Life Insurance Risk And Pricing Components

Insurer and Re-Insurer- A Brief

Discuss about the Life Insurance Risk and Pricing Components.

This report gives a brief about an insurer or a re-insurer or a division of either. For this a particular division or a business class of an insurer has been taken that is currently underwritten. For that case, an analysis has been done on the risk exposures and pricing components related to that insurer or his/ her division.

It is quite evident that insurance is one of the important sectors of business in today’s volatile environment. In economic terms, an insurance policy refers to a contract between two parties- insured (policyholder) and insurer (insurance company). Policies may differ on the basis of the type of risk involved like insured’s life, health, property, commercial, etc. Just like any other business, insurance business is also controlled by a regulating authority like Insurance Authority (IA) in UAE. In context of business, insurance policies are of critical significance due to various risks faced by them (Ćurak et al., 2009).

The most important factors related to insurance policy are the cost of insurance and the risks involved. The cost of insurance is nothing but premium paid by the insured which is determined according to his risk profile. The risk is that component of insured for which he/ she needs protection. Being an insurer, he/ she have to face a pool of such risks. To be an owner of a profitable insurance business, he needs to hold a firm grip on these two components (Grossi, 2005).

To undertake this research and analyse these factors of insurance, I have chosen facets of life insurance, in general. Before I start with the details of these facets, I would like to brief the concept of underwriting business in insurance sector with some insights of an insurer’s role and a re- insurer’s role. 

Insurer

Insurer is referred to as an entity who promises to reimburse pre- set losses or damages if they occur due to specified risks. This entity enters into a contractual agreement with counterparty (known as insured or policyholder) to indemnify his contingent liabilities by subrogating the insured’s position. Generally, an insurer is an insurance company certified under the regulatory body of the country it is operating. Many a times, this insurer is also known as ‘underwriter’.

An insurer has to perform several functions for its clients as well as for society. Reason being a robust sector of insurance in an economy is a barometer for development and modernisation. One of the core functions of an insurer is to facilitate risk management advices by providing superior insurance products and timely reimbursement of claims. As an insurer, they act as a pool of risk and large amount of funds. Hence, they are in a position to assist business people and even society to recover from losses. They also act as one of the largest employers and institutional investors in a country.  Not only themselves, they have also encouraged business associates to invest in large volumes without caring about risk of loss. This accelerates an economy’s growth (Starc, 2014).

Re- insurer

Underwriting- the concept

The insurer or an insurance company which is discussed above is said to be a primary insurer. Such an insurer has to face unlimited risk. Hence, many times primary insurer also takes insurance from another insurance company to shift a part of its risk in return of premium. This other insurer is known as re- insurer. The process of taking re- insurance is also known as cession. The way to distinguish between an insurer and a re- insurer is that re- insurers generally have ‘Re’ word after their names.

Re-insurance helps in giving protection against natural disasters since primary insurer will not be able to reimburse such a large amount of claims alone. By shifting a part of their risk to re- insurer, they are able to benefit the entire society.

The role of a re- insurer can be broadly classified under five heads, brief of which is given below.

• Facultative re- insurance: When primary insurance is large enough that it cannot be borne by a single insurer, then it requires re- insurance.
• Treaty re- insurance: a re- insurance taken for a basket full of similar risk.
• Proportional re- insurance: A proportion of premium and risk is pre- determined to be shared by primary insurer and re- insurer.
• Non- proportional re- insurance: The level of risk mitigated by the re- insurer depends on the size of loss incurred.
• Retrocession re- insurance: It is a situation when a re- insurer takes re- insurance from other.

(Swartz, 2003) 

Underwriting an insurance business simply means to undertake a business of insurance by critical evaluation of risk components. An insurer employs some officials or a team of them to gauge the intensity of risks associated with the clients on boarding or potential clients. Underwriters are responsible to calculate the risk associated with the insured and probability of claims that can occur in future. They carry out a detailed analysis to ascertain such factors and advise clients as to the coverage they need to optimally mitigate their risk. They also assist insurers to determine the cost of insurance policy or what should be charged from the insured in return of the protection given. They also advise whether to accept a particular risk or not. His main role is to safeguard insurer’s interests from taking too much risk. They hold a crucial importance in the application process of a policy. They divide all the clients of a company into various classes depending on their risk. They also have the responsibility to check frauds and misrepresentation on the part of clients. Hence, they give a critical component of pricing of policies (Murtaugh et al., 1995). 

