Chapter 9 - Traditional Risk Classification

Question 1

Explain the importance of selecting proper rating variables.

Answer 1

The selection of rating variable is important to

• Avoid adverse selection
• Predict correctly future loss while keeping operational and legal criteria

Question 2

explain adverse selection and the ultimate outcome if not rectified.

Answer 2

Adverse selection is when a company loses favorable risks while attracting unfavorable risks due to not properly reflecting rate differentials that competitors are capturing.

The process will continue until the compagny

• Refine/improve is segmentation
• Became insolvent
• Write only high-risks and charge approriate rates

Question 3

Describe favorable selection and alternatives to a rate change when you have identified an opportunity that could lead to favorable selection.

Answer 3

Favorable selection happen when a compagny is able to identifies a characteristic that differentiates risk that other compagnie are not using, resulting in a better segmentation.

• Implement it in rating to improve profitability
• “Skiming the cream”: use this information to select risks in underwriting process (writer better risks, reject worse), which will also increase profitability

Question 4

When selecting rating variables, expain the Statistical Criteria.

Answer 4

Our rating should result in groups that are

• Statistically significant - should estimate difference expected loss within an acceptable level of statistical confidence and should be stable over years.
• Homogenous - groups shpuld have similar expected loss.
• Credible - need enough data to accurately estimate expected loss.

Question 5

When selecting rating variables, expain the Operational Criteria.

Answer 5

Our rating variable should be

• Objectif - should have an objectif definition
• Inexpensive to obtain - benefit of adding the variable should not outweigh the cost of obtaining it.
• Verifiable - not subject to untruthful insureds or distribution channels.

Question 6

When selecting rating variables, expain the Social Criteria.

Answer 6

We should consider

• Affordability - need enough data to accurately estimate expected loss.
• Causality - causal relationships between variable and premium.
• Controllability - ability to control the class to which they belong by reducing their risk.
• Privacy - must respect insured privacy.

Question 7

When selecting rating variables, expain the Legal Criteria.

Answer 7

Above any actuarial consideration, our rating structure must follow any legal requirement.

Question 8

Explain what adjustment is necessary on Losses and Expenses when performing Traditional Risk Classification?

Answer 8

• In practive, it is hard to allocate ULAE by class, so we often use loss & ALAE.
• For Short-tailed - may not be necessary to trend and develop
• For Long-tailed or when compagny is growing (shrinking) - apply trend and development factor at a aggregate level.
  
  • Unless there is a reason to velieve that loss or expenses vary by class.

Question 9

Discuss the distortion related to 3 different methods of Traditional Risk Classification.

Answer 9

The Pure Premium method assume a uniform distribution accross all other rating variable, which will create material bias when it is the case.

Loss Ratio and Pure Premium Adjusted method will adjust for distributional bias/correlations only if the current relativities reflect these distributional bias/correlations.

Question 10

What is the primary weakness of the univariate classification risk method?

Answer 10

They do not accurately account for the effect other variable have on the variable being evaluated.