Chapter 41: Pricing and insuring risks

Question 1

Risk classification

Answer 1

Risk classification is a tool for analysing a portfolio of risks by their risk characteristics, such that each subgroup of risks represents a homogeneous body of risk.

Question 2

Risk classification helps the provider to (2)

Answer 2

• charge a more accurate premium for the risks to be covered

- eliminate unnecessary aspects of contract design and to focus cover

Question 3

Risk appetite may relate to:

Answer 3

• existing exposure to the risk
• level of free capital
• the culture of the individual / company
• if a company, the structure of the company (eg mutual, proprietary, subsidiary, parent)
• Size and age of the company
• level of capital available
• previous experience of the board of directors
• attitude to risk of the providers of capital

Question 4

3 properties of insured risks

Answer 4

• the policyholder has an interest in the risk
• the risk is of a financial and reasonably quantifiable nature
• the claim amount payable is commensurate with the size of the financial loss.

Question 5

6 Desirable criteria for a risk to be insurable

Answer 5

• individual risk should be INDEPENDENT
• the PROBABILITY of the event occurring should be relatively small
• large numbers of similar risks should be POOLED to reduce variance
• there should be a LIMIT on ultimate liability undertaken
• MORAL HAZARD should be eliminated as far as possible
• there should be sufficient existing DATA / information in order to quantify risk

Question 6

Once risks have been adequately classified, a provider needs to decide which risks it is prepared to (3)

Answer 6

• take on and keep
• take on but lay off through the use of reinsurance or alternative risk transfers
• refuse

Question 7

Key principle of pooling risks

Answer 7

Insurers and reinsurers take on risks in return for a premium because in doing so they can combine or pool many risks together, which means that there is greater certainty in the future payments they are likely to have to make on the occurrence of an insured event.

Question 8

The factors used in setting premiums

Answer 8

rating factors

Question 9

8 Features of a company that may influence its risk appetite

Answer 9

• size
• age
• the level of capital available
• existence of a parent company / other guarantees
• the level of regulatory control it is exposed to
• institutional structure (eg mutual / proprietary)
• the previous experience of the board members
• attitude to risk of providers of capital

Question 10

Risk efficient system

Answer 10

Where there is a good market for risk transfer.

Question 11

Explain the importance of the policyholder having an interest in the risk

Answer 11

The policyholder must have an interest in the claim event NOT HAPPENING and will not (in theory) encourage it to happen.

Question 12

Explain the importance of the risk being of a “financial and reasonably quantifiable” nature

Answer 12

This is so that an insurer is able to assess the risk and set an appropriate premium.

Question 13

Explain the importance of the risk being “commensurate with the size of the financial loss”

Answer 13

If the claim amount is too small, the policyholder is unlikely to deem the insurance worthwhile.
If it is too large, this will encourage fraud and moral hazard.

Question 14

For the purposes of life insurance, in which other parties might an individual be deemed to have an insurable interest? (3)

Answer 14

• business partners
• someone with whom the individual shares joint ownership of a property
• someone on whom the individual is financially dependent

Question 15

The principle of pooling risks

Answer 15

Insurers and reinsurers take on risks in return for a premium because in doing so, they combine or pool risks together, meaning there is GREATER CERTAINTY in the future payments they are likely to have to make on the occurrence of an insured event.
(due to the LAW OF LARGE NUMBERS)

Question 16

Explain the importance of risks being independent of each other

Answer 16

This is so that there is a spread of risk (ie catastrophes arising from concentrations of risk are avoided) and so that the law of large numbers can apply.

Question 17

Explain the importance of the risk event having a low probability of occurring.

Answer 17

If the likelihood of the insured event is too high, the cost of cover, and hence the premium, could be unaffordable.

Question 18

Explain the importance of there being a large number of similar risks which can be pooled

Answer 18

This is so that the law of large numbers can apply so that actual experience is likely to be in line with expected experience, and hence uncertainty surrounding claims is reduced.

Question 19

Explain the importance of there being an ultimate limit on the liability undertaken by the insurer

Answer 19

This is because an insurer will only have a finite amount of capital with which to absorb risk.
An unlimited liability could cause the insurer to go insolvent.

Question 20

Explain the importance of eliminating moral hazards as far as possible

Answer 20

This is because they are difficult to estimate and can be costly to an insurer.