Flashcards in AAA - Risk classification SOP Deck (10):
How and why individual risk rating affects the needed level of refinement in a classification system.
To the extent that prices are adjusted based on risk's actual experience, less refined risk classification systems are needed.
Experience rating refunds, premium adjustments or dividends, ultimately produce a refined risk classification system.
List four operational considerations and how each contributes to the success of a classification system.
1. Expense - cost of collecting data and pricing classes should not exceed the benefits achieved
2. Absence of ambiguity - classes should be collectively exhaustive and mutually exclusive
3. Minimize abilities to manipulate system
4. Measurability - class variables (age, sex, occupation) should be reliably measurable.
5 Basic principles to achieve the primary purposes.
1. reflect expected cost differences
2. based on relevant cost-related factors
3. applied objectively
4. practical and cost efficient
5. accepted by public
three primary purpose of risk classification system
1. protect insurance systems financial soundness
- risk classification is a primary mean to control instability caused by adverse selection
2. be fair
- prices are not unfairly discriminatory
- reflect expected cost differences
- no redistribution or subsidy among classes
3. encourage coverage availability through economic incentive
- motivate insurer to refine their risk classification system to better serve both high and low cost risks.
List three methods for determining price and one deficiency for each method
1. rely on wisdom, insights, and good judgment
- valuable information is lost when a risk's actual loss experience is not reviewed.
2. Observation of the risk's actual loss experience over an extended period of time
- gradual changes in hazard may render past information useless
3. Observation of losses from groups of individual risks with similar characteristics
- identification of similar risk characteristics before the observation period is problematic
Briefly describe adverse selection
adverse selection arises when buyers are free to select among different sellers, and when sellers react by offering a similar product at a price where the seller has not matched price to cost.
Two methods for controlling adverse selection.
1. risk classification in a voluntary market
- charges each risk an appropriate rate through proper risk classification
- balances the economic forces governing buyer and sellers
2. Compulsory insurance with limited choice
- restriction of buyer freedom prevents adverse selection
What are the three statistical considerations
- Individual risks within a class should have reasonably similar expected cost
- number of claims should be voluminous to warrant credibility
- responsive to changes in the nature of insurance loss
- yet stable in avoid unwarranted abrupt changes
Homogeneity and credibility are in conflict:
making a class more homogeneous by eliminating risks comes at the expense of credibility. There may not end up being enough risks in the class to make it credible.
Discuss advantages and disadvantages of using controllability as a consideration for in
identifying rating variables
- Its close association with an effort to reduce hazard
- general acceptability by the public
- Susceptibility to manipulation
- it's irrelevance to predictability of future costs