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Risk Classification

Criteria

  1. Statistical
    • Statistical Significance
      Expected costs vary by class \(\to\) acceptable level of statistical significance… fairly consistent over time.
    • Homogeneity
      Expected costs for each individual risk within a class, should be reasonably similar. No clearly identifiable subclasses with significantly different loss potential
    • Credibility
      Classes should be Large enough or stable enough to allow credible statistical predictions
  2. Operational
    • Objective
    • Inexpensive to administrator
    • Verifiable
  3. Social
    • Affordability
      Especially for compulsory insurance products
    • Causality
      Public acceptability \(\propto\) intuition for cause-and-effect
    • Controllability
      Encourages insureds to reduce hazards
    • Privacy
      Insureds shouldn't feel that their privacy is being invaded.
  4. Legal
    • Comply with applicable laws and regulations in the jurisdiction

Other Practical criteria

  • If the pure premiums for a certain level is highest but the competitor's rating factor for that level is the lowest, then it is concerning

Adverse Selection

  • Low Risk: A & B
  • High Risk: C & D
  • Many A & B insureds will move to the competitors for the lower price
  • Many C & D insureds will move to ABC company for the lower price
  • A company experiencing adverse selection will collect the same amount of premiums, but will have more high risk insureds, leading to higher losses. Thus the loss ratio would deteriorate.