Overview of Current Ratemaking Methodology - Cont.

In order to produce a more stable and more reliable pure premium, the smoothed pure premium for each county is determined as a weighted average of the indicated pure premiums over all nearby counties. This technique is known as the concentric circle method. Since counties do not possess a uniform, orderly arrangement, RMA has predetermined which counties are included in each concentric circle. The weights for each county are based on the liability of each county, and are computed separately by year. The rationale for the concentric circle method is that the causal or statistically correlated factors that determine the experience for each county operate on a broad geographic basis. A drought, for example, will typically affect an area much larger than an individual county. In comparison, standard actuarial ratemaking procedures tend to disregard the spatial relationships among rating territories, assuming instead that territorial experience is independent of the experience of other nearby territories.

After applying concentric circle smoothing, the smoothed pure premium is increased by a factor of 1.14, which is intended to satisfy the Congressional requirement that the rates be adequate to pay expected losses and build a "reasonable reserve." RMA has defined a reasonable reserve as an amount sufficient to achieve financial adequacy over a 10 year period at an 85% confidence level, evaluated on a countrywide basis. This loading may be understood to be an adjustment for risk to ensure the long term financial viability of the program. It should not be interpreted as an adjustment to the historical experience to more accurately estimate the expected losses, which may be potentially underestimated due to the absence of a catastrophic year in the 20 year experience period. The development of the factor will not be discussed here.