What Is a Composite Rate?
Composite rating is an insurance pricing method in which similar risks are charged the same rate rather than rated individually. It is used for convenience and is not intended to increase or decrease the premium. Composite rating often used on commercial insurance policies covering large businesses. It is also used in group health insurance.
Composite rating utilizes a convenient exposure base, like sales or units, instead of the multiple exposure bases that would normally be used to rate a risk. It offers some advantages to both policyholders and insurers.
- It makes premiums easy to calculate.
- It simplifies the audit process.
- It facilitates cost accounting. When composite rating is used, policyholders can allocate insurance costs to specific projects relatively easily.
How It Works
Composite rating is often used on commercial auto and general liability policies purchased by large businesses. The first step in the rating process is to calculate the annual premium in the normal manner. Next, the underwriter selects a convenient exposure base to use as a substitute for those normally used. The underwriter then calculates an average rate by dividing the premium by the number of exposures.
Commercial Auto Example
The following example demonstrates how composite rating is used in commercial auto insurance. Hal owns Happy Hauling, a business that transports soil, concrete, gravel, and other loose materials. The company picks up materials at construction sites and hauls them to the city dump or another location. Happy Hauling owns 25 dump trucks. All of the vehicles are similar models and are approximately the same size and age. The dump trucks are insured for liability under a business auto policy issued by the Elite Insurance Company.
The liability limit is $1 million.
The trucks are currently rated individually. Happy Hauling's auto policy will expire in three months, and Hal wants to switch to composite rating when the coverage is renewed. Elite Insurance agrees. First, the insurer calculates the renewal premium using the normal procedure for commercial auto rating. The insurer assigns each truck a rating territory, a size class, a user class, and a radius class. It uses these factors to determine the liability rate. Elite classifies all of the vehicles as extra-heavy trucks used commercially within a local radius (within 50 miles of Happy Hauling's storage lot).
The insurer rates each vehicle separately and then calculates the total premium. The annual premium for the 25 trucks is $100,000.
Next, the insurer calculates a composite rate on a "per truck" basis. The composite rate for each truck is $100,000 divided by 25 or $4,000. Happy Hauling's annual premium is $100,000, the same as it would have been had a composite rating not been used. For Hal, the rate is convenient as he knows that he'll pay $4,000 to insure any new dump truck for liability. When the company's policy expires, the insurer will conduct an audit. If Happy Hauling owns 30 trucks on the policy expiration date, it's annual premium will be adjusted to $120,000 ($4,000 times 30).
General Liability Example
Composite rating is also used in rating general liability policies. For example, suppose that Primo Painting Inc. owns a chain of retail paint stores. Primo also operates a contract painting business that specializes in commercial buildings. In addition, the company owns an office building that it leases to a tenant. Primo Painting is insured under a commercial general liability policy that covers all three operations (paint stores, painting business, and office building).
Primo's policy will expire soon and the company wants to switch to composite rating when it renews. Primo's insurer, the Elite Insurance Company, agrees. First, the insurer calculates the annual renewal premium using the standard methods for general liability rating. It uses the class codes included in Primo's existing policy. These are listed in the table below.
|Description||Class Code||Premium Base|
|Paint, Wall Paper or Wall Covering Stores||15991||Sales|
|Painting - Interior - Buildings or Structures||98305||Payroll|
|Buildings or Premises - Lessors Risk||61212||Area|
Each of the three class codes has a different premium base. The paint stores are rated on gross sales, the painting business is rated on the payroll, and the office is rated on square footage. For both the paint stores and the painting business, the premium consists of two parts: a premises and operations premium and products and completed work premium. A separate rate is applied to each. When the insurer calculates Primo's policy premium, it includes the following five elements:
- Premises and operations premium for the paint stores
- Products and completed work premium for the paint stores
- Premises and operations premium for the painting business
- Products and completed work premium for the painting business
- Premises and operations premium (only) for the office building
The insurer determines that Primo's renewal premium is $100,000. Elite and Primo agree to use a composite rate based on gross sales. The rate will be applied to each $1,000 in gross sales. Primo's three businesses generate $25,000,000 in annual sales. To determine the composite rate, Elite divides the $100,000 annual premium by $25,000. The composite rate is $4. When the composite-rated policy expires, the insurer will conduct a final audit. It will calculate Primo's final premium by multiplying the $4 composite rate by the company's annual sales and dividing the result by 1,000.