What is pure risk rating in insurance ?

Dear chandra8159-ga;

Thank you for allowing me an opportunity to answer your interesting
question. Pure Risk is one of the many principles of Risk Management:


The INSWEB GLOSSARY OF INSURANCE TERMS defines ?Pure Risk? as:

?Uncertainty as to whether a loss will occur. Under a pure risk
situation, there is no possibility for gain. Contrast with Speculative
Risk.? [Sometimes referred to as ?dynamic risk?]

INSWEB GLOSSARY OF INSURANCE TERMS ? PURE RISK
http://www.insweb.com/learningcenter/glossary/general-p.htm


This same glossary defines the contrasting term ?Speculative Risk? as:

?Uncertainty as to whether a gain or loss will occur. An example would
be a business enterprise where there is a chance that the business
will make money or lose it. Speculative risks are not normally
insurable. Contrast with Pure Risk.?

INSWEB GLOSSARY OF INSURANCE TERMS ? SPECULATIVE RISK
http://www.insweb.com/learningcenter/glossary/general-s.htm


In other words, in a pure risk situation the only consideration is the
possibility of loss or no loss, but not making a profit, whereas
speculative risk entails a chance of gain as well as a chance of loss.
To put it even more simply, the best-case scenario of a pure risk
situation is that no threats to the assets occur, but profit is a
foregone non-issue entering into the policy. Pure risk is basically
the risk to an organization resulting from physical, environmental or
human threats to a business or part of that business. It might include
such things as fire, flood, earthquake, accidents, injuries,
industrial action, kidnapping, hostage taking, sabotage, plant
failure, theft and fraud just to name a few. As you might imagine, all
of these scenarios are likely to result in major losses and require
preventative action where necessary (or possible).

A fundamental set of risk management issues determine the EXISTENCE of
a pure risk (of which there are obviously several; among them,
personal, property, liability and pure risk arising from the actions
or inactions of others). To determine the LEVEL of risk a company will
need to know (among other things perhaps depending on the insurer) the
following:

Determination of policy and objectives
-- What kind of policy and coverage is needed?

Identification of loss exposures (?risks?)
-- What is likley to threaten the assets?

Evaluation of the exposure
-- What is the likliehood that one of these threats would actually occur?

Frequency
-- How often might (or do) threatening scenarios occur given the
enviormental, policial, geographic, social or economic history?

Severity
-- How bad can a potential loss be?

Expected value of loss
-- What are the assets worth and what would potential replacement or
repair costs be?

Critical, important, and unimportant loss exposures
-- What would the potential collateral damage be?

The firm?s ability and willingness to absorb loss
-- How much financial loss can the insured sustain (or be willing to
sustain) and still remain viable?

The responses to these issues and others perhaps will determine if
there is uncertainty as to whether a loss will occur and/or if there
is no possibility for gain. If so, then a pure risk situation is at
hand. If not, to such a degree, then perhaps a speculative risk
situation is at hand. Needless to say, premiums are adjusted
accordingly to compensate for the risk ratings and the levels of risk
involved.

The risk matrix differs somewhat from one company to another. The FAA
for example has it?s own ?Impact of Risk? management formula and ?Risk
Matrix? which can be seen here. These provide great examples of how
one company comes to it?s pure risk conslusions:

FAA SECURITY RISK MANAGEMENT GUIDE
http://fast.faa.gov/Riskmgmt/Secriskmgmt/docs/00-11-a.doc


I hope you find that my research exceeds your expectations. If you
have any questions about my research please post a clarification
request prior to rating the answer. Otherwise I welcome your rating
and your final comments and I look forward to working with you again
in the near future. Thank you for bringing your question to us.

Best regards;
Tutuzdad-ga ? Google Answers Researcher



INFORMATION SOURCES

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Request for Answer Clarification by chandra8159-ga on 28 Apr 2004 21:21 PDT

Dear Tutuzdad-ga,
Many thanks for your prompt answer. 
Conceptually, your research answer is clarity defined. 
Do also let me know the following :-
A) How does a pure risk rating methodology
define/establish/modify/help continue the relationship between (1)
Insurer & Insured, (2) Insurer and the Statutory/Regulatory Authority,
where appliable, (3) Insurer & Reinsurer and (4) help Insurer in his
risk/portfolio/trend analysis ?
B) How does this rating methodology help the Insurer get a better
understanding of the cost-benefit analysis vis-a-vis his Insured(s)
and the business ?
C) What are the alternate/other similar principles of Risk Management ?

