1. Risk Classification
    Grouping of risks with similar risk characteristics

    Enables development of equitable insurance prices

    Assures availability of needed coverage to the public
  2. What Risk Classification is not
    • Predicting experience for an individual risk in the class

    • Identify unusually good and bad risks

    • Reward or penalize certain groups of risks at the expense of others
  3. List the Difficulty in Risk Classification
    • Fairness

    • Identifying similar risk characteristics
  4. Three Primary Purposes of Risk Classification
    • Protection of Program's Financial Soundness
    • Be Fair
    • Economic Incentives to encourage widespread Availability of coverage
  5. Basic Principles needed in any sound risk classification system to achieve primary purposes
    Should reflect expected cost differences

    Should distinguish among risks on the basis of relevant cost-related factors

    Should be applied objectively

    Should be practical and cost-effective

    Should be acceptable to the public
  6. Give two examples of Hazard Avoidance and Reduction
    • a. Examples
    • • Avoid airplane accidents by not flying
    • • Fire alarm reduce severity of fire losses
  7. Describe the two Programs of Financial Uncertainty
    a.Programs providing benefits based on financial need

    • Charitable organizations and governmental assistance programs

    b. Programs providing benefits based on defined contractual rights

    • Self-insured group pension, welfare plans, gov't and private insurance programs
  8. Public and Private Programs
    • Both involve
    • Transfer of financial uncertainty from one party to another
    • Pooling of risks
    • *Exposure to loss should be broad enough to reasonably predict total losses

    • b. Governmental programs
    • • Provided by public law
    • • Compulsory
    • *Competition plays little or no role
    • • Often provide coverage for hazards not effectively covered by private insurance
    • • Cost of providing insurance need not equal premiums over long-term

    • c. Private insurance
    • • Provided through an individual contractual arrangement
    • • Often voluntary
    • *Competition plays important role
    • • Premiums must cover losses, expenses and profit over long-term
    • • Programs are highly diverse
    • *Coverage available for wide variety of risks
  9. What is the Rationale for Risk Classification?
    Insurer needs to establish a fair price for assuming financial uncertainty
  10. What are the current pricing methods used?
    • • Judgment
    • *Not the best method but may be only one available on new or unique risks

    • • Risk's actual losses over an extended period
    • *Not the best due to risks with no past losses, e.g., life insurance

    • • Losses of groups of individual risks with similar risk characteristics
    • *Most commonly used
    • *Difficulty is choosing relevant similar risk characteristics and related classes
  11. What are the 3 primary purposes of Risk Classification?
    a. Protection of Program's Financial Soundness

    • Minimize adverse selection

    b. Be Fair

    • Price differences between classes should reflect expected costs

    • Individual risks within a class should have similar expected costs

    c. Economic Incentive

    • Want to profitably expand market

    • Increased market penetration provides economies of scale in marketing / distribution

    • • Incentive for risk classifications to be more refined to accurately reflect differences
    • in expected costs

    • • Efficiency also required
    • *Additional expense of refinement must not exceed cost reduction
  12. What are the 9 considerations in designing a risk classification system?
    • 1. UW
    • 2. Marketing
    • 3.Program Design
    • 4. Statistical Considerations
    • 5. Operational Considerations
    • 6. Hazard Reduction Incentives
    • 7. Public Acceptability
    • 8. Causality
    • 9. Controllability
  13. What are the Program Design elements related directly to risk classification?
    • 1. Degree of Choice Available to the Buyer
    • Compulsory programs use broad classes,

    Voluntary programs have more refined classes (o.w. likely to get adverse selection)

    • 2. Experience Based Pricing
    • When used, less refined initial risk class system needed

    • Experience rating refunds, prem adjustments, dividends produce a refined classification system (reflecting actual experience of specific risk)
    • 3. Premium player
    • Some insurance programs, individual doesn't pay entire premium

    * affects risk classification (insured doesn't care):

    Broad classification system may be appropriate

    Distinction between payer and insured decreases likelihood of adverse selection
  14. List the 3 Statistical Considerations
    • 1. Homogeneity
    • 2. Credibility
    • 3. Predictive Stability
  15. Statistical Considerations: Homogeneity
    • 1. Homogeneity
    • * distinct grps of risks with similar expected costs o.w. should be subdivided
    • * Key for class analysis is to identify and group risks with similar expected costs
  16. Statistical Considerations: Credibility
    • 2. Credibility
    • * Grp should be large enough to measure costs w/ enough accuracy
  17. Statistical Considerations: Predictive Stability
    • 3. Predictive Stability
    • * Requires risk classification to be:

    a. responsive to changes in the nature of insurance losses

    b. stable in avoiding unwarranted abrupt changes in prices
  18. Describe how Statistical considerations somewhat conflicting
    Increased # classes improve homogeneity, decrease credibility

    No one statistically correct risk classification system

    System adopted will reflect relative importance of each consideration to insurer (mgmt philosophy, judgement, nature of risks)
  19. What are the 7 Operational Considerations?
    • 1. Expense
    • * Should be as low as possible; minimize adverse selection & maximize equity

    • 2. Constancy
    • * characteristics used should be constant with relationship to risk.
    • * can periodically reclassify

    • 3. Availability of Coverage
    • *properly matching expected costs and price will enhance availability

    • 4. Avoidance of Extreme Discontinuities
    • *should be enough classes to establish reasonable continuum of expected claim costs

    • 5. Absence of Ambiguity
    • * class defiinition should be clear and objective

    • 6. Manipulation
    • * Should minimize ability to manipulate or misrepresent risk's characteristics

    • 7. Measurability
    • * should be suceptible to convenient and reliable measurement
  20. Hazard Reduction Incentive Consideration
    Provides incentive for insureds to act to reduce expected losses (sprinklers, airbags)

    Desirable incentive but not necessary
  21. Public Acceptability Considerations must recognize society values but are difficult to apply in practice bc:
    • 1. difficult to ascertain
    • 2. vary among society segments
    • 3. change over time
  22. Public Acceptability considerations should:
    1. Not differentiate unfairly among risks

    2. Be based upon clearly relevant data

    3. Respect personal privacy

    4. Structured so that risks tend to identify naturally with their classification
  23. What does Causality Consideration imply?
    • Intuitive relationship to insurance costs
    • Closer relationship to costs than correlation
    • Impossible to prove statistically any postulated cause and effect relationship

    • Preferable from social perspective that rating vars based on characteristics that are causal in nature
    • (sump pump reduces water damage losses)
  24. Controllability Consideration
    • Under insured's control & behaviour can reduce premium
    • Insured can be motivated to improve risk characteritic & reduce rate
  25. Describe two desirable and 2 undesirable characteristics of Controllability consideration
    • 1. close association with effort to reduce hazard
    • 2. Generally accepted by public

    • 1. Sucesptible to manipulation
    • 2. Irrelevant to predict future costs
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