also make sure variables are legal. Variables are subject to regulation, and state and federal laws prohibit using rating variables that either directly or indirectly impact groups based on characteristics such as race, nationality, religion, or income.
  • Almost every state in the U.S. has the regulatory authority to reject a rating variable that it feels does not meet state requirements.
• Widespread use of rating variables has given consumers more choice and more fairness in the insurance marketplace.
  • The ability to set accurate prices is a cornerstone to setting actuarially sound premiums that are lower for low risk customers, higher for high risk customers, yet overall sufficient to cover all the insurer’s costs.
  • Better and more available data for use in rating variables means increased ability to determine a person’s exact risk profile.
• Restriction of rating variables that do their job well can lead to potential unintended consequences for the consumer.
  • Restrictions on some variables may result in lower-risk consumers effectively subsidizing higher-risk consumers.
  • Restricting rating variables affects consumers much more than it impacts insurance companies.

Click here to read the paper.