Why do insurance companies ask so many questions about your business? Why do they use revenue, payroll, vehicle counts, building square footage, employee counts, IT security controls, and HR policies to estimate your insurance premiums? The answer: They want to know your "exposure"; exposure is supposed to represent your likelihood of filing a claim.
Insurance companies write insurance contracts to cover potential future financial loss. Unlike other businesses, insurers do not know the "cost of goods sold" until long after selling their product. The insurance contract is just a promise to "cover" a loss in the future, if it happens. To estimate the potential for future losses, insurers measure exposure.
The exposure basis measured by the insurer needs to balance (1) the theoretical quality of the exposure basis, and (2) the accounting rigor of the exposure basis. A theoretically useful exposure basis will be proportional to loss frequency and loss severity. If the exposure basis increases, the number of claims and/or the size of losses will also increase, and vice versa for a decrease. For accounting rigor, the insurer needs to receive accurate measures of the exposure basis. This means that the exposure basis needs to be measurable, available, and difficult to manipulate.
An example of the exposure basis for general liability (GL) insurance is revenue (sales). The business approaches the insurer asking for a GL policy, and the insurer asks how many dollars of revenue they had last year and how many dollars of revenue they expect/project for next year. In GL insurance, a common risk example is the "slip and fall." If a customer slips and falls on your premises, they may sue you for negligence against your GL policy. The exposure basis of revenue may give a reasonable approximation of the number of customers that enter your business each year (theoretical quality), and revenue is a number that each business tracks and audits each year (accounting rigor).
More on Theoretical Quality
Revenue increase may somewhat correspond with an increased number of incidents, but when comparing two identical businesses, it may not differentiate which business has more risk. Let's compare two identical businesses with the same amount of annual foot traffic, but one simply charges higher rates (gets more revenue). Using revenue as the exposure basis, one company has double the revenue, pays twice the insurance premium, but has the exact same rate of insurance claims.
This situation suggests that the exposure basis may not have the theoretical quality needed for differentiating among risks. Actual foot traffic at each business or in-person customer counts would be more accurate for estimating the claim frequency of slip-and-fall incidents. Additionally, the foot traffic exposure basis isn't directly impacted by a change in sales price.
The real exposure faced by a company is even more complex than this single selected exposure basis. Real slip-and-fall GL exposure is actually a result of foot traffic, attitudes of the customers, legal environment of the store's location (state and city), physical environment on the premises, and the industry or type of business engaged in. Balancing exposure basis availability, quality, and relevance to the real risk of loss is paramount to getting an accurate price for insurance coverage.
To add more complexity/reality, the slip-and-fall exposure is only one part of the negligence risk that a business faces. Most GL policies cover various other perils that are not enumerated; the business operations may act negligently in many spheres on a daily basis. These actions may cause or correlate to loss events for a whole host of changing reasons over time. Each peril may have its own good, better, and best exposure measure. This is why insurance applications are so onerous and why insurance underwriters ask so many questions.
Whichever exposure basis is selected becomes the data that is tracked by the insurance company. This exposure basis becomes the denominator that the actuary compares to past claim counts to determine claim frequency: Claim frequency is claim count divided by exposure unit, and claim severity is the total loss dollars divided by the claim count. Combining the estimated number of claims and the average size of those claims gives us the pure loss cost. The insurance premium equals pure loss costs (PLC) plus a risk margin (RM), an expense margin (EM), and a profit margin (PM).
Premium = PLC + RM + EM + PM
Measuring and tracking exposures and their related historical losses is foundational to the actuarial estimation of the pure loss costs and the risk margin. Expense margin is simply insurer expense divided by the number of policies sold. Profit margin is based on the opportunity cost of using capital in the insurance business instead of another venture.
To buy commercial coverage, you'll need to be ready to share your exposure information with the insurer. Over time, insurance evolves to better determine which exposure bases are effective at estimating business risk.
The following are some common exposure bases for common business insurance products.
Insurance Product
Common Insurance Basis
General liability
Revenue (sales), payroll, square footage, customer count, and number of units sold
Workers compensation
Payroll and employee count
Commercial auto
Vehicle count, vehicle type/size, usage, driver record, and location
Commercial property
Square footage, building value, construction, occupancy, and building location (protection and external risk factors)
Employment practices liability
Employee count, HR policies, turnover rate, location, and industry
Cyber insurance
Revenue, industry, IT security controls, transaction counts, database contents, and data volume
Business interruption
Profits, revenue, maximum foreseeable loss, industry, location, and disaster recovery plans
Professional liability
Revenue, payroll, professional staff count, and project value
Inland marine
Property value and revenue
Inventory insurance
Inventory value
Understanding how your risk is measured and how your insurance premium is calculated is the first step to making smart insurance decisions.
Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.
Why do insurance companies ask so many questions about your business? Why do they use revenue, payroll, vehicle counts, building square footage, employee counts, IT security controls, and HR policies to estimate your insurance premiums? The answer: They want to know your "exposure"; exposure is supposed to represent your likelihood of filing a claim.
Insurance companies write insurance contracts to cover potential future financial loss. Unlike other businesses, insurers do not know the "cost of goods sold" until long after selling their product. The insurance contract is just a promise to "cover" a loss in the future, if it happens. To estimate the potential for future losses, insurers measure exposure.
The exposure basis measured by the insurer needs to balance (1) the theoretical quality of the exposure basis, and (2) the accounting rigor of the exposure basis. A theoretically useful exposure basis will be proportional to loss frequency and loss severity. If the exposure basis increases, the number of claims and/or the size of losses will also increase, and vice versa for a decrease. For accounting rigor, the insurer needs to receive accurate measures of the exposure basis. This means that the exposure basis needs to be measurable, available, and difficult to manipulate.
An example of the exposure basis for general liability (GL) insurance is revenue (sales). The business approaches the insurer asking for a GL policy, and the insurer asks how many dollars of revenue they had last year and how many dollars of revenue they expect/project for next year. In GL insurance, a common risk example is the "slip and fall." If a customer slips and falls on your premises, they may sue you for negligence against your GL policy. The exposure basis of revenue may give a reasonable approximation of the number of customers that enter your business each year (theoretical quality), and revenue is a number that each business tracks and audits each year (accounting rigor).
More on Theoretical Quality
Revenue increase may somewhat correspond with an increased number of incidents, but when comparing two identical businesses, it may not differentiate which business has more risk. Let's compare two identical businesses with the same amount of annual foot traffic, but one simply charges higher rates (gets more revenue). Using revenue as the exposure basis, one company has double the revenue, pays twice the insurance premium, but has the exact same rate of insurance claims.
This situation suggests that the exposure basis may not have the theoretical quality needed for differentiating among risks. Actual foot traffic at each business or in-person customer counts would be more accurate for estimating the claim frequency of slip-and-fall incidents. Additionally, the foot traffic exposure basis isn't directly impacted by a change in sales price.
The real exposure faced by a company is even more complex than this single selected exposure basis. Real slip-and-fall GL exposure is actually a result of foot traffic, attitudes of the customers, legal environment of the store's location (state and city), physical environment on the premises, and the industry or type of business engaged in. Balancing exposure basis availability, quality, and relevance to the real risk of loss is paramount to getting an accurate price for insurance coverage.
To add more complexity/reality, the slip-and-fall exposure is only one part of the negligence risk that a business faces. Most GL policies cover various other perils that are not enumerated; the business operations may act negligently in many spheres on a daily basis. These actions may cause or correlate to loss events for a whole host of changing reasons over time. Each peril may have its own good, better, and best exposure measure. This is why insurance applications are so onerous and why insurance underwriters ask so many questions.
Whichever exposure basis is selected becomes the data that is tracked by the insurance company. This exposure basis becomes the denominator that the actuary compares to past claim counts to determine claim frequency: Claim frequency is claim count divided by exposure unit, and claim severity is the total loss dollars divided by the claim count. Combining the estimated number of claims and the average size of those claims gives us the pure loss cost. The insurance premium equals pure loss costs (PLC) plus a risk margin (RM), an expense margin (EM), and a profit margin (PM).
Premium = PLC + RM + EM + PM
Measuring and tracking exposures and their related historical losses is foundational to the actuarial estimation of the pure loss costs and the risk margin. Expense margin is simply insurer expense divided by the number of policies sold. Profit margin is based on the opportunity cost of using capital in the insurance business instead of another venture.
To buy commercial coverage, you'll need to be ready to share your exposure information with the insurer. Over time, insurance evolves to better determine which exposure bases are effective at estimating business risk.
The following are some common exposure bases for common business insurance products.
Understanding how your risk is measured and how your insurance premium is calculated is the first step to making smart insurance decisions.
Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.