Risk Classification Statement of Principles

Part 1 Summary
Insurance Exchanges:
Uncertainty of occurrence, timing, and
financial impact of a particular event

for

Predetermined price

Must estimate probabilities surrounding occurrence, timing, and magnitude of the particular event
Risk classification

The grouping of risks with similar risk characteristics.

Enables development of equitable insurance prices
Assures availability of needed coverage

Risk classification is NOT:

Determining average experience for a particular class of risk is not the same as predicting the experience for an
individual risk.
It is NOT the purpose of risk classification to identify unusually good or bad risks, or to reward or penalize groups.
Its simply to group individual risks having reasonably similar expectations of loss
Three Primary Purposes of Risk Classification:
1. Should protect the insurance systems financial soundness;
2. Should be fair; and
3. Should permit economic incentives to operate and thus encourage widespread availability of coverage
Basic Principles Needed to Achieve These:
1. Should reflect expected cost differences
2. Should distinguish among risks on the basis of relevant cost-related factors
3. Should be applied objectively
4. Should be practical and cost-effective
5. Should be acceptable to the public
Changes in any of an insurance systems factors (risk classification, u/w, administration, etc) must be considered in the
context of the entire system
Part 2 Economic Security and Insurance
Society requires mechanisms for coping with financial impact of chance occurrences, generating economic insecurity
Hazard Avoidance & Reduction
Hazards can be avoided
Frequency & Severity of other hazards can be reduced via safety precautions
Practical application is limited
Hazards can be retained, but retaining major financial uncertainties may be undesirable
Transfers of Financial Uncertainty
Providing benefits based on demonstrated need
o Charitable Organizations
o Government Assistance Programs
Benefits based on defined contractual rights
o Self-insured group plans
o Governmental Insurance programs
o Private Insurance Programs

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Private vs. Public Programs

Governmental Programs
Provided by public law
Usually compulsory
Competition plays little or no role
Often provide coverage for hazards
that cant be covered by private
programs
Value or cost of benefits paid does
not need to have a long-term
relationship to amounts paid into
the program

Both
Involve transfer of financial
uncertainty & pooling of risk
Exposure to loss should be broad
enough to assure reasonable
predictability of total losses

Private Programs
Provided through an individual
contractual arrangement
Voluntary
Competition plays large & vital
role
Long term relationship between
amounts contributed and benefits
paid is important
Highly Diverse, hard to make
uniformly application general
statements

Part 3 The Need for Risk Classification

1.

2.

Rationale for risk classification

a. Insurance exchange doesnt make the uncertain known
b. Insurance program should find a way of establishing a fair price for assuming it
c. 3 ways
i. Rely exclusively on judgment
ii. Observe actual losses over a period of time
1. In many risks, hindsight shows theres little to no cost as an individual moves to a likely
or even certain eventual occurrence
2. Other risks are changing gradually, and the information obtained from the past may not
be applicable to the current or future exposure
iii. Observe the losses of groups of individual risks with similar characteristics (Classes)
1. Reasonable price may be established by observing the losses of the class and relating the
price to the classes average experience
2. Difficulty with this method is in choosing the classes
3. Over time, the optimal set of characteristics tends to emerge through the competitive
mechanism (in a perfect market)
4. In an imperfect market, classes are determined by a combination of fact & judgment
Three Primary Purposes of Risk Classification
a. Protection of Programs Financial Soundness
i. Main financial threat is adverse selection
1. Possible in a market where buyers are free to select among different sellers, with a
motivation to minimize the price
2. Sellers have a limited ability to select buyers and have a basic need to maintain prices at
an adequate level
3. Adverse Selection is the movement of buyers to different sellers within an insurance
market
ii. Risk Classification is one way to minimize the potential for adverse selection
1. Balances the economic forces governing buyer & seller actions
2. Where participation is mandatory & choices are restricted, adverse selection is controlled
by a restriction of the buyers freedom
b. Enhanced Fairness
i. A system designed to reduce adverse selection tends to produce prices that are valid and equitable
ii. Price differences should reflect differences in expected costs, with NO intended redistribution or
subsidy among the classes
iii. Prices & expected costs should also match within each class
iv. An individual with a substantially higher (or lower) than average expected cost should be placed
in a different class.
c. Economic Incentive
i. Companies that are most successful in serving customers will be rewarded with the majority of the
potential customers
ii. Insurers have incentives to expand their markets & to achieve high market penetration
iii. Insurers need a system that
1. will allow them to offer insurance to as many potential customers as possible
2. assures that the prices will be adequate to cover the customers financial uncertainty

