Final answer:
Experience rating in insurance is a method that sets premiums based on a policyholder's historical claims, thereby reflecting their actual risk. It ensures actuarial fairness and adherence to the fundamental law of insurance, which balances premiums with claims, costs, and profits. Disruption by regulators can cause insurers to leave markets to avoid unsustainable costs.
Step-by-step explanation:
The principle of experience rating in insurance refers to the practice of setting premiums based on the historical loss experience of a particular insured or a group. This method allows insurers to adjust the cost of insurance cover more accurately to reflect the actual risk presented by an insured. Essentially, those with a history of making fewer or smaller claims tend to enjoy lower insurance premiums, while those with a history of higher or more frequent claims tend to face higher premiums.
Experience rating is crucial because it promotes actuarial fairness and ensures that the fundamental law of insurance is observed. This law states that over time, the average amount paid in premiums by policy holders must cover the average amount paid out in claims, as well as the costs of running the insurance company, and allow for the company's profits.
When certain factors, such as administrative costs, groups with different risk profiles, and investment income, complicate the insurance landscape, insurers may still adhere to this fundamental law to remain viable. Regulators can sometimes disrupt this balance by imposing low premiums through legislation, potentially leading to a situation where insurers withdraw from markets as seen in New Jersey and Florida, to avoid insuring high-risk parties at unsustainable costs.