What is Actuarial Risk?
Insurance policies offer protection to individuals and businesses from the financial repercussions of unfortunate events such as fires, theft, car accidents and natural disasters. But, the insurance provider needs to calculate the premiums that they charge their customers carefully or else they face the risk of bankruptcy.
Take flooding for example. If the premiums are set too low and catastrophe strikes, the insurance company might not have adequate funds to settle all claims and remain solvent. Everyone suffers in this situation. The property owners in the affected area who took out insurance face economic ruin and the insurer goes out of business.
This risk of paid premiums failing to cover the risk that the insurer is taking on is called actuarial risk, and in the insurance industry, it is the job of a person called an actuary to calculate premiums that cover the financial liability of any risk that a provider takes onto its books.
Actuaries work in many different areas of insurance, calculating premiums for a wide range of policies. By evaluating the actuarial risk of different insurance products, actuaries ensure that the businesses they work can cover the cost of any claims while still making a profit.
Real world applications of actuarial risk in the insurance industry include:
It’s prudent for parents with financial dependents to take out life cover to provide a death benefit in the unfortunate event they pass away prematurely. Actuaries in this field use mortality rates to determine the likelihood of this happening and set premiums accordingly.
Medical insurance covers the cost of private healthcare. The actuarial risk is determined by individual health history and product premiums are set accordingly. Younger, fitter individuals carry less risk and therefore enjoy lower payments.
Without insurance, homeowners face losing everything if their house burned down or was damaged by extreme weather. Actuaries working within property insurance look at geographical and meteorological factors such as risk of flooding or likelihood of hurricanes when making their calculations.
Actuarial risk is an offshoot of actuarial science and became a formal discipline from the late seventeenth century onwards as demand for life insurance rose. The key driver of its development was the long-term nature of these life insurance policies which could potentially pay out many years down the line. This led to the development of a concept known as “present value of a future sum.”
Today, this thinking is applied to many different areas of insurance. When customers agree to a policy, the cover is usually for a set, renewable period like 12 months for example, and either party can move on from the contract at the end of the term.
For the insurance provider, this arrangement allows them to reassess actuarial risk and adjust the premiums accordingly should anything change. A demonstrably safe driver might be rewarded with lower premiums when renewing their policy, while someone caught speeding would see the opposite effect and have to pay more.
Effective actuarial management is absolutely essential for the profitability of any insurance provider. Only by considering all possible outcomes and calculating actuarial risk accurately, can they set premiums that attract customers and cover potential payouts.