Life Insurance- Underwriting

Features of the client	Underwriter’s comments
Advanced cancers, serious heart issues, diabetes and other chronic illness	Table 16/P (400% surcharge)
	Table 9/I (225% surcharge)
Multiple illness with high considerations	Table 8/H (200% surcharge)
	Table 7/G (175% surcharge)
Epilepsy, recent cancer- like serious disease that is resolved	Table 6/F (150% surcharge)
	Table 5/E (125% surcharge)
Highly overweight, hazardous health habits, diabetes, serious heart disease	Table 4/D (100% surcharge)
	Table 3/C (75% surcharge)
Overweight, cancer like serious disease that has been recently resolved, other chronic illness of family or client	Table 2/B (50% surcharge)
	Table 1/A (25% surcharge)
Little inferences on client’s prior illness, family history- presence of chronic diseases, depression, anxiety, etc. are also present	Standard (average premium)
Obesity at a very mild stage, medical history of family says about possibility of death due to illness	Standard plus (standard rates of premium are charged)
Little inferences on family’s medical history, general medicinal consumption for blood pressure, cholesterol, etc.	Preferred (low premium)
Appropriate weight, appropriate height, client’s history of any ailment- Nil, family’s history of chronic diseases- Nil	Preferred plus (better than average risk, lower premiums are charged from this group)

(Otlowski et al., 2007)

Although life insurance products are mainly concerned with giving protection against the life of an insured, but today, many other policies are also provided by life insurers.

• Annuities insurance

Annuity insurance helps people to plan for their retirement. In such policies, insured or the policyholder has to pay some amount to insurer, may be in lump sum or may be in instalments, as desired by the insured. Interest is given on such payments. After stipulated period of time, insured will get regular income or a lump sum payment from these funds.

• Automobile insurance

Rationale of Life Insurance Business

It is also known as auto insurance. If an automobile or a vehicle meets with an accident, then an auto insurer reimburses the losses to the owner under such a policy. Automobile owners pay an annual premium to insurer to avail such benefit where he/ she can get most of the losses recovered like damage to vehicle, etc.

• Flood insurance

Such insurance gives protection against natural disasters. Often, cession is involved in such cases since the amount and number of claims will be large if contingent event occurs. Hence, these insurers give protection to the property owners against natural calamities like flood.

• Health insurance

As the name suggests, health insurance gives protection on insured’s health. It mitigates the expenses incurred in medical and surgical areas if any health issues are detected in the insured. Either they pay directly to care provider or they reimburse expenses to the insured. It is generally used in employee benefit packages.

• Typical life insurance

Life insurance protects financial losses of the family of insured that may occur due to his accidental death. Beneficiary of the insured is entitled to all the claims. Hence, this insurer helps in safeguarding the adverse impact of premature death of the insured. However, the insured has to pay regular insurance premium.

• Travel insurance

This insurance covers the contingent or uncertain expense related to a trip or while travelling. Such expenses may include expenses incurred due to trip cancellation, lost baggage, accidents or any other mis- happenings. They provide protection for international trips and as well as for in- border trips.

• Workmen’s compensation insurance

Generally employers use such insurance as an employee benefit scheme to attract best talent pool in their organizations. During the job, if an employee meets with an accident or incurs any other type of expenses which are not certain, then they are payable by the employer. And, employer will get these expense reimbursed under this insurance (Gerber, 1997). 

If we talk about risk components of a life insurance business, we come to know that underwriters owe a major responsibility to evaluate all the factors that may pose a risk to insurance business. Being a protection seller, life insurer is exposed to unlimited risk which has been transferred by the insured. Not only that, like any other business enterprise, life insurance is also exposed to market risk and credit risk (Kawatkar & Basu, 2013).

The International Actuarial Association has embarked 5 major risks associated with life insurance division. They are liquidity risk, operational risk, market risk, credit risk and underwriting risk. Few of them are discussed below.

