RISK CLASSIFICATION MONOGRAPH
characteristics, such as an individual’s personal driving record or additional detail regarding the reasons for a low credit rating, may facilitate a more accurate assessment of such special cases. 2.
Absence of Ambiguity
In an effective risk classification system, the set of risk classes is collectively exhaustive and mutually exclusive so that, once a factual assessment of an individual risk has been made, as little ambiguity as possible exists concerning the class to which that risk belongs. 3.
Homogeneity and Credibility
The homogeneity of risk classes was discussed in Section III.C above. As was noted there, a refinement of a risk classification system improves the homogeneity of the risk classification system. For risk classes based on the risk characteristic “occupation,” for example, replacing “nurse” with a listing of nursing specialties with detailed descriptions could result in increased homogeneity. If risk classes are insufficiently homogeneous, adverse selection can occur. But, as was also noted, increasing the number of risk classes may decrease the credibility of estimates based on data obtained by observing the results for the classes over time. The credibility of the data accumulated for nurses as a group, for example, will be greater than the credibility of the data for each listed specialty. Achieving a balance between homogeneity and credibility is a major consideration in the establishment of risk classes. If risk classes are homogeneous, it does not follow that the risks assigned to the class will have identical or even similar actual outcomes. Homogeneity of risk classes implies that the risks in each class have similar risk probabilities. If the data gathered through observation of the outcomes is fully credible, the average frequency of past occurrences will be a good predictor of the average frequency of future occurrences. The individual occurrences will be distributed around the average, with some individual results being more favorable and some less favorable than the average. Individual outcomes are not predictable. Altering the number of risk classes alters the balance between homogeneity and credibility. Both are important considerations. Setting the balance requires taking into account the purpose of the security system. There is no one statistically correct risk classification system for a given set of risks. In the final analysis, the risk classification system adopted will reflect the relative importance ascribed to each of these considerations. The decision as to the proper balance will, in turn, be influenced by the nature of the risks, the goals of the security system and the
American Academy of Actuaries
51
www.actuary.org