AAA - Risk classification SOP

Question 1

How and why individual risk rating affects the needed level of refinement in a classification system.

Answer 1

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.

Question 2

List four operational considerations and how each contributes to the success of a classification system.

Answer 2

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.

Question 3

5 Basic principles to achieve the primary purposes.

Answer 3

1. reflect expected cost differences
2. based on relevant cost-related factors
3. applied objectively
4. practical and cost efficient
5. accepted by public

Question 4

three primary purpose of risk classification system

Answer 4

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.

Question 5

List three methods for determining price and one deficiency for each method

Answer 5

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

Question 6

Briefly describe adverse selection

Answer 6

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.

Question 7

Two methods for controlling adverse selection.

Answer 7

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

Question 8

What are the three statistical considerations

Answer 8

1. Homogeneity
   - Individual risks within a class should have reasonably similar expected cost

Credibility
- number of claims should be voluminous to warrant credibility

Predictive Stability

• 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.

Question 9

Discuss advantages and disadvantages of using controllability as a consideration for in
identifying rating variables

Answer 9

Advantage:

• Its close association with an effort to reduce hazard
• general acceptability by the public

Disadvantage -

• Susceptibility to manipulation
• it’s irrelevance to predictability of future costs

Question 10

Three elements of programs design and briefly describe the impact of each on risk classification

Answer 10

1. Degree of buyer choice:
   compulsory system: little choice, less refined risk classification system maybe used without the issue of adverse selection
2. Degree of experience based pricing: to the extent that premium is modified based on individual risk’s actual experience, less refined risk classification system may be used
3. Premium payer - if someone other than the insured is the premium payer, premium is of less concern to the insured. less refined risk classification system may be used.