• Underwriting risk

Product Range Offered By a Life Insurer

We have already discussed underwriting in detail. When an insurance company on- boards a client, i.e. an insurer enters into a contract with a policyholder, they carry a detailed research on the risk profile of the customer. This is what we call as underwriting. During this process, underwriters may make a mistake in analysis. It may also happen that a client misrepresents some facts and go undetected. These mistakes may lead to sever loss incurred by insurance companies. Such a risk of loss comes under the head of underwriting risk. If the hazards covered under the policy are not properly communicated or the underwriting process is not done effectively, then it may lead to serious consequences to the insurer (Kunreuther et al., 1995).

• Market risk

Whatever business sector we discuss, market is a key component of every trade and business. And, it is also evident that market never seems to be placid. It is always so volatile and dynamic that it has consequences on businesses. Life insurance business is a no exception. The risk an insurer faces due to fluctuations in market facets like interest rates, prices of securities, etc. is known as market risk.

Major components of market risk may include interest rate risk, equity risk, real estate risk, currency risk, basis points’ risk, re- investment risk, off balance sheet risk, etc. (Grosen & Jørgensen, 2002).

• Credit risk

If a counter party defaults to pay his/ her liabilities, then there is a risk to insurer to lose his stream of payments. Not only this, insurer has to incur some expenses even to send them legal summons to oblige to their duties. If there is a counter party default or a change in credit rating of counter party, then the risk faced by insurer is known as credit risk. Few examples may include business credit risk on the part of re- insurer, political risk, sovereignty risk or risk associated with non- performing assets (Lindskog & McNeil, 2003). 

To mitigate the above listed risk factors, a life insurer must have a look of the following step by step guide on risk management.

Step 1: Life insurers are generally big enterprises and they carry a big pool of risk. Hence, they have a critical need to have a separate risk management division in their business, which is responsible for mitigating the overall risk of business. Sometimes, this responsibility is given to senior managers. It should be kept in mind that they are risk takers and are also working as risk managers. These two conflicting roles may deter both the responsibilities. Hence, a separate risk management team is required.  

Step 2: Each department of a life insurance company must carefully analyse all the risk areas in depth and breadth that may affect their business adversely. A risk event is quite likely to trigger another risk event. So, all the cross- connections must be carefully identified.

Step 3: Next step is to classify those risks under different heads as discussed above. For example, operational risk will require different strategy from that of a market risk. Therefore, risk facets should be organised under correct heads to give a correct direction to mitigation efforts.

Step 4: Then is the stage to analyse the intensity of various types of risk that may have a severe financial impact and jotting down the results in quantitative terms.

Step5: Lastly, those results are to be used to mitigate the risk and increase profitability. These results will help in formulating alternative courses of action that may reduce the company’s exposure towards risk. 

Factors affecting price of insurance policy

There are several factors that affect the pricing of a life insurance policy. Few of them depend on risk concerned, while few are based on demographic details of the client. Mostly considered components are age, gender, health habits, clients’ health records, medical history of family, lifestyle, driving record of the client and bottom line of the company. Generally, all the life insurers consider all of these basic components to decide the price of their insurance contract, which is known as premium. These factors determine the risk level of a client and hence suggests, to which category of underwriting a client belongs. Few of these components which are considered as most critical are discussed below.

• Age

The most prominent and first question to be asked from a client is about the age. If the client is young, he is less likely to have chronic diseases and other health issues which are common at senior age. Besides that, the person is going to pay many premiums before there is a liability for the insurer to pay a claim, if arises. Hence, they are likely to pay low premium amounts. The case is vice versa for elderly people. Hence, it is recommended to the potential clients that they should take insurance at an early stage.

• Health habits

Most common malpractice towards health is smoking and drinking. In context of insurance, a person who consumes alcohol or is a smoker is put under the head of high risk clients. This makes that person liable to pay more money for the same protection as compared to that of a non- smoker or a non- alcoholic. The difference is such that smokers have to pay double of what a non- smoker is paying. Your current habits depend on what you did in the past.  So, an insurer is also keen to know about your past health records. They conduct a proper medical exam of a client in which all the health issues of the client are identified, whether they are related to past or present. A healthy person with clean health habits is likely to pay less and vice versa. Besides that, how much a person is concerned about his/ her life is also of utmost importance. If a client likes racing or trekking, then he/ she are likely to be a part of such things frequently and they are under a larger threat.

