ASOP12.RiskClass

Reading: Actuarial Standard of Practice No. 12, Risk Classification

Study Tips

Forum   ASOPs generally have these sections:

Section 1. Purpose, Scope, Cross References, and Effective Date

Section 2. Definitions

Section 3. Analysis of Issues and Recommended Practices

Section 4. Communications and Disclosures

Appendices

Sections 3 & 4 contain most of the relevant information. The definitions in Section 2 are usually obvious and familiar, and are covered in either the Werner of Friedland source texts anyway. You can skip Section 1 and the Appendices. The appendices usually contain either very general background information or comments on the draft version of the ASOP.

Estimated Study Time: 1 hr (you may need to occasionally refer back to this ASOP while studying the main pricing and reserving material)

BattleTable

Based on past exams, the main things you need to know (in rough order of importance) are:

• considerations when designing a risk classification system

reference	part (a)	part (b)	part (c)	part (d)
E (2016.Spring #3)	Werner04.Exposures	considerations: - for risk classification
E (2016.Fall #10)	considerations: - for risk classification

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In Plain English!

Section 2: Definitions

The 5 most important definitions (out of 10) in this ASOP are:

risk(s):

- individuals or entities covered by financial or personal security systems

risk classification system:

- a system for assigning risks to groups based on expected cost

risk class:

- a set of risks grouped together under a risk classification system

risk characteristics:

- measurable characteristics for assigning a risk to a risk class (within a risk classification system)

adverse selection:

- when an insurer acquires risks that are underpriced and loses risks that are overpriced due to not properly recognizing risk differentials between classes

Just make sure you can write out these definitions.

Section 3: Analysis of Issues and Recommended Practices

You have to memorize the following list to be able to answer the 2016.Fall exam question.

Question: identify considerations in selecting risk characteristics for a risk classification system [Hint: ROP-LIB]

Relationship to costs (Ex: miles driven relates to expected claim costs)

Objectivity (Ex: miles driven for auto)

Practicality (Ex: # of cars in household is practical & easy to obtain, – note that miles driven may not be practical because it is self-reported)

-

Laws (does the risk classification system satisfy applicable laws – Ex: cannot use race)

Industry practices (should consider current industry practices before deviating from such)

Business practices (should consider company's business practices before deviating from such)

There is one consideration I left out of the above: Causality. I'm not sure why this was even listed with the others because the ASOP says that the actuary need not establish cause & effect between the risk characteristic and expected costs.

As for the 2016.Fall exam problem, it seems from the examiner's report that they accepted almost anything as long as you listed a valid consideration and provided some sort of semi-reasonable explanation. Now that you know what should be considered in selecting risk characteristics, you then need to consider how to use these characteristics to group risks together into risk classes. For example, if you are using miles driven as a risk characteristic, one way of grouping the risks would be to separate them according to whether they drove under or over 50 miles per day to work.

Question: identify considerations in selecting risk classes

• intended use - different risk classes may be appropriate for different uses even if the same set of data is used for both
• actuarial considerations:

- adverse selection - minimized when risk classes are more homogeneous

- credibility - maximized when risk classes are larger

- practicality (same consideration as for risk characterisitics)

• LIB: Laws, Industry & Business practices (same considerations as for risk characteristics)
• reasonableness of results - results should be reasonable and consistent with other available information

Once the actuary has created the risk classification system, it isn't set it stone. It must be evaluated against emerging experience to determine if it needs to be updated.

Question: identify considerations in testing the long-term viability of a risk classification system

• effects of adverse selection

- if it is occurring, the actuary should estimate the impact and provide recommendations to mitigate the impact

• effects of using a different risk classification system

- Ex: if the original classification ignores marital status then the actuary should test an alternate system that does use marital status and assess the impact of such

• effects of changes to original classification system (if there were any)
• quantitative effects of the following items (the first 3 items are the LIB items from earlier)

- Law limitations on what you can do

- Industry practices (differences from company)

- Business practices (may limit what the actuary can do)

- Changes in classification system

- Adverse selection

I don't know how the last bullet point, quantitative effects, is different from the previous bullet points. It seems to repeat what's already been stated, but this comes directly from the ASOP.

Section 4: Communications and Disclosures

This section on communications & disclosures is largely common sense. Regarding risk classification systems, the actuary should communicate information that may have a material impact on the user's interpretation. Examples of such items include but aren't limited to:

• limitations imposed by particular laws (the actuary might want to construct the risk classification system in a certain way but can't because of various laws & regulations)
• significant departures from industry practices that may require additional explanation and justification
• significant departures from company business practices that may require additional explanation and justification
• the possibility that the current risk classification system requires significant changes to continue achieving particular goals for the intended users

Note that many of these same considerations apply to actuarial communications in general.

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