Methods of Risk Classification
Risk can be classified through following two methods in Insurance.
1. Judgement or Assessment method
In Judgement or Assessment method, the insurer studies all the features of the life to be insured based on the material information placed before him, draws a mental picture and brings into play all his knowledge and experience to determine terms of acceptance of the risk. The company has to depend upon the combined judgement of those in the medical, actuarial, and other departments who are qualified for this work.
The judgement method functions effectively when there is only one unfavourable factor to consider or where the decision is simply either to accept the application at standard rates or reject it entirely. Where multiple factors are involved or a proper substandard classification needed, this method is not found useful.
It also requires the use of highly skilled personnel for proper risk appraisal. The method also cannot ensure uniformity in the decisions by the same persons at the same or different times. Besides it is a time consuming process.
To overcome the weaknesses of this method, life insurance companies evolved the other method viz., Numerical Rating Method.
2. Numerical Rating method
Under this method, each factor of insurability is compared with medico actuarially prepared standard and deviations are measured in terms of extra debit or credit points. Adverse features attract debit points while favorable ones are given credit points. The sum total of debit ratings of all factors give the extra mortality of a particular life (risk).
Thereafter total extra mortality ratings are matched with standard charts and converted into monetary value which is called the extra premium. It is on the basis of numerical ratings that underwriter classifies the risk and decides the terms of acceptance of risks.
The following illustration will make the concept of numerical rating method more clearer:
A clerk aged 35 applies for a life insurance policy. As per information available, his height is 5 feet 9 inches and weight 205 pounds; family history is better than average; habits — good; personal history shows slightly elevated blood pressure.
As per the company’s table, the basic rating is 125 as he is overweight i.e., the overweight in such cases is expected to result in mortality that equals 125 percent of normal.
For elevated blood pressure, the extra debit point is +50. On the other hand, a credit is allowed for a favorable family history viz. 10. The net rating is worked out as under:
Based on rating done as above, the insurance company, classifies the risk as belonging to a particular category. The ratings obtained by this method range from a low of 75 to a high of 500.
- The ratings that fall between 75 and 125 are classified as standard risk.
- The ratings above 125 but below 500 are classified as sub-standard risk.
- The ratings more than 500 are classified as un insurable risk.
Merits of Numerical Rating Method
1. Numerical rating method enables direct usage of the results of various Medico-Actuarial investigations.
2. Numerical rating method reduces the operation of subjective factor in underwriting risks to the minimum.
3. Numerical rating method helps the insurers to evolve a uniform underwriting procedure and classify risk in identical groups.
4. Numerical rating method facilitates building up of new statistics on the basis of which the basic ratings are continuously reviewed in the light of up to date trends in insurance medicine.
5. Numerical rating method ensures that no factor is overlooked.
6. Numerical rating method makes possible uniform assessment either by several underwriters or the same underwriter at different times.
7. Numerical rating method enables business to be handled with greater speed.
Limitations of Numerical Rating Method
While the numerical rating method has all the above advantages, it is not without limitations. One of the limitations that it suffers from is that it cannot be extended to assess the occupational hazard and the extra risk resulting from certain standard impairments such as the following:
1. Defects and deformities such as amputated arms and legs, partial or total blindness and deafness, cleft palate, club foot, etc.
2. Standard impairments such as hydrocele, bleeding piles, Caesarean section, etc.
In such cases, the total extra would be obtained by adding the extra premium wherever applicable for the health/physical impairment as per the numerical rating method to the extra premium for occupation and / or other standard impairment if any.
Methods of Treating Sub-Standard Risks
Sub-standard risks are of three types viz. Constant extra risks, Increasing Extra Risks and Decreasing Extra Risks. Such classification helps the insurance company to assess extra premium which is to be charged from the person with sub-standard risks.
The substandard risks may be dealt with in following ways by the insurance companies:
- Increase in premium
- Decrease in death benefits
- Change in the class and /or period of assurance
- Postponement of consideration of risk
Each of the above methods is discussed in detail below:
1. Increase in premium
Premium can be increased in following ways:
1. Rating up age
Under this method, the life to be assured is assumed to be so many years older (say 5 to 10 years) than the real age and the premium for the higher age is charged.
This method is not generally used in cases of decreasing risk type, because the mortality curves of two lives with a difference of say 5 years draw away from one another as the years pass by. In cases of decreasing type of risk, this would unduly penalize the life assured.
2. Flat Extra premium
Under this method a flat annual extra premium is charged. This method should be used in cases of increasing type of risk. But in practice, it is usual to charge a flat extra when the extra risk is constant as in the case of hazardous occupations, or certain types of physical defects or deformities or impairments like pyorrhoea, Hernea, Hydrocel, etc.
In respect of occupation hazards like aviation, it is unsound to charge a flat extra premium throughout the term of insurance, since this is insufficient to cover the heavy risk in the early years. Hence, a heavier extra premium is charged for the initial period when risk is considered to be very heavy and it is removed thereafter.
3. Extra-percentage table
Under this method, a special mortality table is developed for each sub-standard classification, reflecting the experience of each and a set of gross-premium rates is computed for the classification.
2. Decrease in Death Benefits
The death benefits may be reduced to compensate for sub-standard risks in following ways:
This is a contingent debt on the policy. Consequently, in respect of a policy where the lien is operative, if the life assured dies at any particular time when the lien is operative, the amount payable under the policy would be reduced by the outstanding lien. The most common form of this is the decreasing lien reducing by level annual amounts.
For example, a decreasing lien of Rs. 500’per Rs. 1,000 sum assured for 10 years would mean that the amount payable on death would be reduced by Rs. 500 per Rs. 1,000 sum assured if death occurs in the first year of the policy, by Rs. 450 if death occurs in the second year and so on. At the end of 10 years, the lien would become nil. Alternatively, a lien may be constant for the first few years. This method of lien is most suitable – when the extra risk is of a decreasing type like an underweight youth.
An extra premium in such cases is not suitable because the total extra premium collected would not be sufficient to meet the additional death claims.
2. Restrictive clause
Instead of charging an extra premium, a particular application involving extra hazard may be accepted with a restrictive clause. Such restriction limits death benefit in certain circumstances. In case death occurs due to a specified extra hazard, the policy may provide payment on a reduced basis, say, return of premiums.
For example, the “First pregnancy” clause provides that if death is due to causes connected with the first pregnancy, premiums paid are refunded. Usually, such clause is applied in case of female lives who have not undergone a normal full time confinement and who do not wish to pay any extra premium to cover the special risk.
3. Change in the class and period of Assurance
In case of certain increasing type of extra risks, it is possible to recommend a short term policy than what was applied for. By reducing the term, that period of the life in which the risk is heaviest would be shut out from the cover. For example, middle aged over weights may be offered a policy which may mature earlier than say age 60.
This is not a modification of the terms asked for by the applicant. When the initial risk is so heavy that there is little hope of offering immediate assurance, this method is followed. Usually consideration of the application can be postponed for 6 months, 1 year or 2 years. This is because later on, if the immediate danger period is survived, health will improve so that acceptance may be possible, perhaps at usual rates. This also arises sometimes during the period of convalescence after an illness or operation or in cases of heavy under weights.
- Methods of Risk Classification
- Methods of Treating Sub-Standard Risks