AAA Risk Classification

Question 1

Three primary purposes of the Risk Classification process

Answer 1

1. Protect the insurance system’s financial soundness
2. be fair
3. permit economic incentives to operate and thus encourage widespread availability of coverage

AAA pg2

Question 2

The basic principles that should be present in any sound risk classification system in order to achieve the 3 primary purposes

Answer 2

1. The system should reflect expected cost differences
2. The system should distinguish among risks on the basis of relevant cost related factors
3. The system should be applied objectively
4. The system should be practical and cost-effective
5. The system should be acceptable to the public.

AAA pg2

Question 3

3 Societal mechanisms for coping with the financial impact of chance occurrences

Answer 3

1. Hazard Avoidance and Reduction
2. Transfer of Financial Uncertainty
3. Public and Private Programs

AAA pg2-3

Question 4

Alternatives to Risk Classification rating system

Answer 4

1. 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
2. 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

Question 5

Difficulty with risk classification rate making

Answer 5

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

Question 6

How do government insurance programs often protect themselves against adverse selection?

Answer 6

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

Question 7

How do private insurance programs often protect themselves against adverse selection?

Answer 7

Risk classification is the primary means to control the instability caused by adverse selection.

AAA pg6

Question 8

What design considerations are a part of any sound Risk Classification system?

Answer 8

• Underwriting
• Marketing
• Program Design
• Statistical Consideration
• Operational considerations
• Hazard Reduction Incentives
• Public Acceptability
• Causality
• Controllability

AAA pg7-15

Question 9

How does underwriting influence Risk Classification system design decisions?

Answer 9

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

Question 10

How does marketing influence Risk Classification system design decisions?

Answer 10

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

Question 11

What 3 elements of the design of an insurance program relate directly to risk classification?

Answer 11

1. Degree of Choice Available to the buyer
2. Experience Based Pricing
3. Premium Payer

AAA pg8-9

Question 12

How does the program design consideration Degree of Choice Available to the buyer affect the design of the risk classification system?

Answer 12

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

Question 13

How does the program design consideration Experience Based Pricing affect the design of the risk classification system?

Answer 13

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

Question 14

How does the program design consideration of Premium Payer affect the design of the risk classification system?

Answer 14

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

Question 15

What statistical considerations affect the design of the risk classification system?

Answer 15

1. Homogeneity
2. Credibility
3. Predictive Stability

AAA pg9-10

Question 16

How does the statistical consideration Homogeneity affect the design of the risk classification system?

Answer 16

The expected costs for each of the individual risks in a class should be reasonably similar. In a given class, there should be no clearly identifiable subclasses with significantly different potential for losses.

The concept of homogeneity in no way is comprised by the inevitable outcome that not all risks in a class will have identical actuarial claim experience.

AAA pg9-10

Question 17

How does the statistical consideration of Credibility affect the design of the risk classification system?

Answer 17

It is desirable that each of the classes in a risk classification system be large enough to allow credible statistical predictions about that class.

This does not necessarily mean that each class must be large enough to stand on its own. Accurate predictions for relatively small, narrowly defined classes often can be made by appropriate statistical analysis of the experience for broader groupings of correlated classes.

AAA pg10

Question 18

How does the statistical consideration of Predictive Stability affect the design of the risk classification system?

Answer 18

The predictive capability must be responsive to changes in the nature of insurance losses, yet stable in avoiding unwarranted abrupt changes in resulting prices.

AAA pg10-11

Question 19

How might the statistical considerations of Homogeneity, Credibility, and Predictive Stability be somewhat conflicting?

Answer 19

e.g. increasing the number of classes may improve homogeneity, but at the expense of credibility.

AAA pg11

Question 20

What Operational Considerations affect the design of the risk classification system?

Answer 20

1. Expense
2. constancy
3. Availability of Coverage
4. Avoidance of Extreme Discontinuities
5. Absence of Ambiguity
6. Manipulation
7. Measurability

AAA pg12-13

Question 21

How does operational expense affect the design of the risk classification system?

Answer 21

For reasons of efficiency and competitiveness, the expenses should be as low as possible, while effectively permitting the system to minimize adverse selection and maximize equity.

The cost of utilizing a given variable for classification purposes should be reasonable in relation to the benefits achieved for the insurance program and those insured.

AAA pg11

Question 22

How does the Operational consideration of Constancy affect the design of the risk classification system?

Answer 22

Lack of constancy in a characteristic tends to increase the expense and reduce the utility of that characteristic, thus reducing the reliability of the classification system.

AAA pg12

Question 23

How does the Operation consideration of Availability of Coverage affect the design of the risk classification system?

Answer 23

It is desirable to have a classification system which maximizes the availability of insurance. To the extent that the classification system properly reflects the expected costs of each class and determines the price accordingly, overall availability of coverage should be enhanced.

AAA pg12

Question 24

How does the Operation consideration of Avoidance of Extreme Discontinuities affect the design of the risk classification system?

Answer 24

There should be enough classes in the system to establish a reasonable continuum of expected claim costs but few enough so that differences in prices between classes are reasonably significant.

AAA pg12

Question 25

How does the Operational consideration of Absence of Ambiguity affect the design of the risk classification system?

Answer 25

The definition of classes should be clear and objective. The classes should be collectively exhaustive and mutually exclusive.

AAA pg12-13

Question 26

How does the Operational consideration of Manipulation affect the design of the risk classification system?

Answer 26

The system should minimize the ability to manipulate or misrepresent a risk’s characteristics so as to affect the class to which it is assigned.

AAA pg 13

Question 27

How does the Operational consideration of Measurability affect the design of the risk classification system?

Answer 27

The variables used for classification should be susceptible to convenient and reliable measurement.

AAA pg13

Question 28

How do Hazard Reduction Incentives affect the design of the risk classification system?

Answer 28

Hazard reduction incentives are desirable but not necessary. Reduced cost of life insurance for non-smokers encourages insured not to smoke and reduces hazard of premature death due to smoking.

AAA pg13

Question 29

How does Public Acceptability difficult to apply in practice in the design of the risk classification system?

Answer 29

Any risk classification system must recognize the values of the society in which it is to operate. Social values: 1. are difficult to ascertain, 2. vary among segments of the society, 3. change over time.

AAA pg14

Question 30

What are some major public acceptability considerations affecting risk classification systems?

Answer 30

• They should not differentiate unfairly among risks.
• They should be based upon clearly relevant data.
• They should respect personal privacy.
• They should be structured so that the risks tend to identify naturally with their classification.

AAA pg14

Question 31

How does Causality affect the design of the risk classification system?

Answer 31

In insurance it is often impossible to prove statistically any postulated cause and effect relationship. Causality cannot, therefore, be made a requirement for risk classification systems. However general sense of plausible relationship between the characteristics of a class and the hazard insured against.

Risk classification characteristics should be neither obscure nor irrelevant to the insurance provided; but they need not always exhibit a cause and effect relationship.

AAA pg15

Question 32

How does Controllability affect the design of the risk classification system?

Answer 32

Judgment must be used when considering the controllability of a classification variable.

can mean the variable can be manipulated. could mean reduce hazards. could be good or bad.

AAA pg15