Academic journal article Journal of Risk and Insurance

The Value of Information in Insurance Pricing

Academic journal article Journal of Risk and Insurance

The Value of Information in Insurance Pricing

Article excerpt

Introduction

If an insurer charges too much for a risk, it is likely to lose that business, and if it charges too little, it is likely to lose money. Little research has been conducted, however, on the value of increasing the accuracy of pricing, on commonly used methods of increasing accuracy, or on the effects of raising or lowering prices. There have been many articles on improving accuracy through better classification and experience rating systems, and some insurers have used the systems set forth in these articles with great success.

Insurance company managers are interested in the speed with which pricing is done, but it seems that they often underestimate the value of accuracy as well as the effects of various methods that can be used to improve accuracy. Methods of quantifying both of these things are discussed in this article. I address questions of how much money should be spent on data, classification and experience rating systems, and underwriters' and actuaries' salaries. The effect of adverse selection on pricing adequacy and the effect on profitability of raising or lowering prices also are examined.

The Value of Accuracy

Considerations in Risk Selection

The expected profitability of a risk depends on the relation between the risk's expected losses and its experience-modified premium (if there is any experience modification). Another consideration in the selection process is whether the risk is better than average for its classification. Future experience rating credits and debits will not fully reflect experience unless the risk has 100 percent credibility. Therefore, in the long run, a risk with lower expected losses than the provision for losses in its unmodified premium will also tend to have expected losses that are less than the provision for losses in the modified premium. The reverse is true for risks with higher than average expected losses. This long term consideration involves an estimate of how long the risk will continue renewing its coverage with the company if it is selected.

Competitive strategy should be considered in deciding whether to insure a risk for a given premium or in deciding the level of premium to charge. The prices demanded by the competition, and the prices that buyers are willing to pay, clearly influence and affect the insurer. For example, at a low point in the insurance profitability cycle, an insurer may not even expect to make a profit. It may merely try not to lose too much money or too many customers who will be valuable in the profitable part of the cycle.

The Process of Risk Selection

During the process of risk selection, an insurer sometimes offers to insure a risk for some price. It then wins or does not win the contract depending upon what prices are quoted by other insurers. In other cases, the insurer receives an offer of a price from the buyer or the buyer's representative.

If the insurer makes an offer, it is possible to estimate in advance the average expected loss ratio for those cases in which the insurer will win the contract. The estimating method uses the insurer's estimate of the expected loss ratio, the accuracy of such estimates, and the probability, given each possible expected loss ratio of the risk, that the insurer will win the contract.

If the insurer receives an offer, the average expected loss ratio of those risks accepted depends on the probability distribution of possible expected loss ratios of the risk and on the accuracy and selectivity of the insurer.

In both cases, the situation can be analyzed through the mathematics of prior and posterior distributions. One must exercise judgment in estimating the probability distributions to be used in particular cases. No matter what other considerations are present when negotiating premiums or selecting risks, the expected losses are an extremely important consideration. Other considerations may affect the expected loss ratio that an insurer is willing to accept for a given risk at a given time. …

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