Insurance is a type of financial service and, like many service contracts, insurance coverage is often agreed upon for a limited time period, such as six months or a year, at which time commitments are complete. Particularly for general insurance, the need for coverage continues and so efforts are made to issue a new contract providing similar coverage. Renewal issues can also arise in life insurance, e.g., term (temporary) life insurance, although other contracts, such as life annuities, terminate upon the insured’s death and so issues of renewability are irrelevant.
In absence of legal restrictions, at renewal the insurer has the opportunity to:
- accept or decline to underwrite the risk and
- determine a new premium, possibly in conjunction with a new classification of the risk.
Risk classification and rating at renewal is based on two types of information. First, as at the initial stage, the insurer has available many rating variables upon which decisions can be made. Many variables will not change, e.g., sex, whereas others are likely to have changed, e.g., age, and still others may or may not change, e.g., credit score. Second, unlike the initial stage, at renewal the insurer has available a history of policyholder’s loss experience, and this history can provide insights into the policyholder that are not available from rating variables. Modifying premiums with claims history is known as experience rating, also sometimes referred to as merit rating.
Experience rating methods are either applied retrospectively or prospectively. With retrospective methods, a refund of a portion of the premium is provided to the policyholder in the event of favorable (to the insurer) experience. Retrospective premiums are common in life insurance arrangements (where policyholders earned “dividends” in the U.S. and “bonuses” in the U.K.). In general insurance, prospective methods are more common, where favorable insured experience is rewarded through a lower renewal premium.
Claims history can provide information about a policyholder’s risk appetite. For example, in personal lines it is common to use a variable to indicate whether or not a claim has occurred in the last three years. As another example, in a commercial line such as worker’s compensation, one may look to a policyholder’s average claim over the last three years. Claims history can reveal information that is hidden (to the insurer) about the policyholder.