Actuarial Notes

Risk Classification (for All Practice Areas)

By Actuarial Standards Board · 2005 · ASOP No. 12

Study guides: Exam 5, Exam 8, Exam GH-101

The Actuarial Standards Board's guidance for actuaries designing, reviewing, or changing risk classification systems, in every practice area. This revised edition (Doc. No. 132), adopted in December 2005 and updated for deviation language effective May 1, 2011, replaced the original ASOP No. 12, Concerning Risk Classification, adopted in 1989. It is effective for professional services commenced on or after May 1, 2006.

On the syllabus

  • Exam 5 — objectives A4–A5; the standard as revised in 2005 and updated for deviation language in 2011.
  • Exam 8 — objective A2.
  • Exam GH-101 — Outcomes 2f.

Transmittal Memorandum

1 Purpose, Scope, Cross References, and Effective Date

  • 1.1 Purpose
  • 1.2 Scope
    • Applies to all actuaries designing, reviewing, or changing risk classification systems used with financial or personal security systems, including expert testimony, regulatory and legislative activities; a departure to comply with applicable law is dealt with under section 4.
  • 1.3 Cross References
  • 1.4 Effective Date

2 Definitions

  • 2.1 Advice
  • 2.2 Adverse Selection
    • Adverse Selection: actions taken by one party using risk characteristics or other information known to or suspected by that party that cause a financial disadvantage to the financial or personal security system (sometimes referred to as antiselection).
  • 2.3 Credibility
    • Credibility: a measure of the predictive value in a given application that the actuary attaches to a particular body of data.
  • 2.4 Financial or Personal Security System
  • 2.5 Homogeneity
    • Homogeneity: the degree to which the expected outcomes within a risk class have comparable value.
  • 2.6 Practical
  • 2.7 Risk(s)
  • 2.8 Risk Characteristics
  • 2.9 Risk Class
  • 2.10 Risk Classification System
    • A risk classification system assigns risks to groups based upon the expected cost or benefit of the coverage or services provided.

3 Analysis of Issues and Recommended Practices

  • 3.1 Introduction
  • 3.2 Considerations in the Selection of Risk Characteristics
    • 3.2.1 Relationship of Risk Characteristics and Expected Outcomes
      • A relationship between a risk characteristic and an expected outcome is demonstrated if the variation in actual or reasonably anticipated experience correlates to it; rates are equitable if differences in rates reflect material differences in expected cost.
    • 3.2.2 Causality
      • The actuary need not establish a cause and effect relationship between a risk characteristic and the expected outcome in order to use it.
    • 3.2.3 Objectivity
    • 3.2.4 Practicality
    • 3.2.5 Applicable Law
    • 3.2.6 Industry Practices
    • 3.2.7 Business Practices
  • 3.3 Considerations in Establishing Risk Classes
    • 3.3.1 Intended Use
      • Different sets of risk classes may suit different purposes — when setting reserves, the actuary may subdivide or combine some of the classes used as a basis for rates.
    • 3.3.2 Actuarial Considerations
      • Adverse selection, credibility and practicality: when the data are not sufficient for credible inferences, the actuary balances predictability against homogeneity.
    • 3.3.3 Other Considerations
    • 3.3.4 Reasonableness of Results
  • 3.4 Testing the Risk Classification System
    • On establishing the system and on later review, the actuary should, if appropriate, test the long-term viability of the financial or personal security system.
    • 3.4.1 Effect of Adverse Selection
    • 3.4.2 Risk Classes Used for Testing
    • 3.4.3 Effect of Changes
    • 3.4.4 Quantitative Analyses
  • 3.5 Reliance on Data or Other Information Supplied by Others
  • 3.6 Documentation

4 Communications and Disclosures

  • 4.1 Communications and Disclosures
    • Disclose any known significant impact of limitations due to applicable law, departures from industry practices, limitations created by business practices, a determination that experience indicates a need for change, and expected material effects of adverse selection — with the ASOP No. 41 deviation disclosures and any recommendations to mitigate adverse selection.

Appendix 1 Background and Current Practices

  • Background
    • Risk classification is generally used to treat participants with similar risk characteristics consistently, to permit economic incentives to operate and so encourage widespread availability of coverage, and to protect the soundness of the system.
  • Current Practices

Appendix 2 Comments on the Exposure Draft and Responses

Related readings

  • ASOP 23 - Data Quality (ASB - 2016) — ASOP No. 23, Data Quality, to which §3.5 refers for reliance on data supplied by others and §4.1 for communications

Sources