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Risk Classification
Grouping of risks with similar risk characteristics
Enables development of equitable insurance prices
Assures availability of needed coverage to the public
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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
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List the Difficulty in Risk Classification
• Fairness
• Identifying similar risk characteristics
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Three Primary Purposes of Risk Classification
- Protection of Program's Financial Soundness
- Be Fair
- Economic Incentives to encourage widespread Availability of coverage
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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
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Give two examples of Hazard Avoidance and Reduction
- a. Examples
- • Avoid airplane accidents by not flying
- • Fire alarm reduce severity of fire losses
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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
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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
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What is the Rationale for Risk Classification?
Insurer needs to establish a fair price for assuming financial uncertainty
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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
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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
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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
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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
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List the 3 Statistical Considerations
- 1. Homogeneity
- 2. Credibility
- 3. Predictive Stability
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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
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Statistical Considerations: Credibility
- 2. Credibility
- * Grp should be large enough to measure costs w/ enough accuracy
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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
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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)
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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
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Hazard Reduction Incentive Consideration
Provides incentive for insureds to act to reduce expected losses (sprinklers, airbags)
Desirable incentive but not necessary
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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
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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
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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)
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Controllability Consideration
- Under insured's control & behaviour can reduce premium
- Insured can be motivated to improve risk characteritic & reduce rate
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Describe two desirable and 2 undesirable characteristics of Controllability consideration
- DESIRABLE:
- 1. close association with effort to reduce hazard
- 2. Generally accepted by public
- UNDESIRABLE
- 1. Sucesptible to manipulation
- 2. Irrelevant to predict future costs
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