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Adverse Selection
1. Company fails to segment business based on meaningful characteristic used by other insurers or does not charge the appropriate differential when others do:
Highcost insureds select a company due to that company not differentiating these risks from lowcost risks
2. Results in distributional shift toward higherrisk insureds for company that doesn't differentiate

Adverse Selection Process will continue until
 Company improves rate segmentation
 Becomes insolvent
 Decides to focus on highrisk insureds and price accordingly

Speed and severity of process depends on various factors
 Whether insureds have full and accurate knowledge of competitor rates
 How much price alone influences purchasing decisions

Describe Favorable Selection & how to use this information
Company identifies a characteristic that differentiates risk that other companies are not using
 Use this information to:
 1. Implement a new rating variable
 2. Use for risk selection, marketing or agency management (may use characteristics to identify, attract & select lowerrisk insureds)

Criteria for evaluating Rating Variables
 1. Statistical Criteria  rating variables should reflect the variation in expected costs among diff groups:
 Statistical significance, Homogeneity, Credibility
 2. Operational Criteria  must be practical to use in rating algorithm:
 Objective, Inexpensive to administer, Verifiable
 3. Social Criteria  social acceptability of using a particular risk characteristic:
 Affordability, Causality, Controllability, Privacy
 4. Legal Criteria  laws and regulations:
 Statutes, Regulations

Describe Statistical Criteria
 1. Statistical significance:
 Expected cost estimates should vary for different levels of rating variables
 Estimated differences should be within an acceptable level of confidence & be relatively stable over time
 2. Homogeneity:
 Levels should represent distinct groups of risks with similar expected costs (homogeneous within group, heterogeneous between groups)
If grp contains materially diff risks, further subdivide
KEY for class analysis is to ID and grp risks with similar expected costs
 3. Credibility
 Group should be large enough to measure with sufficient accuracy

Describe Operational Criteria
 1. Objective Definition
 Little ambiguity
 Class definitions should be mutually exclusive & exhaustive
 2. Inexpensive to administer
 If cost outweighs potential benefit, doesn't make sense to use
 3. Verifiability
 Insureds may lie if reduces premium => honest insured end up paying more than they should
Consider cost to verify vs. cost of inaccuracy

Describe Social Criteria
 1. Affordability
 Especially important when insurance is required
 For extreme highlevel risks, may result in unaffordable premium
 2. Causality
 Implies intuitive relationship to insurance costs
 Preferable from social perspective that rating variables based on characteristics that are causal in nature
 3. Controllability
 Insured can control this variable
 Insured motivated to improve risk characteristic to decrease rate
 4. Privacy
 Affects accuracy, verifiability and administrative cost

Describe Legal Criteria
 1. Statutes
 Can impose restrictions on insuers, vary by state
 e.g. Rates cannot be excessive, inadequate or unfairly discriminatory
 2. Regulations
 Include details about what can & can't be in risk classification
 Company must follow the laws & regulations of jurisdiction of where writes business

Steps to calculate Indicated Rate Differentials
Pure Premium Approach
 1. Indicated Pure Prem = Loss / Exposure
 2. Indicated Relativity = (1)/(1tot)
 3. Ind Relative to Base = (2)/(2base)

Distortion of Pure Premium approach to calculate relativities
Assumes uniform distribution of exposures across all other rating variables
 By ignoring correlation between territory and class, loss experience of various classes can distort the indicated territory relativities:
 Results in a doublecounting effect

Loss Ratio Approach: Differences from Pure Premium method
 LR approach uses premium instead of exposure
 LR approach calculates an adjustment to the current relativity

Steps to calculate Indicated Rate Differentials: Loss Ratio Approach
 1. Loss Ratio = Loss & LAE/Premium @ CRL
 2. Ind Rel Change Factor= (1)/(1tot)
 3. Current Relativity (given)
 4. Indicated Relativity = (2)*(3)
 5. Ind Rel to Base = (4)/(4tot)

Distortions with Loss Ratio Method
Loss ratio is better than Pure Premium method but still not correct relativities
 *PP relies on exposure so each risk is treated equal regardless of class
 *LR uses prem which reflects class
Remaining distortion reflects the variation for class relativities being charged instead of true variation

Adjusted Pure Premium Approach to calculate relativities
 Adjustment made to Pure Premium approach to minimize impact of any distributional bias
 Use exposures adjusted by the exposureweighted average relativity of all other variables
 Makes results more consistent with LR method

Steps to calculate Indicated Rate Differentials: Adjusted Pure Premium Method
 1. Adjust exposures by exposureweighted avg relativity of all other variables
 2. Indicated PP = Loss & LAE/(1)
 3. Indicated Relativity = (2)/(2tot)
 4. Ind Rel to Base = (3)/(3base)

Distortions with Adjusted Pure Premium Method
Same as LR method since current class rels used for adj making indicated relativities equal
If true class rels used to determine exposureweighted average relativities, then method would produce correct relativities

