Adverse Selection
1. Company fails to segment business based on meaningful characteristic used by other insurers or does not charge the appropriate diff erential when others do:
High-cost insureds select a company due to that company not differentiating these risks from low-cost risks
2. Results in distributional shift toward higher-risk insureds for company that doesn't di fferentiate
Adverse Selection Process will continue until
Company improves rate segmentationBecomes insolventDecides to focus on high-risk insureds and price accordingly
Speed and severity of process depends on various factors
Whether insureds have full and accurate knowledge of competitor ratesHow much price alone influences purchasing decisions
Describe Favorable Selection & how to use this information
Company identifies a characteristic that differentiates risk that other companies are not using
Use this information to:1. Implement a new rating variable2. Use for risk selection, marketing or agency management (may use characteristics to identify, attract & select lower-risk insureds)
Criteria for evaluating Rating Variables
1. Statistical Criteria - rating variables should reflect the variation in expected costs among diff groups: Statistical signi ficance, Homogeneity, Credibility
2. Operational Criteria - must be practical to use in rating algorithm: Objective, Inexpensive to administer, Verifiable
3. Social Criteria - social acceptability of using a particular risk characteristic: Aff ordability, Causality, Controllability, Privacy
4. Legal Criteria - laws and regulations: Statutes, Regulations
Describe Statistical Criteria
1. Statistical significance:Expected cost estimates should vary for different levels of rating variablesEstimated differences should be within an acceptable level of confidence & be relatively stable over time
2. Homogeneity:Levels should represent distinct groups of risks with similar expected costs (homogeneous within group, heterogeneous between groups)
If grp contains materially diff risks, further subdivide
KEY for class analysis is to ID and grp risks with similar expected costs
3. CredibilityGroup should be large enough to measure with sufficient accuracy
Describe Operational Criteria
1. Objective DefinitionLittle ambiguityClass definitions should be mutually exclusive & exhaustive
2. Inexpensive to administerIf cost outweighs potential benefit, doesn't make sense to use
3. VerifiabilityInsureds may lie if reduces premium => honest insured end up paying more than they should
Consider cost to verify vs. cost of inaccuracy
Describe Social Criteria
1. AffordabilityEspecially important when insurance is requiredFor extreme high-level risks, may result in unaffordable premium
2. CausalityImplies intuitive relationship to insurance costsPreferable from social perspective that rating variables based on characteristics that are causal in nature
3. ControllabilityInsured can control this variableInsured motivated to improve risk characteristic to decrease rate
4. PrivacyAffects accuracy, verifiability and administrative cost
Describe Legal Criteria
1. StatutesCan impose restrictions on insuers, vary by statee.g. Rates cannot be excessive, inadequate or unfairly discriminatory
2. RegulationsInclude details about what can & can't be in risk classificationCompany must follow the laws & regulations of jurisdiction of where writes business
Steps to calculate Indicated Rate Differentials
Pure Premium Approach
1. Indicated Pure Prem = Loss / Exposure2. Indicated Relativity = (1)/(1tot)3. Ind Relative to Base = (2)/(2base)
Distortion of Pure Premium approach to calculate relativities
Assumes uniform distribution of exposures across all other rating variables
By ignoring correlation between territory and class, loss experience of various classes can distort the indicated territory relativities:Results in a double-counting e ffect
Loss Ratio Approach: Di fferences from Pure Premium method
LR approach uses premium instead of exposureLR approach calculates an adjustment to the current relativity
Steps to calculate Indicated Rate Differentials: Loss Ratio Approach
1. Loss Ratio = Loss & LAE/Premium @ CRL2. Ind Rel Change Factor= (1)/(1tot)3. Current Relativity (given)4. Indicated Relativity = (2)*(3)5. Ind Rel to Base = (4)/(4tot)
Distortions with Loss Ratio Method
Loss ratio is better than Pure Premium method but still not correct relativities
*PP relies on exposure so each risk is treated equal regardless of class*LR uses prem which reflects class
Remaining distortion reflects the variation for class relativities being charged instead of true variation
Adjusted Pure Premium Approach to calculate relativities
Adjustment made to Pure Premium approach to minimize impact of any distributional biasUse exposures adjusted by the exposure-weighted average relativity of all other variablesMakes results more consistent with LR method
Steps to calculate Indicated Rate Differentials: Adjusted Pure Premium Method
1. Adjust exposures by exposure-weighted avg relativity of all other variables2. Indicated PP = Loss & LAE/(1)3. Indicated Relativity = (2)/(2tot)4. Ind Rel to Base = (3)/(3base)
Distortions with Adjusted Pure Premium Method
Same as LR method since current class rels used for adj making indicated relativities equal
If true class rels used to determine exposure-weighted average relativities, then method would produce correct relativities