Regards,
chandra8159-ga

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Clarification of Answer by tutuzdad-ga on 29 Apr 2004 09:08 PDT

How does a pure risk rating methodology define/establish/modify/help
continue the relationship between:

Insurer & Insured:

The very nature of a pure risk situation is constant in that it
changes as the assets of the insured change and as the political,
environmental, social and economic dynamics evolve over time. The
insurer must frequently identifying pure risk occurrences and
determining financial consequences of such losses and re-evaluate the
assets and needs of the insured and as such he becomes quite familiar
- perhaps more familiar  - with the needs and assets of the insured
than his client is. The relationship must be very real and fluid in
order to meet the needs of the client in much the same way as an
accountant or lawyer addresses their clients? needs on a personal and
regular basis. By virtue of this the insurer then becomes a real-time
player and advisor in the client?s enterprise or investment and the
pair?s common goal to protect and provide for the enterprise or
investment is not only necessary, but also quite effective.

Insurer and the Statutory/Regulatory Authority:

The regulatory authorities interact with insurers (and visa-versa),
not so much to ensure compliance but to ensure satisfaction,
consistency and fairness with clients. Among these conceptual
guarantees include loss prevention, loss reduction, and premium
reduction just to name a few. One of the purposes behind this pure
risk rating methodology is to provide a consistent means of fairly
evaluating each individual circumstance to the best possible benefit
to the insured.


Insurer & Reinsurer:

As with all insurance ventures there is an element of risk. This may
be magnified in the reinsurance business simply because the client?s
are not historically as well known (claims may have already been
incurred before the beginning of the reinsurance treaty). Reinsurers
though are well aware of these added risks and depend on insurers to
pass on these clients in order to benefit their own industry but the
relationship here is based primarily on good faith. The added risks
are calculated and include ?Underwriting risks? and ?Timing risks?.
Reinsurance is a proportional or non-proportional reinsurance treaty
with reduced underwriting risk, but with a possible timing risk. The
period of reinsurance is for several years, as the results between the
direct insurer and the reinsurer are balanced out over a longer time
period. Underwriting and timing risk are important criteria for
supervisory and tax authorities when deciding whether a Financial
Reinsurance contract is reinsurance, pure loan or investment. In the
USA, the insurance authorities require there to be a significant
underwriting risk and the possibility of a loss to the reinsurer in
order to acknowledge a Financial Reinsurance contract as reinsurance.

The Reinsurance Relationship?How Special Is It?
http://www.irmi.com/expert/articles/schiffer004.asp


Help Insurer in his risk/portfolio/trend analysis?

Obviously the pure risk rating scheme aids the insurer in mitigating
the potential pure risk losses for the client and provides a
consistent means (and perhaps a starting point) by/from which a
portfolio can be regularly and consistently evaluated, and if
necessary adjusted to accommodate new risks or to reduce premiums
(read: savings) due to dissolved, expired or removed risks. As with
all pure risk situations, the risk management and evaluation of the
portfolio is the fundamental basis from which the coverage and
policies originates and successfully protects the enterprise or
investment.

B) How does this rating methodology help the Insurer get a better
understanding of the cost-benefit analysis vis-a-vis his Insured(s)
and the business?

The rating methodology is a necessity in distinguishing risk and
uncertainty. The insurer must fully understand the variables in order
to successfully analyze the cost-benefit issues. The pure risk rating
provides a measure of certainty in an uncertain situation based on
historical outcomes or possibilities within each business or
investment. Ideally, an astute and informed insurer can plug in the
variables and have much greater insight into the potential risks,
which, in itself helps to manage the portfolio. These risks, when
weighed against the ability of the business can often help determine
the individual cost-benefit. I think you will find this article
informative:

COST-BENEFIT ANALYSIS IN PRACTICE AND THEORY RISK AND UNCERTAINTY
http://www.uea.ac.uk/dev/publink/cameron/cbarisk.pdf
http://www.uea.ac.uk/dev/publink/cameron/cbarisk.doc



C) What are the alternate/other similar principles of Risk Management?

It is impossible to make one statement that will fit all situations
equally with regard to the principles of risk management because each
situation and each entity differs in its requirements and views of the
issues. A Credit Union for example may differ from a Bank and a
Corporation may differ from a private enterprise, etc. In banking for
example the Risk Management Principles fall into three broad, and
often overlapping, categories of issues that are grouped together for
simplicity: Board and Management Oversight; Security Controls; and
Legal and Reputational Risk Management. Obviously this differs
significantly from one industry to another depending on the needs and
the threat assessment. Overall, the principles of risk management are
quite complex and volumes have been written by authors interested in a
variety of industries regarding the issue. I recommend this book to
fully study the matter in its entirety:

PRINCIPLES OF RISK MANAGEMENT
http://www.legallibraries.com/Principles_of_Risk_Management_and_Insurance_8th_Edition_0201785633.html




Other Related reading:

ALIBRIS
Fundamentals of Risk and Insurance
http://www.alibris.com/search/search.cfm?qwork=2496938&matches=33&qsort=r

I hope this adds significantly to what has already been discussed.

