Have you ever wondered why life insurance companies ask so many questions when you sign up for a new insurance policy ? Why do they care whether you smoke or not ? And can they learn anything from your weight and height?
Insurers need this information because there are really only two factors which determine the premium you will pay on your life or health policy. These concepts are pooling and underwriting.
In supplying this information you're helping the insurer 'grade' you. It's a bit like being a fruit on a 'sorting' conveyer belt. Some fruit gets labelled A1 and packed for export, some gets packed for local distribution, and the balance gets canned or juiced. An experienced fruit sorter uses a set of pre-determined standards to decide where each fruit belongs. And with enough experience she'll hardly ever make a mistake.
Deciding where you'll swim...
When insurance companies receive your life policy applications they need to establish what risk 'pool' you belong to. Dr Christoph Nabholz, Head of Business Development at Swiss Re Centre for Global Dialogue summarises the process as follows: "Pooling is the process of grouping similar risks and charging the same premium rate for each person in the pool." The best example of such grouped risk is the standerd age band applied to certain life insurance products, quelities which determine where you get to swim include health and genetic history.
Premium matters
The difference between a fruit sorter and a life assurance company is that insurers have huge volumes of data to assess risks and apply appropriate premiums. Once the criteria for a particular risk pool have been established the insurer can set about calculating an appropriate premium for the collective risk in each pool.
It sounds quite simple; but nothing in insurance ever is. In fact two of the critical aspects to managing the risk pool are contradictory. On the one hand the insurance actuary wants to limit the introduction of additional risk to the pool while on the other he wants the pool to be as large as possible!
Management of each risk pool is vital to an insurance companies' survival. The reason is that insurance margins are generally low. If "marketing, administration, reinsurance cover and taxation" costs are added to the modelled claim events, the insurer is usually running very close to break-even. Any unexpected spike in claims will wipe out initial profits and result in spiralling premiums. And that's where underwriting comes in.
Underwriting
"Individual life underwriting," says Nabholz, "describes the process of judging whether an individual falls within a particular pool and how any extra risk might be handled." A major motivation for underwriting is to avoid the cross-subsidisation process. An example best illustrates how this situation develops. Imagine a life insurance policy is made available to both heart attack victims and healthy individuals at the same price. This effectively means that life insurance is cheap for the risky individual (who is then encouraged to take life cover) and expensive for the healthy.
Medical schemes face similar problems when forced to provide equal benefits to young and old. Young individuals feel comprehensive cover is too expensive and take out cheap hospital plans. The result is an increase in the age of members with comprehensive cover followed by an inevitable increase in claims and medical aid premiums.
And that's why regulatory meddling and risk profiling don't make good bedfellows.
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