Why Professional Liability Premiums Change: Factors that Affect Pricing (Part Deux)

Our previous article in the September 2015 edition of our newsletter discussed how the number of attorneys and “attorney class” factors affect your professional liability insurance premiums.  In this eagerly anticipated follow-up article, we will discuss several additional factors that also affect your premium:  (1) areas of practice; (2) policy limits; and (3) deductibles.  We’ll first tackle how areas of practice affect premiums, since it’s the most involved. 

While the discussion about attorney class factors in the first article required an understanding of the difference between “claims made” and “occurrence” coverage, understanding why premiums differ by area of practice requires a grasp of several actuarial concepts, defined below.  Please keep in mind throughout this article that the concepts discussed or defined are either developed based on the experience of our overall book of business or the experience of all attorneys practicing in a particular area, and not the experience of an individual firm or attorney.     

Loss Development – projecting the ultimate settlement values of claims, including unpaid and unreported, from a particular point in time to the time of claim closing.

Frequency – number of claims per exposure, which in our case is the number of claims per attorney.

Frequency Trend – the rate of change in the number of claims per attorney over a period of time.

Severity – average loss (which includes indemnity and costs of defense) per claim.

Severity Trend – the rate of change in the average loss per claim over a period of time.

Pure Premium – frequency multiplied by severity, or average loss per attorney.

Practice areas are generally categorized as either: 1) low frequency, low severity (such as criminal law and arbitration/mediation); 2) low frequency, high severity (such as securities, intellectual property and commercial real estate); and 3) high frequency, low severity, (such as residential real estate).  Since pure premiums for each area are a product of frequency and severity, it is understandable that areas of practice may have different pure premiums due to differences in frequency and/or severity.  For example, all other things being equal, a criminal defense lawyer should anticipate a lower premium than a real estate lawyer because both frequency and severity in criminal law are lower than in real estate.  Further, a residential real estate lawyer should expect a lower premium than commercial real estate lawyers because, while frequency is higher, the difference in severity from one area to the next more than offsets the difference in frequency.      

We must briefly cover loss development or trend, because both affect pure premiums.  In order to determine a pure premium for an area of practice, our actuaries analyze our loss experience in each area over various periods of time.  The time periods selected are known as experience periods, and are generally five, seven or ten years.  In order to get a true picture of loss experience, the actuaries must “develop” these losses to get an estimate of the ultimate values.  They then analyze how these ultimate values have changed over time and assume that they will continue to change at the same rate as they’ve changed in the past (actuaries must make assumptions).  This is known as trending.  Trend is affected by things like the economy, inflation and changes in the law.

Note that many attorneys and firms practice in several practice areas, so the final premium takes into account the percentages practiced in each area.  Also note that insurers discount pure premiums to reflect the time value of money and also must add a component for expenses.  At Lawyers Mutual, we focus on keeping our expenses low, which helps keep your premiums down.  This focus also allows us to spend more of each premium dollar on claims than our competition.

Moving on to policy limits.  This could be a very complicated discussion that covers loss severity distributions.  (I’ll save that for the real actuaries.)  The short answer is that higher policy limits increase our exposure to loss.  However, you’ll note that when you double your policy limit, your premium does not double.  Why is that?  For example, it’s because the expected loss at a $2M each claim limit is not twice the expected loss at a $1M each claim limit.  In other words, expected losses do not double just because the policy limit doubles.  In order to arrive at premiums charged for limits above a basic or base limit, which in our case is $100,000 each claim, we apply what is called an increased limit factor.  Increased limit factors equal the quotient of dividing the expected loss at the higher limit by the expected loss at the basic limit.            

And finally, on to deductibles.  Deductibles affect premiums because they are included in the limit of liability.  For example, if you have a policy with a $1M each claim limit and a $5,000 deductible, our exposure to loss is $995,000 ($1M minus $5,000).  With higher deductibles, we have less exposure to loss because a greater percentage of the expected loss falls within the deductible.

We’ve not covered everything, but hope that these articles have helped explain some of the major factors that affect your premium.  If you have questions about the concepts in these articles, please let us know.  We’re always happy to hear from our insureds and will do our best to answer your questions.