The 3 Main Methods of Insurance Rating

When you buy insurance, how is your premium or rate determined? Insurance companies use different methods of rating to calculate policy rates based on risk factors.

The three primary methods of insurance rating are:

• Judgment rating
• Class rating
• Merit rating

Understanding how these methods work can provide insight into why your insurance costs what it does.

An Overview of Insurance Rating

Insurance rating refers to the process of evaluating risk exposures and assigning premium rates accordingly. The goal is to categorize policyholders into groups with similar risk profiles and charge appropriate premiums based on that risk.

Rating helps insurance companies:

• Assess the likelihood and severity of potential losses
• Price policies at levels sufficient to cover claims costs
• Remain profitable across their book of business

The rating system varies by insurance line. Health insurance uses different criteria than auto or home insurance. But the core methods are generally the same.

Regulations also shape rating rules. States require rates to be adequate, not excessive, and nondiscriminatory. Insurers must justify their rating classifications and rules.

Judgment Rating

Judgment rating relies on the underwriter’s expertise to evaluate risks individually and assign premiums. This method is used when risks are so varied that clear manual rating is impossible.

The underwriter reviews the unique characteristics of the exposure and uses their judgment to determine an appropriate rate. This often occurs for large, specialized risks like commercial property, ocean marine, or aviation insurance.

For example, to insure a commercial building, the underwriter may assess:

• Building construction, materials, age
• Fire protection systems
• Natural catastrophe exposure
• Crime rate of the area
• Quality of management

Based on these risk factors, they assign a premium. Judgment rating requires underwriting knowledge and experience. A lack of statistics on future losses also necessitates this case-by-case approach.

Class or Manual Rating

Class rating groups policyholders with similar risk profiles into rating classes. It is also known as manual rating because rates are based on information from rate manuals.

All policies in the same class pay the same base rate. The manual outlines rating classifications and base premiums derived from historical group loss data.

For example, in auto insurance risk is classified by:

• Vehicle make and model
• Driver age
• Gender
• Marital status
• Driving record
• Location

A 16-year-old male with a speeding ticket will fall into a high-risk class with a higher rate than a 45-year-old married female driver in the same city.

Benefits of manual rating include:

• Speed and efficiency from standardized classifications
• Broader experience data for more accurate base rates
• Easy for agents to quickly determine rates during quotes

A downside is less individualization – some risk variations within classes are not recognized.

Merit Rating

While class rating looks at group risk, merit rating adjusts the standard manual premium up or down based on policyholder attributes. Also called experience rating, it aims to factor in individual characteristics overlooked in broad classifications.

Common merit rating elements include:

Driving Record

• Accidents
• Speeding tickets
• DUI violations

Credit-Based Insurance Score

• Payment history
• Debt levels
• Length of credit history

Policyholder Tenure

• Years insured with company
• Prior lapses in coverage

Claims History

• Frequency of past claims
• Dollar amounts paid out

So a driver with no accidents may get a premium discount, while someone with large recent claims could be surcharged. Merit rating often uses variable percentages above or below the base class rate.

Comparing the Rating Methods

In practice, most insurers blend class and merit rating. Classification provides standardization and merit factors individualize further. Large or unusual risks may still require judgment ratings as well.

Rating Variables by Insurance Type

The specific variables used in rating differ by insurance product:

Auto Insurance

• Driver age, gender, marital status
• Vehicle make, model, age
• Primary use (commute, leisure, business)
• Mileage
• Location, territory
• Driving record
• Claims history
• Credit score
• Coverage limits and deductibles

Home Insurance

• Location
• Construction materials and age of home
• Size of living space
• Protective devices (alarms, sprinklers)
• Claims history
• Credit score
• Coverage and deductibles

Business Insurance

• Industry
• Nature of operations
• Size of business
• Location
• Construction and safety features
• Loss control programs
• Claims history
• Coverage and deductibles

Health Insurance

• Age
• Gender
• Location
• Lifestyle factors (tobacco use)
• Number of dependents
• Plan design choices (deductible, copays)

Life Insurance

• Age
• Gender
• Health and family medical history
• Lifestyle (occupation, tobacco use)
• Hobbies and activities
• Face amount and term length

The more a policy variable correlates to risk, the more weight it carries in the rating formula.

The Goal of Equitable Premiums

Ideally, the rating process aims to assess risk accurately and set equitable premiums across policyholders – charging higher rates for large expected losses and lower rates for smaller expected claims.

However, insurers must also watc