AAA Risk Classification Flashcards
Three primary purposes of the Risk Classification process
- Protect the insurance system’s financial soundness
- be fair
- permit economic incentives to operate and thus encourage widespread availability of coverage
AAA pg2
The basic principles that should be present in any sound risk classification system in order to achieve the 3 primary purposes
- The system should reflect expected cost differences
- The system should distinguish among risks on the basis of relevant cost related factors
- The system should be applied objectively
- The system should be practical and cost-effective
- The system should be acceptable to the public.
AAA pg2
3 Societal mechanisms for coping with the financial impact of chance occurrences
- Hazard Avoidance and Reduction
- Transfer of Financial Uncertainty
- Public and Private Programs
AAA pg2-3
Alternatives to Risk Classification rating system
- estimate a price based solely on wisdom, insight and good judgment concerning the nature of the particular hazard involved and the exposure to loss.
Only method for new risks, e.g. new occupations that did not exist in the past - fair price for the transfer is to observe the risk’s actual losses over an extended period of time. No good for life insurance
AAA pg4
Difficulty with risk classification rate making
The need to choose the relevant similar risk characteristics and related classes before the observation period. Perfectly competitive markets are seldom achieved, and the risk characteristics commonly used reflect both observed fact and informed judgment.
AAA pg5
How do government insurance programs often protect themselves against adverse selection?
Participation is mandatory and choices are restricted or non-existent (e.g. social security). Adverse selection is controlled by the restriction of the buyer’s freedom.
AAA pg6
How do private insurance programs often protect themselves against adverse selection?
Risk classification is the primary means to control the instability caused by adverse selection.
AAA pg6
What design considerations are a part of any sound Risk Classification system?
- Underwriting
- Marketing
- Program Design
- Statistical Consideration
- Operational considerations
- Hazard Reduction Incentives
- Public Acceptability
- Causality
- Controllability
AAA pg7-15
How does underwriting influence Risk Classification system design decisions?
The design of a risk classification system must recognize that it is applied through the underwriting process. In practice, the application of the UW function controls the practical impact of the classification system, and misapplication of the classification system in the UW process will achieve results different from those intended.
AAA pg8
How does marketing influence Risk Classification system design decisions?
The insurer’s marketing program has an important influence on its mix of business-i.e. what products are sold and to whom.
AAA pg8
What 3 elements of the design of an insurance program relate directly to risk classification?
- Degree of Choice Available to the buyer
- Experience Based Pricing
- Premium Payer
AAA pg8-9
How does the program design consideration Degree of Choice Available to the buyer affect the design of the risk classification system?
For programs which are largely or entirely compulsory and where there is no voluntary choice among competing institutions, broad classifications are sometimes used, the extreme being single class.
Conversely, where participation is vol, a system that classifies risks more broadly than competing systems could invite adverse selection.
AAA pg8
How does the program design consideration Experience Based Pricing affect the design of the risk classification system?
Some insurance programs provide for price adjustment after the insurance is acquired, based at least in part on the risk’s actual emerging experience.
To the extent that prices are adjusted based on a risk’s emerging actual experience after the insurance and its initial price have been established, less refined initial risk classification systems are needed.
AAA pg8-9
How does the program design consideration of Premium Payer affect the design of the risk classification system?
If the price is paid by other than the individual insured, the classification system is generally a matter of indifference to that individual. It is possible that broad classification systems may be appropriate, since the distinction between payer and insured can operate to reduce the likelihood of adverse selection.
AAA pg9
What statistical considerations affect the design of the risk classification system?
- Homogeneity
- Credibility
- Predictive Stability
AAA pg9-10