What Is Exposure Rating?

Exposure rating is a procedure used to calculate risk exposure in a reinsurance treaty. The loss experience of a portfolio of similar, but not identical, risks is examined in order to determine the potential losses of a client. This process is usually initiated if the reinsurer does not have sufficient credible claims history from the insured party in question.

Exposure rating is one of two risk calculations used in the insurance industry — the other being the experience rating method.

Key Takeaways

  • Exposure rating is a procedure used to calculate risk exposure in a reinsurance treaty.
  • The loss experience of a portfolio of similar, but not identical, risks is examined to estimate the potential losses of a client.
  • This method is often used when the reinsurer does not have sufficient credible claims history from the insured party in question.
  • The assumption is that risks in similar risk groups will display similar loss experiences.

Understanding Exposure Rating

Treaty reinsurance is insurance purchased by one insurance company from another. A contract is drawn up between the ceding insurance company and the reinsurer, who agrees to accept the risks of a predetermined class of policies over a period of time.

When developing the reinsurance treaty price, the reinsurer must estimate the likelihood that a loss will exceed the damage amount retained by the ceding company. Sometimes, reinsurers may execute an excess of loss reinsurance treaty, in which the reinsurer agrees to pay for losses above the specific amount retained by the cedent. Excess of loss treaties may also cap the damages for which the reinsurer is responsible.

In any case, both reinsurance treaties require the reinsurer to estimate the frequency and severity of claims, creating a general risk profile that they may reference when setting the treaty price.

Insurance companies closely monitor the claims and losses that come from the policies that they underwrite to determine whether certain classes of policyholders are more prone to claims, and are thus more risky to insure.

Using either exposure rating or experience rating, a reinsurer will determine their risk-to-reward horizon. Reinsurers often use exposure rating when the company does not have enough historical data to develop an experience rating. Exposure is also useful when the probability that a specific loss will occur is considered low.

Exposure Rating Method

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 display 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 percent. 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.

Ruth Salzmann developed the exposure rating method in the 1970s when writing about the relationship between homeowners fire loss and the corresponding amount of insurance. The pricing structure that she developed became known as the Salzmann Curves.

Exposure Rating vs. Experience Rating

Exposure ratings differ from experience ratings in that they do not require the reinsurer to have had direct historical experience with the specific risk.

With experience rating, a reinsurer will examine historical loss data their company has experienced in association with a specific risk event. For instance, 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. 

Limitations 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 approach.