Technical Pricing of Insurance - Business Standard
04 November, 2009
The general perception about the insurance industry is by and large flawed in that, they sell policies and make substantial profits like any other product off the counter. The reality is far more complex and the pricing of products is no easy task but a long-drawn exercise involving market analysis, past claims history and a collaborative effort amongst underwriters, actuaries and the marketing teams. The post detarrification era has been witness to plunging margins due to the huge discounts offered among competitors. Making profits in commercial as well personal lines insurance has increasingly become a difficult task.
Many insurance companies are now altering their marketing strategy by saying no to irrational competition and developing the competencies to maintain a balance between sustainable retention and value for money for the consumer. Insurance companies are seeking to move towards a technical pricing of risks. This, in simple terms, means that the insured pay premiums that are appropriately priced to match their likelihood of making a claim. This methodology of risk pricing is economically and socially important due to a number of reasons. Firstly, the risk pricing of insurance products makes it economically feasible to provide insurance cover to a much wider segments of the population.
When we price insurance according to risk, we make it possible for many low risk people to buy insurance than in the current scenario where they are forced to pay higher premiums in order to subsidize the premiums of more risk-prone individuals.
There is another interesting defense of applying the risk pricing methodology. For instance, if you consider the current scenario where insurance reduces the cost of automobile accidents and having insurance for an accident could encourage people to engage in riskier driving than they might have engaged in if they did not have insurance. Riskier driving could result in higher probability of the occurrence of an accident and risk pricing could reduce this hazard by allowing insurers to charge a premium that appropriately matches the risk being insured. Therefore, higher the risk, the higher would be the premium and this could lead to less risky behavior from the policyholder.
The inability of insurers to adjust a premium according to risk results in undercharging some customers and over charging some others. The customers who are being over charged shift to other insurance companies which offer a lower price, leaving the under charged customers with the current insurance company. This impacts the profitability of the current company and consequently lower profitability may often result in higher premiums, which may not be risk true. This is a vicious cycle in which neither the insurance company nor the customers benefit.
In the current insurance industry scenario, where all insurers are under pressure to improve their underwriting profitability, fundamental insurance principles like risk differentiation becomes an important tool to decide on the appropriate premium to be charged for a risk. This would lead to a reduction in cross subsidization and even loss of insurance cover for some unfortunate citizens.
In the final analysis, it is imperative that the insurance companies use the regulatory freedom, given to them by Irda to exercise their essential tasks of risk differentiation and risk classification to achieve a socially and economically beneficial scenario for all stake holders.