Understanding Actuarial Management: the actuarial control cycle, Bellis, el al.

Copyright 2003 The Institute of Actuaries of

Australia. Posted with permission. All rights reserved.

Chapter 5: Meeting Consumers’ Needs

by Anthony Asher

5.8 Product risks

Products carry risks for the issuer and the customer. By extension, there are also risks for the regulator and the
government. In this section, we shall consider some of the key risks for product issuers and how they can be managed.
A more detailed discussion on risk and risk management will be found in Chapter 6.
Customer protection is discussed in 5.10.

5.8.1 Insurance product risks

The risks to the insurer arise from three sources:
• model risk – that the insurer has misunderstood the nature of the claims process;
• parameter risk – that the parameters underlying the claim distributions have not been estimated correctly, or have
changed from when they were estimated;
• random variation in the number or amounts of claim.
In this subsection, we discuss some examples of how one or more of these sources can cause problems for the insurer.

Catastrophic correlations
A particular problem arises with the correlation of risks. Firstly, the risk models need to be very sophisticated as to
properly evaluate the probability of catastrophes. The correlations measured under normal circumstances do not
necessarily apply when rates of claim are high. Modern developments in extreme value theory are described in
Embrechts, Klüppelberg and Mikosch (1997).
Some sources of these catastrophic correlations include
• geographical concentration, eg property insurances concentrated in one city or region – which can be addressed by
ensuring a diverse portfolio and by using reinsurance;
• economic correlation, eg capital guaranteed products, which can be mitigated by limiting the amount of such
business written and, to some extent, by the use of financial insurance products, ie derivatives;
• other concentration of risk, eg major exposure to one industry or to one type of risk (such as asbestos), which can be
addressed by diversification and by a thorough understanding of the nature of the insurances being offered;
• legal risk – an adverse interpretation of the wording of one policy affects all similar policies, which suggests that
the insurer needs to be able to amend definitions and must avoid excessive exposure to one product.

Anti-selection
Insurance must appear to be of adequate value if people are to buy it, which may mean that they are more likely to take
it out if they are bad risks. For example, a person would not be inclined to buy a lifetime annuity if he or she only
expected to live for a few years. This may be because of ill health, or for less tangible reasons.1
An insurer needs to recognise the likelihood of anti-selection and manage the resultant risk of higher claims. This can
be done by underwriting (assessing the risk), limiting cover or withdrawing the availability of cover. For example, it is
understandable that general insurers will refuse to issue building insurance to someone whose property is near an
active bushfire.

1
As a young man, Sir Winston Churchill believed that he would live a short life. He lived to 90, despite a lifestyle which would be regarded by most
insurers as unhealthy.
One way to mitigate the effect of anti-selection is to limit the possibility of choice. This principle applies to group life
insurance, for example: the insurer will offer automatic acceptance limits below which all applications will be accepted
without medical evidence, provided that almost all of the members of the group (eg employees of the company) are in
the scheme.
Anti-selection will be incorporated into all insurance models, but is a problem if conditions change and the model no
longer applies. This can occur even with apparently innocuous changes like using a new sales channel to sell an old
product.

Propensity to claim
The models can also break down for other reasons and insurers can find themselves paying out in circumstances
which were not intended to be covered. These can be divided into three categories:
• product design flaws – contingencies allowed for under the policy may be far more common than expected or may
be interpreted by a court in ways which were not expected;2
• moral hazard – it may be relatively easy for the insured to claim more than he or she needs or is really entitled to.
For example, it is easy to prolong a disability income claim for a stress-related illness – and it is particularly
tempting to do so if the monthly benefit payment is high;
• non-disclosure or fraud – the insured may accidentally or deliberately conceal important information when applying
for insurance or make a fraudulent claim.
These risks can be managed by careful product design, active claims management and aggressive pursuit of suspected
frauds. However, these actions may damage the image of the insurer and cause it to lose too many sales. A delicate
balance is required.

Claims inflation
Some general insurance claims, particularly those involving liability, may take years to settle. These long tail claims
expose the issuer to the risk of claims inflation, ie the risk that the total amount of the claim will increase over time. A
major source of potential claims inflation is the legal system – court awards of damages, both in amount and in fact,
can have a huge impact on the likely cost of claims in a particular area. Asbestos liability claims are just one example.
Insurers can mitigate this risk by adding additional margins to their premiums, with reinsurance and by early
settlement of claims, although these solutions may be expensive. They can also simply avoid writing the business. For
example, many insurers avoided writing some types of liability insurance and professional indemnity insurance in
Australia following a significant deterioration in experience.

5.8.2 Savings product risks

For a product issuer, such as a life insurer, the two key risks associated with savings products are asset/liability risk and
expense risk.

