Thursday, May 11, 2006
Organise Speech: Pricing of Insurance In a Nutshell
Introduction
The roots of insurance might be traced to Babylonian traders some four thousand years ago when lenders to early sailing merchants sold possibly the first loan guarantee insurance. Later in 600 AD, the Greeks and Romans originated health and life insurance when they set up "benevolent societies" which cared for the families and funeral expenses of members upon death.
Hence even in ancient times, protecting against the risks associated with everyday life is essential to everyone’s well-being and peace of mind. Insurance is a way of minimizing our individual financial damages by pooling our potential losses with that of others.
Today I will be sharing with you some basic principles of insurance pricing for an insight into this age-old risk management instrument. These principles are the foundation to the analytical pricing I do as an insurance professional in the past 16 years.
Basic Principles of Insurance
Although many types of insurance seem complicated, the basic principles are straightforward.
In every business transaction, and in everything we do in life, there is an element of risk. In the world today, insurance companies, or insurers in short, exist to run the business of accepting other people's risks in return for a price.
The first principle of insurance pricing is that we must be able to quantify the risk i.e. to assess the likelihood and timing of the insured event and the potential losses associated with it. Hence, based on past experience and their expertise, the insurer calculates the price or the premium that the customer pays to protect against injury or loss. When the insured event happens, the insurer pays out the agreed level of claim.
In a nutshell, insurance is a risk transfer mechanism. The insured policyholder exchanges uncertainty for certainty. In return for a small definite loss, which is the premium he pays, he is relieved from the uncertainty of a potentially much larger financial loss arising from the insured event.
The Law of Large Numbers
The second principle of insurance pricing builds on the law of large numbers. This law simply means that the greater the number insured, the more the actual loss experience will tend towards the expected losses. Thus the larger the group insured, the more predictable will be the losses for the group as a whole.
For example to insure a single life against death for $100,000 during a year is clearly a gamble. If the number of persons insured is increased to one hundred, the element of uncertainty decreases but is still present to a large extent. If a hundred thousand lives of similar characteristics are combined into the same group, then average death rates will fluctuate lesser. The insurer can then determine its anticipated insurance claims with a higher degree of accuracy for this larger pool of insured.
Fair Treatment of policyholders
The third principle I will now touch on is the principle of equitable contribution. By this we mean that each insured should be charged fairly according to the risk he transfers to the pooled insurance fund. Hence life insurance premium do get more expensive with age since the older the person the greater is the probability of death.
Age is not the only factor used in isolation. The insurer’s underwriting policy is also critical. Underwriting is the process by which the insurer decides to accept, postpone or decline an application, and if it has decided to accept, then at what rates or terms and conditions.
Most applications are accepted at standard rates. This is primarily assessed via the application form where questions may include age, occupation, current health and past illnesses.
Some applicants are asked to fill further questionnaires or are sent for medical examinations. Rest assured, the insurer won’t send you for unnecessary tests as these do cost money. The insurer underwrites only to classify risks in order to charge an appropriate premium.
Insurance Pricing in a nutshell.
Today’s product designs have evolved to insure many more events besides death. Any risk that can be quantified probably has a type of insurance to protect it e.g. motor, health , travel insurance, to name but a few.
The insurance of present times may appear a far cry from the days of Babylonian traders or the Roman and Greek benevolent societies. But the underlying principles of pooling and sharing of risks are largely unchanged. First, the insurance risk must be quantifiable. Next the law of large numbers is supported with as large a pool of insured as possible. Lastly the principle of equitable contribution is reflected in premiums charged according to risk.
Using these principles, the ultimate task of an insurance company is to price suitable insurance plans for managing the risks faced in our everyday lives. In a nutshell, this boils down to the basic purpose of insurance: Giving Peace of Mind, Creating Certainty out of Uncertainty.
The roots of insurance might be traced to Babylonian traders some four thousand years ago when lenders to early sailing merchants sold possibly the first loan guarantee insurance. Later in 600 AD, the Greeks and Romans originated health and life insurance when they set up "benevolent societies" which cared for the families and funeral expenses of members upon death.
Hence even in ancient times, protecting against the risks associated with everyday life is essential to everyone’s well-being and peace of mind. Insurance is a way of minimizing our individual financial damages by pooling our potential losses with that of others.
Today I will be sharing with you some basic principles of insurance pricing for an insight into this age-old risk management instrument. These principles are the foundation to the analytical pricing I do as an insurance professional in the past 16 years.
Basic Principles of Insurance
Although many types of insurance seem complicated, the basic principles are straightforward.
In every business transaction, and in everything we do in life, there is an element of risk. In the world today, insurance companies, or insurers in short, exist to run the business of accepting other people's risks in return for a price.
The first principle of insurance pricing is that we must be able to quantify the risk i.e. to assess the likelihood and timing of the insured event and the potential losses associated with it. Hence, based on past experience and their expertise, the insurer calculates the price or the premium that the customer pays to protect against injury or loss. When the insured event happens, the insurer pays out the agreed level of claim.
In a nutshell, insurance is a risk transfer mechanism. The insured policyholder exchanges uncertainty for certainty. In return for a small definite loss, which is the premium he pays, he is relieved from the uncertainty of a potentially much larger financial loss arising from the insured event.
The Law of Large Numbers
The second principle of insurance pricing builds on the law of large numbers. This law simply means that the greater the number insured, the more the actual loss experience will tend towards the expected losses. Thus the larger the group insured, the more predictable will be the losses for the group as a whole.
For example to insure a single life against death for $100,000 during a year is clearly a gamble. If the number of persons insured is increased to one hundred, the element of uncertainty decreases but is still present to a large extent. If a hundred thousand lives of similar characteristics are combined into the same group, then average death rates will fluctuate lesser. The insurer can then determine its anticipated insurance claims with a higher degree of accuracy for this larger pool of insured.
Fair Treatment of policyholders
The third principle I will now touch on is the principle of equitable contribution. By this we mean that each insured should be charged fairly according to the risk he transfers to the pooled insurance fund. Hence life insurance premium do get more expensive with age since the older the person the greater is the probability of death.
Age is not the only factor used in isolation. The insurer’s underwriting policy is also critical. Underwriting is the process by which the insurer decides to accept, postpone or decline an application, and if it has decided to accept, then at what rates or terms and conditions.
Most applications are accepted at standard rates. This is primarily assessed via the application form where questions may include age, occupation, current health and past illnesses.
Some applicants are asked to fill further questionnaires or are sent for medical examinations. Rest assured, the insurer won’t send you for unnecessary tests as these do cost money. The insurer underwrites only to classify risks in order to charge an appropriate premium.
Insurance Pricing in a nutshell.
Today’s product designs have evolved to insure many more events besides death. Any risk that can be quantified probably has a type of insurance to protect it e.g. motor, health , travel insurance, to name but a few.
The insurance of present times may appear a far cry from the days of Babylonian traders or the Roman and Greek benevolent societies. But the underlying principles of pooling and sharing of risks are largely unchanged. First, the insurance risk must be quantifiable. Next the law of large numbers is supported with as large a pool of insured as possible. Lastly the principle of equitable contribution is reflected in premiums charged according to risk.
Using these principles, the ultimate task of an insurance company is to price suitable insurance plans for managing the risks faced in our everyday lives. In a nutshell, this boils down to the basic purpose of insurance: Giving Peace of Mind, Creating Certainty out of Uncertainty.
# posted by CME @ 9:47 PM 
