A little more detail_1

Modern insurance — although based on a very simple principle — is an extremely sophisticated risk-transfer mechanism that comes in many forms. Insurance has developed over many centuries. It started with crude marine insurance y which merchants agreed to make contributions to those who had suffered a loss after it had taken place. The problem with this system was that it did not fully transfer the uncertainty; the merchants never knew how much they might have to pay. Modern insurance has, therefore, developed so that policyholders know upfront the full extent of their required share of losses (ie their premium).

The value of this certainty to individuals, society and the economy is huge (see p13). Indeed, it is fair to say that modern society could not function without insurance. Many daily activities that we take for granted involve some risk of loss and might not be performed were it not for insurance.

In general, a large number of similar risks are required for insurance to be economic. Insurance for unique risks is nevertheless possible, but it can be prohibitively expensive. There are certain prerequisites that have to be fulfilled for something to be insurable (see p10) and regulation has a crucial role to play here (see p17).

How do insurers assess a risk?
The process by which the risk of the policyholder is assessed is called underwriting. The premium and terms of the insurance contract are based on the insurer’s assessment of the level of the risk. Each individual or entity wishing to be insured brings a different level of risk to the insurer; a timber house is at greater risk of fire than one made of brick, for example. To make sure that each insured pays a fair premium, insurers use a series of rating factors to assign the level of risk. In general, the higher the risk, the higher the premium.

The underwriting process will differ from insurer to insurer, depending — for example — on the level of risk they are prepared to accept. Terms and conditions may be applied to policies to further homogenise the risks by removing particular events or circumstances under which claims would be paid. Terms and conditions are also important to help reduce the impacts of moral hazard and adverse selection (see p8).

Risk assessment is economically efficient, as it allows the price of the insurance to reflect the cost of providing it. While underwriting must be consistent with the law, any restriction of the freedom of insurers to underwrite and price according to the risks they are accepting will most likely lead to higher insurance prices and therefore lower availability, affordability and choice for consumers. The role of regulation here is explained in more detail later (see p16).

Does risk-based pricing have any other advantages?
Yes, risk-based pricing encourages insurers to innovate so that they can compete more effectively both on price and on products. Developing new, or more sophisticated, rating factors can enable insurers to offer more competitive rates, or to offer insurance for risks that were previously uninsurable. As insurers learn more about the diagnosis and treatment of certain illnesses, for example, cover can be offered for diseases that were previously uninsurable. Likewise, better modelling of flood risk can make previously uninsurable homes insurable. Risk-based pricing can also influence positively the behaviour of individuals (see p14 on the promotion of safe practices).