RISK CLASSIFICATION MONOGRAPH
When an effective risk classification system has been established, the coverage provider is better able to estimate risk probabilities for each risk class and thus the expected costs for risks in the class. By facilitating the estimation of expected costs of coverage, a risk classification system helps the security system to satisfy the three success criteria identified above as necessary, although not necessarily sufficient, for the success of the security system. An effective risk classification system, therefore, can play a critical role in the success of a security system. To be effective, a risk classification system must be carefully designed. Design flaws that seem innocuous at first can become unmanageable over time. In addition, the design must be reviewed and necessary changes must be made to reflect the inevitable changes in the nature of the risks and the circumstances in which the security system operates. This is true for both voluntary and compulsory systems and for both competitive and singlepayer systems. Improper design has proven over time to lead to the failure of both small privately-run systems and large governmental systems. Both the initial design and the maintenance of the risk classification system depend on the type of security system and the system’s goals, which in turn could be affected by organizational, social and legal considerations. It is usually desirable that a risk characteristic be objective and measurable and that potential participants cannot easily manipulate or control the value of the characteristic. In cases in which a specific quality of the risk subject can be shown to be correlated to a risk probability, the quality provides sufficient useful information for it to be used as a risk characteristic. The existence of a persistent correlation often prompts a search for an explanation that takes the form “A causes B.� A cause and effect explanation sometimes is readily apparent. This is true, for example, for the correlation of a prior heart attack with shortened longevity. Sometimes, however, a statistical correlation may be wellestablished, but a cause and effect explanation may not be evident. In such cases, introduction of additional risk characteristics might facilitate a more accurate assessment of the relevant risk probabilities.6 Other considerations in establishing risk classes include absence of ambiguity, proper balance between homogeneity and credibility, avoidance of overly large discontinuities and considerations of expense and practicality. Due to the dynamic nature of risk, changes might be required from time to time to maintain the effectiveness of the risk classification system. In some cases, simply changing the prices or other terms and conditions applicable to the various risk classes may suffice. In other cases, the risk classes themselves may need to be updated. Different considerations apply if changes are made to risk classes only for new participants than if 6
This point will be discussed more fully, and examples will be given, in Section IV.C.1.c below.
American Academy of Actuaries
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