March 15th, 2016

Rates That Reflect Risk

Posted at 1:00 AM ET

Insurance marketplaces that are stable and viable in the long-term succeed when insurers offer policies and coverages at premium rates that are appropriate and are subject to the requirements and standards of not being excessive, inadequate or unfairly discriminatory. At the same time, premium rates should be balanced and take past and prospective loss and expense experience into consideration. When these factors are not successfully accomplished, a public sector solution often emerges.

Looking beyond the expected loss component of rate, private insurers set risk loads with consideration to both the amount of downside risk as well as the correlation of this risk across all policies. More specifically, for two policies with the same expected loss, but one having a maximum loss ten times greater than the other, one would expect to pay more for the policy with the greater downside. For two policies with equal expected loss and maximum downside loss, the insurance company will charge more for the policy that correlates with other policies that produce loss at the same time, as these policies have greater probability of pressuring both investor returns and insurer financial stability. The rate-setting process determines the risk preferences perceived by insureds - riskier choices command higher premium rates. While actuarially fair, the process may create outcomes deemed socially unfair and worthy of subsidization. Irresponsible subsidization can result in inequities and threatens the success of insurance mechanisms.

Rate setting outcomes for public sector solutions may be significantly complicated by social considerations and discussions around disparate outcomes. If rates do not appropriately reflect loss costs, risk loads and expenses, consumers’ perceptions of the risk they carry may be distorted. When the subsidization is understood, supported and stable, subsidies can help provide balance and in turn play a role in long-term solutions. Unfortunately, sometimes subsidized prices entice new consumers to engage in sub-optimal behaviors, increasing the size of the subsidy needed and compounding the risk mitigation challenge. The size of this increased subsidy is sometimes not recognized for years, until there is a demand to pay that may be frequently greater than any accumulated reserves, if specifically funded at all.

When the subsidy is no longer supported that may signal the need for a transition period to unsubsidized rates or privatization, such as regulated rate increase caps to allow consumers to adjust. Also, hazard mitigation activities might be instituted, applying to a specific home/policy where the structure is physically elevated to reduce flooding or community/nationwide initiatives such as rebuilding flood walls or engineering flood solutions.

Destruction caused by catastrophes is often exacerbated by inadequate construction practices and questionable land use planning decisions in both emerging and developed economies. Following the 2004 Indian Ocean earthquake and tsunami, The Hyogo Framework for Action identified the need to incorporate disaster risk reduction in reconstruction efforts following disasters (1). The United Nations cites this event as the first to draw global attention to the issue.

Community resiliency is a recognized and key theme around the issue of disaster risk management, and “building back better” is a means to address the poor decisions of the past. Unfortunately, communities often find that they lack the financial resources to proceed, and as a result, ambitious reconstruction projects lose momentum as communities revert to the status quo.

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1. World Conference for Disaster Reduction, Kobe, Hyogo, Japan, January, 2005.

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