Asset/liability risk
Asset/liability risk is the risk that the assets are insufficient to meet the liabilities. Consider, for example, a capital
guaranteed product, such as an investment account policy, backed by equities. If the stockmarket falls and policies are
surrendered (cashed in), there is a risk that there would be insufficient assets to meet these payments.
There are at least six ways to address this risk. Product issuers may combine elements of these approaches:
• overcharge for the guarantees provided and release part of the resultant surplus as additions to the policy benefits
– this is the traditional with-profit approach and is described in 5.8.3 and Chapter 18;

2
Re-read the own or similar occupation definition of disability (5.5.6) and consider whether it could be construed to mean that the insured is entitled to
claim if there is any single such occupation in which he or she is now unable to work.
• closely match the assets and liabilities – for example, investment-linked contracts define the liabilities in terms of
the assets, while it is possible to closely match expected annuity cash flows with a portfolio of fixed interest assets;
• support any guarantees with large amounts of capital – this is the approach required by many regulators if the
product issuer wishes to mismatch assets and liabilities. It is only sustainable if it is possible to charge a high
enough price for the guarantees to pay for tying up the capital;
• monitor the difference between assets and liabilities and ensure that any projected deficiency is funded – this is,
essentially, the approach taken in defined benefit superannuation funds;
• buy financial insurance – for example, use derivatives to reduce the effect of a decline in share prices;
• avoid or reduce the risks in the liabilities – many superannuation funds do not guarantee to increase pensions in
line with inflation, even if it is their intention to do so in practice.
If liabilities are indexed to inflation, the company may find it hard to find matching assets, particularly if there are few
or no indexed bonds available. Some people would argue that growth assets (shares and property) provide a natural hedge
against inflation but this is by no means certain. Even if it is true in the longer term, it does not appear to hold in the
short term. For a detailed discussion of the characteristics of different assets, refer to Chapter 12.
From the above discussion, it might appear that investment-linked contracts do not carry an asset/liability risk. This is
not quite true, because errors in unit pricing (which create a difference between the value of assets and the value of
liabilities) can have a major effect on profit.

Expense risk
Many financial services companies make most of their profit from the difference between fees and expenses, where fees
include the difference between interest earned on funds and interest paid or credited to customers’ accounts.
A large part of a financial institution’s cost base is likely to be fixed costs, meaning those costs which would not be
significantly affected by a change in the volume of business. This would include much of the cost of operating and
maintaining the company’s computer systems, for example. This means that one expense risk is that volumes of
business are considerably lower than planned; so that there is reduced fee income to cover these fixed costs.
Many products cost very much more to sell and issue than the initial revenue that they generate. The deficiency must
be recovered from future fee income. Therefore, another expense risk is that customers terminate contracts earlier than
expected.
Finally, the extent to which a company can make up for high expenses with high fees is constrained by competition.
Therefore, companies must manage the risk that operating practices are inefficient and unproductive, at least relative
to key competitors.

5.8.3 With-profit approaches

As we have discussed, one way to manage the risks in operating savings products is by overcharging and giving the
customer a share of the resultant profits. In fact, this approach is also available for insurance risks and is quite
commonly used for group insurance schemes.
The with-profit approach, also known as profit sharing and participation, shares the risks attached to the contract between
the insurer and its policyholders. This is appropriate if the costs the insurer would have to charge for volatility or
uncertainty about the future are high relative to the value placed on guarantees by policyholders. Profit sharing
arrangements can also be used to reduce moral hazard. For example, they are frequently applied in reinsurance
contracts so that both parties have an interest in the profitability of the business. Another example is the use of no-
claim bonuses in motor insurance, whereby policyholders with a better claims record pay lower premiums.
Profit sharing arrangements are discussed in more detail in Chapter 18.

5.8.4 The role of government

For the purposes of this chapter, the role of government relates to regulation of products; encouragement (or
otherwise) of insurance and savings; and consumer protection. The last of these is discussed in 5.10.
Product regulation
Governments can regulate all imaginable aspects of the design and operation of financial products. Possible areas of
regulation (other than those set out in 5.10) include:
• prescribing product design, eg requiring the inclusion of earthquake cover in buildings insurance policies;
• banning certain products;
• limiting discretion to underwrite, eg in New Zealand it is technically illegal to decline an application for
insurance, although insurers have the (challengeable) right to set a premium which would be unacceptable;
• disallowing or limiting discrimination, eg in many countries it is illegal to discriminate by race in setting premium
rates;
• limiting the range of premium rates, eg in some countries, private health insurers must maintain a set relativity in
premium rates based on the insured’s age of entry to private health insurance (lifetime community rating) and must
also obtain government approval for increases in the general level of premium rates.

Encouragement of insurance and savings

As we have seen, governments can compel people to take out certain forms of insurance or to set aside a certain
proportion of income for savings. They can also use the taxation and welfare systems to encourage or discourage
certain forms of insurance or savings.
There are economic and political arguments for and against both compulsion and encouragement. The fact remains
that many governments do both.
In Australia, for example, there is compulsory third party insurance and a compulsory employer contribution to
superannuation. Taxation and welfare systems have a broadly neutral effect on the attraction of voluntary insurance
products but superannuation attracts tax concessions and it is possible for many people to structure their retirement
income products to gain social security benefits including at least partial access to the age pension.

Exercise 5.8
(a) Insurance policies shift risks from people to institutions. Some of the risks
can be pooled with others to produce a series of claims that are relatively
smooth. Others put the institution at risk because the claims will be
correlated with each other. Which of the risks listed in 5.3 can be pooled
without putting the institution at risk? Do with-profit arrangements allow for
more pooling?
(b) It has been suggested that some risks are more difficult to pool because of
moral hazard. For each of the products mentioned in 5.5, list the moral
hazards to which the provider is exposed.
(c) Are no-claim bonuses a with-profit arrangement or do they simply use
previous claims experience to produce a more credible estimate of future
claims experience? Consider your answer in light of the fact that some
companies will give new policyholders a no-claim bonus.

Reference
Embrechts, P., Klüppelberg, C. & Mikosch, T. 1997, Modelling Extremal Events for Insurance and Finance, Springer-Verla.