What is Exposure Rating

Exposure rating is a procedure used by reinsurers to calculate risk exposure in a reinsurance treaty. The reinsurer does not need previous exposure to underwriting the specific risk. The exposure rating method is one of two risk calculations used in the insurance industry. The second method is called the experience rating method.

BREAKING DOWN Exposure Rating

When developing the reinsurance treaty price, the reinsurer estimates the likelihood that a loss will exceed the damage amount retained by the ceding company. Reinsurers may also execute an excess of loss reinsurance treaty, in which the reinsurer agrees to pay for losses above the specific amount retained by the ceding company. Excess of loss treaties may also cap the damages for which the reinsurer is responsible. Both reinsurance treaties require the reinsurer to estimate the frequency and severity of claims, creating a general risk profile that they may use when setting the treaty price.

Using either exposure rating or experience rating, a reinsurer will determine their risk-to-reward horizon. Exposure ratings differ from experience ratings in that they do not require the reinsurer to have had direct historical experience with the specific risk.

Exposure Rating Usage 

Ruth Salzmann developed the exposure rating method in the 1960s. Salzmann wrote about the relationship between homeowners fire loss and the corresponding amount of insurance in "Rating by Layer of Insurance." Reinsurers use exposure rating when the company does not have enough historical data to develop an experience rating. Exposure is also useful when the probability of a specific loss occurring is considered low.

An exposure rating is generated by examining the loss experience of a portfolio of similar, but not identical, risks. The assumption is that risks in similar risk groups will have similar loss experiences. The result of an exposure rating is an estimation of the expected losses the company could expect to experience for a specific event. The method expresses loss as a percentage of the amount of value insured. The data will generate an exposure curve. As you move along the curve, the cumulative loss, as a percent of insured value, approaches 100%. Exposure rating allows the reinsurer to examine loss severity in layers, and will ultimately allow the reinsurer to set prices for risks that are estimated to fall within each of the various layers.

Experience Rating Usage 

A reinsurer will use experience rating to examine historical loss data their company has experienced in association with a specific risk event. As an example, the reinsurer may look at the value of claims they covered for earthquakes in a particular region. The reinsurer will use their historic experience and will adjust historical loss data to estimate future losses to the same specific risk. 

Drawbacks of Exposure Rating

One disadvantage of the exposure rating method is that it creates a zone in each layer in which the losses approach, but do not reach, the next level of retention. Reinsurers may use a distribution table to set the rate for the lower bounds of the layer. An additional drawback is that the reinsurer must assign a high degree of credibility to data sources that are not its own. It must depend on the data derived from other insurers and third-party rating systems to set its risk exposure. For this reason, the experience rating method may be the preferred method.