A large, well-established home insurance company writes insurance policies to co

Question

A large, well-established home insurance company writes insurance policies to cover losses from fire, theft, and vandalism. In a recent financial review, managers discovered that company performance was lagging behind projections. They examined pricing and claims history in more detail and identified a group of about 10,000 customers whose claims far exceeded the collected premiums. Members of the actuarial group, whose compensation was partially tied to profitability of the policies they priced, were particularly frustrated. How would you recommend the insurer address this problem? Before continuing, first answer the following 3 questions to diagnose and solve the problem. Then, please elaborate in your answer to the question above. 1) Who is making the bad decision? 2) Do the actuaries have enough information to make a good decision? 3) Do the actuaries have the incentive to make a good decision?

Explanation / Answer

1) Who is making the bad decision?

Since the actuaries are responsible for deciding the premiums on the basis of the perceived risk of failures, it is the group of the actuaries who are taking the bad decisions. From the given limited information, it is clear that the particular group of insured people are more prone to claim. This should have been adjusted by the premiums they pay so that the overall cash flow from the policies could be made positive. But under the present scenario, the premium received is less than the claim due to the fallacies in predicting the probabilities of occurrence of the failures. THis happens to be the responsibilities of the actuary group.

2) Do the actuaries have enough information to make a good decision?

Note that this group of policyholders are more prone to failure than the other groups. Had it been the issue with the skill or competence of the actuaries, the company should have incurred an equal loss for all the groups of policyholders. But this is not the case. This makes clear that there must have been some issues particular to this group of policyholders and the reason could be a lack of information to the actuaries. The group of actuaries may not be having enough information to predict the failure rate and thus the adequate premium amount has not been designed.

3) Do the actuaries have the incentive to make a good decision?

As per the given information, the compensation of the actuaries is related partially to the profitability of the policies priced by them. This is an incentive to work prudently and effectively because if they don't do their job properly, they will lose out their payment partially as this is happening in this case. There is an incentive to perform and thus the actuaries are frustrated with the poor performance of the policy they have priced.

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How would you recommend the insurer to address the problem?

Here, the actuaries lack crucial information regarding this group of policyholders. Losses are likely related to either the fact that the company cannot detect the behavior after policy purchase (which is a moral hazard) or the company is unable to observe the intrinsic risks faced by potential customers (which is an adverse selection). One obvious solution is to gather more relevant information. But what type of information will be useful? The company may examine the 10,000 clients’ claims histories to find out any resemblance or trend in the type of incidents. For example, instead of focusing on the number of prior claims in deciding the price, the monetary value of the prior claims could be taken.
Thank you....

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