insurance risk 101

Copyright 2001 by the American Academy ofActuaries
All Rights ReservedInsurance Risk 101 1
Insurance Risk 101
Pat Teufel, FSA, MAAA
Timothy J. Tongson, FSA, MAAA
James E. Rech, MBA, ACAS, ASA, MAAA
July 9, 2001
RHOB 2220

Life Insurance Risk 101
Timothy J. Tongson, FSA, MAAA

Overview
Principles of insurance
Life insurance products and pricing
Risks a life insurer faces
Mortality risk and underwriting
Other risks

Principles of Insurance
Gambling vs. Insurance Gambling creates a risk that did not previously
exist
Insurance transfers the financial consequencesof an existing risk for a known dollar amount(premium)

Law of Large Numbers Statistics (Bernoullis Theorem)
The greater the number of similar exposurers,the more predictable the outcome
Used to develop reliable assumptions forpricing and risk management

Risks insured (life insurance) Premature death
Outliving accumulated savings

Life Insurance Products
Term Life - Pure death protection Permanent Life - Term + Savings
Whole, Universal and Variable
Deferred Annuities - Tax deferredsavings product (SPDA, VA)
Payout Annuities - income for life with aperiod certain

Considerations in SettingPremium Rates
Premium rate adequacy Premiums charged must in aggregate, cover the
benefits promised and expenses associated withpaying the benefits
Inadequate premiums can lead to severefinancial problems including insolvency

Premiums must be equitable Insureds who have similar risk profiles should
be charged the same premium
No unfair subsidies - for example, nonsmokersvs. smokers
Equity is a goal

Premiums should be fair The amount charged should not be excessive in
relation to the benefits
Market competition is a major factor toensuring fairness

The Pricing Process
Probability of event occurring
Time value of money
The benefit promised
Expenses
Contingencies (risks)
Profit

Insurance Company Risks
Some examples Legal - litigation
Operational - mistakes, errors, etc.
Pricing - inadequate premiums
Regulatory - new requirements
Reputation - negative press

Life Insurance Pricing Risks
Mortality - when death occurs
Persistency - how long the customer keeps thepolicy
Expenses - how efficient the company operates
Investment - return of and on invested cashflows

Mortality Risk
Historical perspective The bedrock in the growth and development of
the life insurance industry
Based on a single-wage earning family model
Premature death of breadwinner haddevastating financial consequences

Mortality Risk
Trends Improvement in life expectancy at virtually
every age
Traditional model has changed, but the basicconcerns regarding the prudent management ofmortality risk still exist

Mortality Risk
Insured vs. Population Data Insured life mortality reflects a selection
process (underwriting) to determine theappropriate premium rate classification for thebenefit being insured against
Population mortality reflects the generalpopulation and does not reflect any selectionprocess (eg. census data). Many that would notqualify for insurance

Mortality Risk
The Adverse Selection Problem The buyer usually knows more than the insurer
about their own health and other riskcomponents
Adverse Selection is when a buyer uses thisinformation to gain an advantage on the insurer
Underwriting is used to deter and detectadverse selection

Underwriting
Selection The process by which insurers decide whether
to issue insurance according to specific termsand prices
Classification The process of assigning a proposed insured to
a group (class) of insureds with approximatelythe same expected loss probabilities

Underwriting
Major factors considered Age
Gender
Physical condition
Family history
Personal history and habits (eg. tobacco, alcohol and drug use, hazardous
avocations, financial status)

Underwriting
Classification Methods Method should accurately measure each factor
affecting risk on an equitable, yet relativelysimple basis
Judgement Method - Requires highly skilled andexperienced personnel
Numerical Method - Point system where debits andcredits are applied to risk factors

Underwriting
Classification Categories Standard
Preferred, smoker, nonsmoker, other
Substandard Multiple or flat extra premium
Decline Not eligible for coverage

Other Risks
The traditional model has changed
Concern for outliving retirement assets isbecoming a greater concern than premature death
This has caused growth in asset accumulationproducts
Investment risks and competition with banks andsecurities firms is significant for insurers

James E. Rech, MBA, ACAS, ASA, MAAA
An Overview of Property &Casualty Insurance

Property & Casualty InsuranceOutline of Discussion
Insurance Value Chain
Risk Aggregation Activities
Risk Spreading Activities

Distribution UnderwritingRisk
Classification
Claims Reinsurance Investment
RiskAggregation
Activity
RiskSpreadingActivity

Insurance Value ChainP&C Lines of Business (LOB)
Personal Lines
Commercial Lines
Reinsurance

Insurance Value ChainPersonal Lines
Personal Automobile
Homeowners
Fire, Allied Lines, Earthquake
Inland Marine

Commercial Auto Commercial Multiple
Peril Workers
Compensation Other Liability Fidelity Surety Boiler & Machinery
Medical Malpractice Professional Liability Other Accident &
Health Fire, Allied Lines, EQ Farm-owners Multiple
Peril Ocean Marine Aircraft
Commercial Lines

Risk Aggregation ActivitiesDistribution Channels
Underwriting Services
Claims Services
Risk Spreading ActivitiesReinsurance Services
Investment Services

Risk Aggrega

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