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Introduction

Grouping of individuals with similar risk profiles.

ASOP 12

Adverse Selection

Insured Type True Expected # of Risks Insurer A Price Profit # of Risks Insurer B Price Profit
Low-risk $200 50 $500 $15,000 50 $500 $15,000
High-risk $800 50 $500 ($15,000) 50 $500 ($15,000)
Total $500 100 $500 $0 100 $500 $0

Info

A identifies the distinction, charges Low-risk less (20 Low Risk individuals shift from B to A) charges High-risk more (20 High Risk individuals shift from A to B)

Insured Type True Expected Risks Insurer A Price Profit # Risks Insurer B Price Profit
Low-risk $200 70 $400 $14,000 30 $500 $9,000
High-risk $800 30 $800 $0 70 $500 ($21,000)
Total $500 100 $520 $14,000 100 $500 ($12,000)
  • A is experiencing favorable selection.
  • B is experiencing adverse selection.
  • Recognizing the lower cost group of insureds that is not identified by the competition, and distinguishing this through underwriting and marketing instead of just rating, is known as "skimming the cream" #jargon.
  • Insurers use Underwriting (UW) Guidelines to protect this trade-secret.

4 Criteria for Evaluating a Rating Variable

Statistical

  • Statistical Significance
    • Expected Costs should vary by class with statistical significance.
  • Homogeneity
    • There should be no significantly different subclasses (otherwise they should be moved to their own separate class).
  • Credibility
    • The classes should be large enough or stable to allow credible statistical predictions.

Operational Criteria

  • Objective
    • Measurable and clearly defined (anti-example: psychological profile).
    • Exhaustive and mutually exclusive.
  • Inexpensive to administer
    • Cost of obtaining and maintaining data to establish classes should not be too high.
  • Verifiable Levels
    • The levels of a rating variable (e.g., Short, Medium & Tall) should be easily verifiable. We should minimize the ability for intentional misclassification.
    • Miles driven: Telematics (verifiable) versus Insured reporting (hard to verify).

Social Criteria

  • Affordability
    • Subsidies exist to promote affordability.
  • Causality (not a necessity)
    • The public will accept it as a variable if an intuitive cause and effect relationship can be shown.
  • Controllability (not a necessity)
    • To reduce hazards.
  • Privacy
    • Insured shouldn't feel a breach of privacy.
  • Must be in compliance with any laws in the jurisdiction in which the policy is being written.

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