Regards;
Tutuzdad-ga

The answer may not be quite what the questioner was looking for. This
deals with the risk management concept of "pure risk" vs "speculative
risk". As outlined, the difference being that "pure risk" situations
only involve potential losses. Insurance is just ONE form of risk
management and traditionally has been limited to "pure risks" but has
been expanding in recent years to cover some types of speculative
risk.

The method of assessing (rating) risk for INSURANCE purposes must
necessarily deal with determining costs and pricing (to calculate
premiums). A broad outline of the risk management process for a
company ? which is what the answer provides ? is relevant but still
quite different. (PS: The reference used for this part of the answer
was forgotten. It is:
http://www.coba.unt.edu/firel/SYLLABI/2003%20Fall/INSU/4600%20Thornton.pdf
or http://216.239.57.104/search?q=cache:wRorxbh9nGIJ:www.coba.unt.edu/firel/SYLLABI/2003%2520Fall/INSU/4600%2520Thornton.pdf+insurance+4600+risk+management&hl=en
 )

There is also another issue here relating to what the questioner was
actually interested in. It may not have been the evaluation of "pure
risk" situations for insurance purposes but the quite different
insurance idea of setting premiums that proportionately match the
actual risk level. Currently, most insurance markets use premiums that
do not vary sufficiently to match all risk situations. This often
leads to potentially high risk clients either finding it hard to get
insurance or, alternatively, being subsidized by low risk clients.
COnversely, low risk clients generally pay significantly more than
their actual risk level requires in order to put a cap on premium
levels and allow high risk clients to be insured.

The practice of matching premiums to actual risks is known as "pure
risk rating." There are various advantages and disadvantages to
actually trying to implement such a policy. Here's one online excerpt
that discusses it:

"In its proposed changes to the insurance market, the Pauly group
takes a position almost opposite to that of the Heritage Foundation.
The Pauly group would allow insurers to charge any premiums they
wished to new policyholders, a practice known as pure risk rating.
Insurers would face limits, however, in the premium increases they
could charge people renewing their policies. To allow insurers this
scope, the federal government would have to preempt the growing number
of state laws that limit the variation in premiums charged to
individuals and small groups. Under such a system, insurers would have
little incentive to seek out low-risk applicants and avoid high-risk
applicants, since everyone could be charged premiums that reflected
their risk levels. Insurers would presumably use risk rating to a
greater extent than they do now, since any that did not do so could be
at a competitive disadvantage. This matching of premiums to risk
levels could require a substantial expenditure of resources, however.
If pure risk rating proved to be impractical, the proposal says that
limits on premiums could be instituted."

Ref: http://www.cbo.gov/showdoc.cfm?index=4896&sequence=0

Hopefully, this helps clarify the answer required. :)

I had actually found the latter quote early in my research and chose
not to use it since clearly a PROPOSAL about a pure risk rating
CONCEPT is of little use here.

Thanks anyway though;
tutuzdad-ga

Clearly, the primary question here is what "pure risk rating" is.
Given that understanding, the secondary questions relate to the
implications for an insurer of using this methodology. The final
question is what other alternatives to rating and pricing risk exist.

So far the answer hasn't defined what "pure risk rating" is (as
opposed to what "pure risks" are which is something altogether
different). The only methodology outlined is actually a course outline
of the "risk management process" not a pure risk rating methodology.
(Ref: http://www.coba.unt.edu/firel/SYLLABI/2003%20Fall/INSU/4600%20Thornton.pdf
)

My original comment tried to dispel the confusion and clarify this
distinction for both the person asking the question and the one
answering it. I've defined what "pure risk rating" is and explained
the critical principle that differentiates it from other methods of
rating and pricing risk. Once one understands this, the implications
of using such a principle and the alternatives become clear.

So, far from the definition and explanation of "pure risk rating" I've
offered being of little use, it is actually what you need to answer
the question. Moreover, if you review the follow-up questions you'll
see how this understanding of "pure risk rating" makes perfect sense
of the secondary questions (relating to the implications and
alternatives) and allows specific, useful answers to be given to them.

I have a background in finance and risk management, and will be happy
to provide further explanation if necessary.