Introduction

In section 5.9 we saw that, for most classes of general insurance, many possible sources of heterogeneity of risk exist. A premium rate based on the observed claim rate for a heterogeneous portfolio might prove quite inadequate if, as is likely, the mix of risks were to change. To reduce this danger, policies are usually grouped according to the different levels of the various risk factors involved. Claim frequency rates and premiums for the different groups are then calculated. This approach to the problem is called group rating. Multivariate methods can also be used to estimate the effects of the various levels of each risk factor on the claim frequency rate and premium.

Even when policies are grouped according to the different levels of various relevant risk factors, the residual heterogeneity within the groups is often still considerable. Many policies will have underlying claim frequency rates near the mean rate for the group. Some, however, will have considerably higher underlying rates, and some considerably lower, and it is desirable that we distinguish between these. We may attempt further subdivision of the groups using additional risk factors or additional intermediate levels of existing factors.