AAA - Risk Classification Statement of Principles

I. SummaryRisk classification is the grouping of risks with similar risk characteristics for the purpose of setting prices.

Risk classification is NOT predicting the experience for an individual risk, identifying unusually good or bad risks or rewarding groups at the expense of others.

Three primary purposes of the risk classification system:

Protect the insurance system's financial soundness

Be fair

Permit economic incentives to operate and thus encourage widespread availability of coverage

Five basic principles of the risk classification system:

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

II. Economic Security and InsuranceMechanisms for coping with the financial impact of chance occurrences:

Hazard Avoidance and Reduction

Practical application is limited, it is wise to transfer major uncertainties

Options for Transfer of Financial Uncertainty

Benefits based on need > Charitable org and Government assistance

Benefits based on contract > Government/Private Insurance, Self-insured group

Public vs Private Programs

Similar > Transfer of financial uncertainty and pooling of risks

Compulsory/Monopoly (Government) vs Voluntary/Competition (Private)

III. The Need for Risk ClassificationA. Rational for Risk Classification

Insurance programs can't predict uncertainties but should be able to price them fairly.

Three ways to estimate a price:

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AAA - Risk Classification Statement of Principles

Rely on wisdom, insight and good judgement (not the best, only way sometimes)

Observe risk's actual losses over time period (not suitable for life ins., changes in hazards over time render past information unusable)

Observe groups of similar risks (classes) over time period. Relate price to average experience of the class. This is the most used approach. The major difficulty is to select similar risk characteristics before observation period. Optimal set of characteristics would emerge under perfect competition. In practice, the set reflect both observed fact and informed judgement.

B. Three Primary Purposes of Risk Classification (FSEFEI)

B1. Protection of Program's Financial Soundness

Adverse selection : Is a threat to solvency. Created by buyers freedom of choice and sellers inability to select buyers (classify). Risk classification (competition) and restricting buyer's freedom of choice (monopoly) can control adverse selection.

B2. Enhanced Fairness

Differences in prices among classes should reflect differences in expected costs with no intended redistribution or subsidy among the classes. Risks in a class should have pretty much the same expected cost.

B3. Economic Incentive

Offer insurance to as many customers as possible at adequate prices

Intense competition for lower cost risks

Desire to sell to higher cost risks to achieve better market penetration

Increased market penetration provides economies of scale

Competition leads to more refined classification

Additional expense of obtaining more refinement should not be greater than the reduction in expected costs for the lower cost risk classification (efficiency)

IV. Considerations in Designing a Risk Classification SystemA. Underwriting

Underwriting evaluates unique characteristics of each risk. Risk classification is the framework in which underwriting takes place.

B. Marketing

Influence what products are sold and to whom. Impact the mix of business.

C. Program Design

1. Degree of Choice Available to the Buyer

Compulsory (Broad Classification) VS Voluntary (Refined Classification)

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AAA - Risk Classification Statement of Principles

2. Experience Based Pricing

Less refined classification is needed when experience rating adjustments are used

3. Premium Payer

If the buyer of insurance is not the insured, a more broad classification system may be appropriate since adverse selection potential is reduced (Group ins.)

D. Statistical Considerations

1. Homogeneity

Expected costs for each of the individual risks in a class should be reasonably similar. It is viewed when the risk is originally classified.

2. Credibility

Classes large enough to allow credible statistical predictions.

3. Predictive Stability

Elements of classification must be useful for predictive purposes, responsive to changes, yet stable in avoiding abrupt changes in resulting prices.

Increasing the number of classes may improve homogeneity, but at the expenses of credibility. There is no statistically correct risk classification system.

E. Operational Considerations

1. Expense

Includes obtaining and maintaining the data required to establish classes, assigning each risk to a class, determining a price for each class

Should be as low as possible for competitiveness and efficiency reasons

Cost of using a variable should be reasonable in relation to benefit achieved

2. Constancy

The lack of constancy in a characteristic's relationship to a risk tends to increase the expense and reduce the utility of that characteristic, thus reducing the reliability of the classification system

3. Availability of Coverage

It is desirable for a risk classification system to maximize the availability of ins.

Some risks may be uninsurable. Specific limitation on the coverage available help to reduce the size of the uninsurable class.

4. Avoidance of Extreme Discontinuities

Establish a reasonable continuum of expected claim costs while having reasonable differences in prices between classes. Particular care is required for classes at the extreme ends of the range.

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AAA - Risk Classification Statement of Principles

5. Absence of Ambiguity

Definitions of classes should be clear and objective

Classes should be collectively exhaustive and mutually exclusive

6. Manipulation

System should minimize the ability to manipulate or misrepresent a risk's characteristic

7. Measurability

Characteristic should be susceptible to convenient and reliable measurement

F. Hazard Reduction Incentives

Encourage insured to reduce hazard and expected losses. These incentives are desirable, but not necessary, features.

G. Public Acceptability

Is hard to apply because social values are difficult to ascertain, vary among segments of the society and change over time.

Major public acceptability considerations affecting risk classification systems:

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 risks tend to identify naturally with their classification

Laws, regulations and public opinions all constrain risk classification systems. Legislators must find a balance between public acceptability and market dislocation due to adverse selection.

H. Causality

Cause and effect relationship increases confidence and public acceptability but it is often impossible to prove statistically. Causality cannot be made a requirement but characteristics must be relevant to the insurance provided.

I. Controllability

Refers to ability of a risk to control its own characteristics. Desirable in the context of hazard reduction incentives and acceptability by the the public, but undesirable in the context of manipulation where it can render a characteristic irrelevant.

V. ConclusionStriking the balance is not always easy, but it is in the public interest.

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I. SummaryII. Economic Security and InsuranceIII. The Need for Risk ClassificationIV. Considerations in Designing a Risk Classification SystemV. Conclusion