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iv. Competition for lower cost risks will be most intense

v. Insurers also want to sell to the higher cost risks
vi. Increased market penetration provides
1. Economies of scale in marketing or distribution system
2. Ability for insurer to provide better service
vii. To be more successful, and insurer bust refine its classification system and thus its pricing
structure to more accurately reflect the differentials in expected costs among identifiable classes of
risks
viii. Risk Classification system must be efficient. Additional expense of obtaining more refinement
should not be greater than the reduction in expected costs for the lower cost risk classification
ix. Economic incentive operates over time to favor class plans that result in a price for each risk
which most nearly equals the expected cost associated with the class to which that risk is assigned.
Part 4 Considerations in Designing a Risk Classification System

Underwriting
o Class plan development is done a priori
o Underwriting process involves an evaluation of the individual and unique characteristics of the risk
o Class plan is applied through the u/w process
o Application of the u/w function controls the class plans practical impact
Marketing
o Influences mix of business
o Restrictions on or adjustments to the class plan by others may produce unintended changes in the mix of
business
Program Design
o Degree of Choice available to buyer
For compulsory programs, broad classifications are used (Extreme = single class)
For voluntary programs, systems that classify risks more broadly than competitors could lead to
adverse selection
o Experience based pricing
When purchased by an organization for a group of individuals
adjustment is an experience rating adjustment
if data is large enough to be credible, use own data, otherwise merge with comparable
groups
When purchased for an individual risk, adjustment is made by adjusting premium or paying a
dividend
To the extent that prices are adjusted based on a risks actual experience, the class plan needs to be
less refined (differences in risks reflected via experience adjustment, not in initial pricing)
o Premium Payer
Separation between payer & insured can affect the class plan
If purchased by someone other than the insured, the class plan doesnt matter to the individual,
broad class plans may be appropriate (will reduce adverse selection)
Statistical Considerations
o Homogeneity
Expected costs for each risk in a class should be reasonably similar
No clearly identifiable subclasses
Homogeneity is based on expected costs at original classification
All risks in a class will not have identical claim experience.
Experience will be statistically distributed around the average experience for a class
Different classes dont mean that risks in 2 classes cant/wont have the same claim experience
o Credibility
Larger number of observations = more accurate statistical predictions
Accurate predictions for small classes can be made by analyzing experience for broader groups of
correlated classes
o Predictive stability
Must be responsive to changes in the nature of losses
Must be stable to avoid unwarranted abrupt changes in resulting prices
Judgmentally analyze noninsurance trends that might reduce the future usefulness of the plan
Operational considerations
o Expense

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Expenses should be as low as possible, while permitting the system to minimize adverse selection
and maximize equity
Cost of utilizing a variable should be reasonable in relation to benefits achieved
o Constancy
Characteristics should be constant in their relationship to a particular risk (over the period covered
by the contract or over the period for which the class is assigned)
Lack of constancy tends to increase the expense and reduce the utility
o Availability of coverage
Should be able to provide coverage to all individuals who desire it (should maximize availability)
Sometimes the expected cost for the highest risks may be so high that it makes the price
unaffordable.
Generally, however, a more refined class plan that properly matches expected cost and price paid
will enhance availability, rather than inhibit.
Sometimes the class plan will define some risks as uninsurable. Attempt to minimize the size of
the uninsurable class by requiring a specific limitation of coverage to the otherwise uninsurable
risk.
o Avoidance of extreme discontinuities
Should be enough to establish a reasonable continuum
Should be few enough so differences between classes are reasonably significant.
Pay attention to the extreme classes, in order to reduce large differences in anticipated average
claim costs between extreme class and adjacent classes
o Absence of ambiguity
No ambiguity should exist concerning which class a risk is in
Classes should (collectively) be exhaustive and mutually exclusive
o Manipulation
Minimize the ability to misrepresent or manipulate characteristics to change the class assigned
o Measurability
Variables used should be susceptible to convenient and reliable measurement
Hazard reduction incentive
o Plan design can provide incentive for insureds to act to reduce expected costs
o These are desirable, but not necessary
o There are limits to which a class plan can be extended in an attempt to solve societys problems
Public acceptability
o Must recognize values of the society in which it should operate
o Difficult, because social values:
Are difficult to determine
Vary across societal segments
Change over time
o Public acceptability considerations:
Dont discriminate unfairly
Based on relevant data
Respects personal privacy
Structured so risks identify with their classification naturally
o Constraints
Public Opinion
Laws
Regulations
Causality
o Plan may be more acceptable to the public if a demonstrable cause & effect relationship exists
o Often impossible to prove, so this cant be a requirement
o Can be used to describe a plausible relationship
Controllability
o Sometimes desired, because its closely associated with an effort to reduce hazards, and therefore the
overall cost of coverage
o Can be associated with negative qualities
Manipulation
Impracticality
Irrelevance
o Evaluate positives & negatives

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