• Family medical history

One cannot do anything with hereditary problems. But they impact a person’s life. Insurers make sure that the family of the client do not have any history of chronic diseases. Only then, they will be allowed to pay lesser premium. Otherwise, as the intensity of such risk rises, the premium amount will rise in a direct relationship (Bacinello, 2003). 

Pricing is the only factor of business facets that is aimed at earning revenues, others incur costs. Hence, to maintain profitability, it must be critically analysed. No obtuse criteria should be used to determine premium of a policy. Premium rates should be determined after a rational statistical analysis of the losses that had occurred in past in the same risk area. The client’s past records should also be checked thoroughly. But sometimes, past records analysis do not give best forecasts. So, stochastic and catastrophe modelling should be used by actuaries.

Another important fact to be noted is that being a business enterprise, insurance company will set premiums to the level which can cover risk, loss, expenses and a good profit margin. Competition should not be avoided while determining pricing strategies. It should be kept at lower levels to attract customers. Hence, optimum level is to be decided to set premiums for all product ranges while complying with regulatory laws related to pricing of insurance. 

Conclusion

Life insurance is one of the most prominent classes of insurance business. It includes cession as well. A life insurer, being a consortium of unlimited risks, takes insurance from a rather big insurer to shift a part of his risk exposure to re- insurer. Life insurance is typically about selling protection against life of the insured. But this business also involves a variety of other policies ranging from health insurance to travel insurance. Having such a diversified product range also increases the insurer’s risk exposure like market risk, credit risk, operational risk and underwriting risk. An insurance company needs to have a separate risk management team for controlling the adverse impact of these risks on business’ profitability. Besides that, pricing or rate making of insurance is also a critical aspect of insurance business. Various components are needed to be evaluated carefully by an actuarial analyst to decide the most appropriate price for the policy. 

References

Bacinello, A.R., 2003. Pricing guaranteed life insurance participating policies with annual premiums and surrender option. North American Actuarial Journal, 7(3), pp.1-17.

Ćurak, M., Lončar, S. & Poposki, K., 2009. Insurance sector development and economic growth in transition countries. International Research Journal of Finance and Economics, 34(3), pp.29-41.

Gerber, H.U., 1997. Life insurance. Life Insurance Mathematics, pp.23-33.

Grosen, A. & Jørgensen, P.L., 2002. Life insurance liabilities at market value: an analysis of insolvency risk, bonus policy, and regulatory intervention rules in a barrier option framework. Journal of risk and insurance, 69(1), pp.63-91.

Grossi, P., 2005. Catastrophe modeling: a new approach to managing risk. Springer Science & Business Media, 25.

Kawatkar, S. & Basu, H., 2013. Risk Management & Solvency Assessment of Life insurance companies. Institute of Actuaries of India (IAI).

Kunreuther, H., Meszaros, J., Hogarth, R.M. & Spranca, M., 1995. Ambiguity and underwriter decision processes. Journal of Economic Behavior & Organization, 26(3), pp.337-52.

Lindskog, F. & McNeil, A.J., 2003. Common Poisson shock models: applications to insurance and credit risk modelling. Astin Bulletin, 33(02), pp.209-38.

Murtaugh, C.M., Kemper, P. & Spillman, B.C., 1995. Risky business: long-term care insurance underwriting. Inquiry.

Otlowski, M. et al., 2007. Investigating genetic discrimination in the Australian life insurance sector: the use of genetic test results in underwriting, 1999-2003. Journal of law and medicine, 14(3), pp.367-96.

Starc, A., 2014. insurer pricing and consumer welfare: Evidence from medigap. The RAND Journal of Economics, 45(1), pp.198-220.

Swartz, K., 2003. Reinsuring risk to increase access to health insurance. The American Economic Review, 93(2), pp.283-87.