The Effect of Expense Loadings

Abstract

One of the important trends in actuarial research in the 1980s has been the development of several premium calculation principles, and the study of their properties (see, for instance, Gerber, 1974a, 1974b, and Goovaerts, De Vijlder and Haezendonck, 1984). While this line of research may have been instrumental in inducing insurers to reevaluate their rating principles, it mostly focused on risk premiums (net premiums and safety loadings), while casting aside the determination of the loading for expenses, commissions, taxes, and profits. This chapter attempts to show that this neglect may have some severe consequences. It is futile to try to assess the risk premium with great accuracy if expense loadings are only be roughly calculated. Risk premiums with desirable properties can be distorted through the loading process. This should be obvious since in many cases the expense loading exceeds the risk premium. Note that the same remark was made by Jewell (1980): The next step in premium setting is to determine the additional 50–200% increase which determines the commercial premium by adding expense and profit loadings. Except in life insurance where there are specific cost models for sales commissions (in many cases of regulated form), there seems to be no further modelling principles used, except [multiplying the risk premium by a factor 1+α]. This lacuna in the literature is all the more surprising, as it is in sharp contrast to the fields of engineering and business management, where extensive and sophisticated cost allocation and modelling are the order of the day. Are these activities outside the realm of the actuary?