Chapter 41: Pricing and insuring risks

Question 1

Risk classification

Answer 1

A tool for analysing a portfolio of prospective risks by their risk characteristics, so that each subgroup is homogeneous.

Question 2

Once risks have been classified, what does the insurance provider have to decide?

Answer 2

• which risks to take on and keep
• which risks to take on but transfer through reinsurance or alternative risk transfer
• which risks to refuse

Question 3

2 Factors that a company’s risk appetite will be dependent upon

Answer 3

• existing exposure to risk

- culture of the company

Question 4

Why is there a market for risk?

Answer 4

Because different entities have different appetites for risk.
Those with smaller risk appetites transfer to those with a larger risk appetite, in exchange for a payment.

Question 5

What makes a risk insurable?

Answer 5

A risk is insurable if:

• the policyholder has an interest in the risk
• the risk of a financial and reasonably quantifiable nature

Question 6

What are other ideal criteria for a risk to be insurable?

Answer 6

• MORAL HAZARD eliminated as far as possible
• ULTIMATE LIMIT on the liability size
• DATA sufficient for quantifying the risk
• POOLING of similar risks to reduce the variance
• INDEPENDENT risk events
• SMALL PROBABILITY of the risk event

Question 7

Homogeneous pricing

Answer 7

Essentially, the risks are twofold. Selling a lot of unprofitable business and/or not selling much profitable business.

The common rate will presumably have to be somewhere between the standard low risk rates and the standard high risk rates. The position in the range will determine the nature of the risks.

Question 8

Homogeneous pricing – premium close to low risk

Answer 8

• Risk that many policies sold to high risk individuals = large losses (if premium less than cost of claims)
• Increase in market share = systems cant cope = expenses increase (possible new investment) and/or cust dissatisfaction
• Increase in market share = fall in UW standards

Question 9

Homogeneous pricing – premium close to high risk

Answer 9

• Sales to low risk sector fall = less potentially profitable business that would be needed to support losses on high risk policies
• Lose less on policies sold to high risk group
• Business volumes among high risk would not increase much but large fall among low risk
• Higher risks from perceived low risk group remain after price hike - antiselection
• Increase in unit costs due to fall in business volumes
• Problems with intermediaries (eg lower commissions to compensate rise in claims)
• The regulators may not like such loss making business
• May be hard to obtain re-insurance.

Question 10

Homogeneous pricing – solutions

Answer 10

• Exclusions for claims specific to high risk group (claims that make high risk group inherently risky). May not be marketable but no frills policy may attract those who believe they are low risk
• Exclude those who are obviously high risk based on eg medical UW as opposed to using proxy (age).
• Sell additional cover as add on to cover exclusions
• Stricter UW = expensive and potentially unmarketable but attractive to those who believe they are low risk
• Low max payout for some risks
• Certain sales channels will allow insurer to charge higher premiums, which may offset losses on uniform premium policies (depends on commission paid to intermediary)
• Less of a problem if cover is niche (lack of comp) or offers innovative perks (discounts elsewhere etc)