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Unformatted text preview: Insurance Pricing • Risk pooling principles tell us: E(X) = E(X) Var(X) gets small as more people added to pool • So, with large numbers of identical and independent risks, insurer’s best guess of average claim payout per policy is E(X) • For this reason, insurance pricing starts with E(X) and builds on that number Insurance Premiums (Pricing) – Determinants of Insurance Premium • Expected Claim Costs • Timing of Claims Payments • Expected Investment Income • Administrative Costs • Profit Loading Pricing Example $100,000 with prob. 0.02 Loss = $20,000 with prob. 0.08 $0 with prob. 0.90 Find Competitive Insurance Premium if: • Policy provides full coverage of losses • Underwriting expenses = 20% of expected loss (undiscounted) • Claims are paid at the end of one year • Interest rate (discount rate) = 8% • Claim processing costs = $5,000 per claim • Profit = 5% of expected loss (undiscounted) Pricing Example Expected claims = $3,600 • PV of expected claims = $3600/1.08 Underwriting costs + profit = (0.20+0.05)($3,600) = $900 Expected claim processing costs = ($5,000)(0.10) = $500 • PV of expected claim processing costs = $500/1.08 Premium = ($3600+$500)/1.08 + $900 = $4,696 Determining Expected Claims Costs • In class examples, we have assumed that the insurer knows the probability distribution of losses for each individual policy holder • Insurer sells policies to a large number of buyers with the same (known) probability distribution of losses • In practice: • Insurers apply statistical techniques to large loss databases to predict E(F), E(S) and outliers based on observed characteristics of policyholders • Group consumers into “risk pools” with similar predicted values of expected loss...
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This note was uploaded on 05/07/2009 for the course PAM 4230 taught by Professor Tennyson during the Spring '07 term at Cornell.
 Spring '07
 TENNYSON

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